[00:01:51] Intro: You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

[00:02:11] Clay Finck: All right. Like I said at the top, today, I’ll be continuing my review of Gautam Baid’s book, The Joys of Compounding. Jumping right into chapter seven, it’s one of the shorter chapters in the book, covering the virtues of philanthropy and good karma. Warren Buffett says that if you are in the luckiest 1% of humanity, you owe it to the rest of humanity to think about the other 99%. Last week I discussed the importance of humility, and it really takes humility to not get so caught up in the material things and understanding the importance of giving back to others. Gautam writes, we are able to create wealth only with the help of others, so giving back also needs to be part of our planning.

[00:02:52] Clay Finck: If you’re fortunate to have earned or inherited more than you need to live out your personal definition of a good life, you will have the opportunity and the responsibility to decide where and how to direct the surplus funds. Most individuals in this situation focus on two kinds of beneficiaries, both of which can be deeply meaningful, family members and philanthropic organizations such as schools, colleges, hospitals, and religious organizations.

[00:03:18] Clay Finck: The latter or giving back to society is a highly noble activity. You can derive a great deal of happiness and personal fulfillment from the act of making a positive difference in other people’s lives. This reminds me that starting about a year ago, Stig let all of us know at TIP, that 1% of profits will be donated to charity.

[00:03:37] Clay Finck: So, by listening to this podcast, you’re actually helping contribute to various charitable organizations all over the world. The way he does it is that he takes 1% of profits and divides it up amongst all of the TIP employees that are then sent to selected charities, which I think is just something that’s really cool and something that’s really unique to be a part of.

[00:03:57] Clay Finck: A couple more quotes from Gautam here. The meaning you give to wealth says a lot about you and the way you will be seen and remembered. And as the adage goes, you can’t take your wealth with you after you pass. Givers derive great happiness from converting their financial resources into actions and values they truly care about.

[00:04:16] Clay Finck: Warren Buffett is pretty well known for committing the vast majority of his wealth to charity. One philanthropist that Buffett looked up to was John D. Rockefeller. Rockefeller started regularly contributing to charity when he got his first job at age 16. So, it’s an important reminder that it’s never too early to start giving in helping others no matter how small you do.

[00:04:37] Clay Finck: Gautam explains that to make a difference in someone’s life, you don’t have to be brilliant, rich, or perfect. You just have to care. It doesn’t matter where you are or if you have a little to give or a lot to give. Something happens to your heart when you share with others something that changes you for the better.

[00:04:54] Clay Finck: Writing down and sharing my life’s biggest learnings is my way of giving back to the investment community. Our goodwill compounds when we share it with others. As Charlie Munger so beautifully puts it, the best thing a human being can do is to help another human being know more. And he briefly talks about how helping others brings good karma into our lives, and how we should selflessly help others without any expectation of getting anything in return.

[00:05:20] Clay Finck: Someone in Gautam’s circle in 2017 sounded the alarm bells on one of his holdings, letting him know that they were gonna be defaulting on one of their upcoming interest payments. And he warned Gautam at just the right time, as just a few days later, the news broke out that the company was, you know, falling behind on their payments and the stock fell by 30% just after Gautam exited that position.

[00:05:42] Clay Finck: When he called this person to thank him and ask him why he warned him of this, he said that Gautam had always been so helpful sharing data and information at work when it wasn’t asked of him to do so. Since he was always so willing to lend a helping hand to others. Others are willing to do the same for him.

[00:05:58] Clay Finck: This is what good karma can bring you. At the end of each day, Gautam asks himself if he did at least one good act to help someone that day. And that’s something that he consistently is striving to do to help give himself that inner peace that he is doing good in the world and constantly helping others. I find this topic quite interesting because giving to others with no expectation of receiving anything in return, it really does do something to your heart and your spirit.

[00:06:24] Clay Finck: It’s almost impossible to explain the benefits of doing this and how it can actually benefit the person who is doing the giving. You almost just have to experience it for yourself. Transitioning to chapter eight, it’s titled Simplicity is The Ultimate Sophistication. During last week’s episode, I discussed how when you understand a subject really well, you’re able to distill it down to first principles or the fundamental truths that underlie it.

[00:06:48] Clay Finck: Whether you’re talking about a sport or investing or whatever field, the best of the best flawlessly execute and understand the fundamentals. Just think about someone like Elon Musk. He wanted to build a rocket and explore the solar system, and he saw that rockets were just too expensive for him. So, we started looking at, okay, what are the components that go into a rocket and found that he could source those components and put them together at a cost that was one 10th the cost of other producers.

[00:07:15] Clay Finck: That is someone who is able to think from first principles, breaking it down to the fundamental truths, and then working up from there. Much of what Buffett says about investing is actually fairly basic and straightforward. As he says, things like investing is simple but not easy, and that the number one rule of investing is not to lose money.

[00:07:33] Clay Finck: Much of his famous quotes or lines go back to the fundamental truths of investing. In a 2011 Business Wire interview, Buffett said that if you understand chapters 8 and 20 of the Intelligent Investor by Benjamin Graham, as well as Chapter 12 of General Theory by John Maynard Keynes, you don’t need to read anything else and you can turn off your TV.

[00:07:54] Clay Finck: Chapter 8 of Graham’s book discusses Mr. Market in making him your servant rather than your master. Chapter 20 explains that you should only buy a business if the current price implies a large margin of safety. Gautam says that Buffett’s key takeaway from The Intelligent Investor was that if you eliminate the downside, all that remains is the upside.

[00:08:14] Clay Finck: After knowing that the key is to keep emotions in check and be patient, it’s really that simple. It’s simple, but not easy as Buffett. Occam’s Razor is a principle that states that among various hypotheses, the hypothesis with the fewest assumptions should be selected. Other more complicated solutions might provide better predictions, but in the absence of differences in predictive ability, the fewer assumptions that are made the better.

[00:08:39] Clay Finck: That’s what Occam’s Razor says. Gautam states that as investors, our job is to simply compound capital over time at the highest possible rate with the minimum amount of risk. We achieved this objective by seeking out undervalued stocks of companies within our circle of competence. Investing is not about being original or creative.

[00:08:59] Clay Finck: It’s about looking for the greatest amount of value for the price paid with the least amount of risk. Putting in more time and effort does not guarantee better results and investing. Rather, it’s more beneficial to do less and make fewer but better decisions. Charlie Munger takes this idea to the extreme as he encourages people to take a simple idea and take it seriously, and he says that the goal of investment is to find situations where it is safe not to diversify.

[00:09:27] Clay Finck: Buffett and Munger have taken this idea of simplicity to the extreme. We all know they want to buy great businesses at fair prices that have managers in place that they look up to, and they have confidence in their ability to determine what their company’s future will hold. There are three steps, Gautam outlines on simplification, the first of which is to avoid wasting time on things that are unknowable and unimportant.

[00:09:49] Clay Finck: Buffett explains how there are two questions you ask yourself as you look at the decision you’ll make. First is it knowable, second is it important. If it’s not knowable, we forget about those, and if it’s unimportant, whether it’s noble or not, it won’t make a difference. We don’t care. Where interest rates are, the stock market, where the economy’s heading are all important things, but they’re unknowable.

[00:10:12] Clay Finck: The second step of simplification is focus. Attention is a scarce resource that we should, guardians being wasted. We should also focus on one thing at a time. Even though most of us might think we’re really good at multitasking, the reality is it’s very likely that we are more efficient when we focus on one thing at a time, especially when you’re working on something that’s complicated.

[00:10:34] Clay Finck: As I’ve already talked about in last week’s episode, Buffett is very good at focusing. He suggests writing down your top 25 goals and to circle the five most important ones. Then he says to take anything that you didn’t circle and put it on a not to-do list, stating everything you didn’t circle just became your avoid at all cost list no matter what.

[00:10:55] Clay Finck: These things get no attention from you until you succeeded at your top five. Another Buffett quote is, the difference between successful people and very successful people is that very successful people say no to almost everything. When you say no, you are saying no to only one option. When you say yes, you are saying no to every other option, so be careful to what and to whom you say yes to.

[00:11:21] Clay Finck: The third step for simplification is to reason backward, which is similar to Munger’s idea of inversion. When you think about what you want. It can be helpful to determine all of the ways in which you won’t get to your desired outcome. When you’re analyzing an investment, look for reasons not to buy it.

[00:11:38] Clay Finck: It can be difficult for us to seek discomforting evidence because sometimes, once we’ve done the work, we want to confirm our preexisting beliefs about a company. Gautam asks himself four inverted questions prior to purchasing any stock. First, how can I lose money instead of how can I make money? If you focus on preventing the downside, the upside takes care of itself.

[00:12:00] Clay Finck: Second, what is this stock not worth? Instead of what is this stock going to be worth? If you can identify the floor price or a cheap price for a stock, it’s far easier to make profitable decisions. Third, what can go wrong versus what growth drivers are there? Rather than focusing just on the growth catalyst, think probabilistically in terms of a range of possible outcomes and contemplate the possible risks, especially those that have never occurred.

[00:12:26] Clay Finck: Fourth, what is the growth rate being implied by the market in the current valuation of the stock versus what is my future growth rate assumption? A reverse discounted cash flow fleshes out the current assumptions of the market for the stock. We can then compare the market’s assumptions with our own and make a decision accordingly.

[00:12:45] Clay Finck: Gautam then explains, good investors demonstrate the flexibility to completely change their opinions if necessitated by the facts. They don’t hope they will be right. They keep evaluating why they might be wrong. Then I love this section at the end of chapter eight, covering simplicity as a way of life.

[00:13:02] Clay Finck: He writes, have you ever considered that there are too many things that you need to evaluate day after day? Too many news items, too many questions, too many possessions, too many options for everything. If that’s the case with you, what you need to bring peace to your life is minimalism. Minimalism is basically an extension of simplicity.

[00:13:22] Clay Finck: You not only take things from complex to simple, but you also try to get rid of anything that is completely unnecessary. Few things in life really matter. Because few things matter, we must think carefully about what really matters to us, and then commit our time primarily to those things. That way we will remain focused on what matters rather than chasing the new thing, which probably will not really matter.

[00:13:46] Clay Finck: The goal is not to have the fewest number of things, but to have the optimal number of things. Practicing minimalism has brought peace and simplicity to my life. I cherish it for the time it has freed up for me, to focus on those aspects that are more meaningful, giving more time to my family, friends, personal health and learning activities.

[00:14:05] Clay Finck: From traveling with less personal luggage, eating less junk food and sugar, and using fewer apps on my phone to having fewer stocks in my portfolio. I have embraced minimalism as a way of living. I already can see the immense benefits of clarity, focus, and efficiency that this has brought to my life. To me, minimalism is about living with less stress.

[00:14:26] Clay Finck: The fact that it saves me money is just an added benefit. I just loved this chapter on simplicity because it’s just so easy to fall into the trap of making life too complicated, whether it be constantly getting new ideas on Twitter, clouding our focus and judgment, and having too many investments and too complicated of a portfolio and whatnot.

[00:14:45] Clay Finck: There’s tremendous beauty and peace that I believe can be found in simplicity. This brings us to chapter nine, covering financial independence. One of my favorite topics, financial independence, is being in a position where you don’t have to work in order to pay your bills. This can mean you have enough income coming in from investments, or you just have enough money saved up that’s enough for you to live on for the rest of your life.

[00:15:07] Clay Finck: Being financially independent means that you don’t have to depend on others, including a boss. You know, any clients, a schedule or a paycheck. Gautam says that true wealth is measured in terms of personal liberty and freedom, not monetary currency or money. Money alone does not signify independence.

[00:15:25] Clay Finck: Control over our time does. The only definition of success is being able to spend your life in your own way. Achieving financial independence is simple, but not necessarily easy. It takes a lot of hard work, sacrifice, discipline, and patience. Gautam recommends reading The Way to Wealth by Benjamin Franklin, The Richest Man in Babylon, The Millionaire Next Door, and Rich Dad, Poor Dad by Robert Kiyosaki.

[00:15:50] Clay Finck: In order to learn more about achieving financial independence and what it takes to build wealth. I don’t want to dive too much into this topic as I think our audience is quite well versed in this, but I will touch on some of the basics here. The first step for anyone to start building wealth and then eventually achieve financial independence is to spend less than you make.

[00:16:09] Clay Finck: Building wealth has more to do with how much you save rather than what your income is or what your investment returns are. Peter Lynch stated in the long run, it’s not just how much money you make, that will determine your future prosperity. It’s how much of that money you put to work by saving and investing it. Gautam brilliantly explains, to him money represents freedom and independence and not a means to engage in conspicuous consumption.

[00:16:33] Clay Finck: Spinning beyond a modest level of materialism is mostly a reflection of one’s ego. One of the most effective ways to increase your savings is not to raise your income but raise your humility. If money were a true measure of wealth, every rich person would be happy, but we know this isn’t true. Money can’t buy a loving family, good health, integrity, ethics, humility, kindness, respect, character, or a clear conscience. The most important things in life are priceless, and in my view, those are the true measures of wealth. Lasting happiness is achieved by living a meaningful life, a life filled with passion and freedom in which we grow as individuals and contribute beyond ourselves.

[00:17:17] Clay Finck: Growth and contributions are the bedrocks of happiness, not stuff. So, if you agree with him here that true wealth is found in things that money can’t buy, then ironically, you can only focus on these things if you no longer rely on money. So, the more money you have saved and the lower your spending level is, then the more financially secure you are, and the more you’re able to focus on those things that actually truly matter to you.

[00:17:42] Clay Finck: Then Gautam made the connection between the similarities of Charlie Munger and Benjamin Franklin throughout their own lives in achieving financial independence. Benjamin Franklin was actually one of Munger’s favorite people to have studied through all of the biographies he read. At the age of 42, Franklin retired and transitioned to focusing on being useful to others rather than focusing on building wealth.

[00:18:05] Clay Finck: He believed that everyone should contribute to society and that we should enthusiastically approach each day as we make those daily contributions. Munger lived a very similar life to Franklin in many ways. He wasn’t born into exceptional wealth. He had a successful career in law until he saved 10 times his annual expenses or $300,000.

[00:18:25] Clay Finck: Then he started working in the real estate development business, taking his assets to three to $4 million. Then he decided to become what Gautam calls a full-time capitalist. He started working with Buffett at Berkshire and was a chairman for Wesco Financial. We can use Munger as an example for ourselves and how we can build wealth as well.

[00:18:45] Clay Finck: Initially, Munger worked hard. He got an education; he developed valuable skills and then with those skills he traded time for money so he could further develop those skills and then build a strong financial foundation by saving and investing. He continued to save until he had 10 times his annual expenses.

[00:19:02] Clay Finck: Then he accelerated his wealth accumulation journey by starting a business that scales where he is no longer exchanging his time for money. Really the only way to build wealth quickly is by starting a business, but this is also much riskier and much more difficult than having a career, as most of the listeners probably know.

[00:19:19] Clay Finck: Then at some point, your investments earn enough passive income to comfortably support your living expenses. When you’re financially independent, it really doesn’t matter what you do during the day because you earn enough money while you’re sleeping. In order to achieve this level of freedom, we also need to be wary of what’s called the hedonic treadmill.

[00:19:37] Clay Finck: Which is when someone’s expenses tend to gradually increase as their income increases. The reason this is so dangerous is because as our income grows, our savings stay the same if our expenses grow as well, or maybe our savings could be decreasing too. Another important point to remember is that as your spending grows, that means you need to save much more money in orders to achieve financial independence because your living expenses have increased with your income.

[00:20:02] Clay Finck: So, the hedonic treadmill, otherwise known as lifestyle creep, is pretty much a double-edged sword. Regarding the hedonic treadmill. Morgan Housel writes the solution, particularly after basic needs are met, is actively seeking contentment with what you have. That doesn’t mean you stop saving, stop putting in the effort, or stop sacrificing.

[00:20:23] Clay Finck: It means you come to terms with the idea that the outcome isn’t a fountain of happiness. So, if you’re going to grind, you better damn well, enjoy the process. That rounds out Chapter nine on financial independence. Bringing us to chapter 10, covering living life according to an Inner Scorecard. I talked about this concept on episode 519, covering Guy Spier’s book The Education of a Value Investor.

[00:20:45] Clay Finck: A quote from guys included here at the beginning of the chapter, the Path to True Success is through authenticity. Buffett popularized the idea of living life by an inner scorecard. As he says, there are two kinds of people in life. Those who care about what people think about them and those who care about how good they really are.

[00:21:03] Clay Finck: For over 60 years, Buffett lives in the house he bought in 1958 for $31,500. During the tech bubble, Buffett was humiliated by the leading financial commentators on TV and Berkshire’s stock was getting hammered. Yet he always stuck to what his father taught him, that the only scorecard that counts is your inner scorecard.

[00:21:24] Clay Finck: During that time, most other value investors either shut down their investment firms or transitioned to invest in overvalue tech companies. Buffett stuck with his longly held principles, such as investing in what he understood and investing with a margin of safety, both rules of which he would’ve broke had he invested in most of the tech companies that other value investors were interested in. He never forgot his teacher, Ben Graham’s words that in the short run, the market is a voting machine, but in the long run it’s a weighing machine.

[00:21:52] Clay Finck: Gautam explains an outer scorecard, which many people have asks, what will people think of me? Will they judge me by the way I dress or the way I look, or the car I drive? But the inner scorecard, which is much more important, asks, am I doing the right things? Am I treating people correctly? Is this working for me as an individual?

[00:22:12] Clay Finck: What Buffett and Munger and a lot of other successful people have in common is that they strive for a happy and fulfilling life. They aren’t just trying to get rich. They’re not just trying to be famous but living a truly satisfying existence with full integrity and helping others around them achieve the same.

[00:22:28] Clay Finck: This chapter really boils down to just being a good person, being useful, and being kind to others and doing what you believe is right, treat others how you would like to be treated. Because over the long run what goes around comes around. Turning to chapter 11, it’s titled, The Key to Success in Life is Delayed Gratification.

[00:22:48] Clay Finck: This is the last chapter in section two of the book covering, building a strong Character. Before we transition to section three, which covers investing in common stocks. Gautam begins this chapter with the famous Stanford University marshmallow experiment that presented four and five year olds with a very difficult choice.

[00:23:06] Clay Finck: They could eat one marshmallow immediately, or they could wait 15 minutes and be rewarded with two marshmallows. So it’s essentially testing for their time preference. Those kids with a high time preference are more likely to want the marshmallow immediately as high time preference in individuals value to present moment more than the future.

[00:23:25] Clay Finck: Those with the low time preference are more likely to delay present gratification in order to achieve some benefit in the future. Over the next 40 years during the study, it was found that those students who were willing to delay gratification ended up having higher SAT scores, lower levels of substance abuse, lower likelihood of obesity, better responses to stress, better social skills, and better scores on a range of other life measures.

[00:23:51] Clay Finck: So, the study highlighted the virtues of delayed gratification or doing what is hard now, rather than doing what is easy. This discipline of delayed gratification builds up like a muscle and strengthens and improves with time. As those see the fruits of their labor of hard work, this encourages them to want to do more hard work and improve further to achieve an even greater level of success. Gautam uses one example of Charlie Munger. Charlie Munger has always been a big proponent of delayed gratification. He has emphasized the importance of patience in being prepared to act at scale when great opportunities arise. These are rare and fleeting, so we need to be patient, prepared and decisive to seize them.

[00:24:34] Clay Finck: Munger has shared an inspiring example. He has been reading the Barron’s magazine for more than 50 years and found only one actionable idea in it. It was a cheaply valued auto parts company, which he bought at $1 per share and sold a few years later at $15 per share. This earned him 80 million dollars in profits.

[00:24:54] Clay Finck: Munger then gave Li Lu the 80 million and Li Lu turned this into 400 million. Through just two investments, Munger turned a few million into 400 million. This example illustrates the significance of extreme patience, deferred gratification and displaying strong decisiveness at the right moment. It is why Munger said it takes character to sit there with all that cash and do nothing.

[00:25:20] Clay Finck: I didn’t get to where I am today by going after mediocre opportunities. Munger also believes in finding management teams that are willing to defer gratification as well. Management that wants to build a durable economic franchise, and they’re focused on the longevity of the business. They’re willing to forego near-term earnings for long-term value.

[00:25:40] Clay Finck: This obviously reminds me of Costco, which is one of Munger’s very favorite companies. He recently said in the Daily Journal Q&A that he loves everything about Costco, and he is never going to sell a share. Most companies are solely focused on achieving high returns in the short term or near term, whereas companies like Costco forego near term opportunities that might be appealing to some, but they opt for the longer-term opportunities that are going to maximize that long term shareholder value.

[00:26:08] Clay Finck: This also reminds me of Nick Sleep’s destination analysis in thinking about where a company is going to be 10 or 20 years down the road, and if management is taking the right steps to take that business to that destination. I think that Berkshire Hathaway, Amazon, and Constellation Software, which is the company I covered on episode 531, these are all great examples of companies optimizing for long-term shareholder value. Parasitic companies tend to be more short-term oriented, engaging in acts such as price gouging, which can destroy trust with customers. Bezos has stated that we’ve done price elasticity studies, and the answer is always that we should raise prices.

[00:26:48] Clay Finck: We don’t do that because we believe that by keeping our prices very, very low, we earn trust with customers over time, and that actually does maximize free cash flow over the long term. The best part about this is that if you’re like me and you’re in the earlier part of your career or your life, then you have many years ahead of you to first find these types of businesses you want ownership in and partner with them as a long-term shareholder, if I knew I needed the money and was forced to have that short-term time horizon, then I wouldn’t be able to benefit from the force of compounding over long periods of time.

[00:27:23] Clay Finck: So, having that long holding period is really, really critical. Thomas Russo explains these businesses as companies with the capacity to suffer, to invest in companies with the capacity to suffer, we must be willing to suffer with them, and we must have a high tolerance for short-term pain. Peter Lynch said that the stocks that have been the most rewarding to me have made their greatest gains and their third or fourth year that I own them.

[00:27:49] Clay Finck: So rather than judging a company by its stock price, judge it by their business performance. In the end, the stock price will reflect the performance of the business. If the management team executes, then the stock price will eventually follow. Then he talks about this idea of changing your mind on an investment, and it really hit home for me.

[00:28:08] Clay Finck: Gautam writes, it pays to have a long-term view, but a long-term investment horizon must be married with an investment process, willing to continually question the core investment thesis. Investors should exercise active patience that is diligently verifying their original investment thesis in doing nothing until something materially adverse or negative emerges.

[00:28:31] Clay Finck: All too often when a stock doesn’t work out as planned, we call it a quote unquote long-term investment. When we spend a lot of time getting to know a business and its management team before investing, as we investors often do, it becomes difficult to change our mind. Investors don’t want to feel like all that time was wasted, learning things that they didn’t really use.

[00:28:50] Clay Finck: We gain an advantage over time by staying intellectually honest while studying new ideas in existing holdings and only investing in the few in which we think the odds are significantly in our favor. Investors tend to become complacent and stop questioning their existing holdings when their stock prices are going up.

[00:29:08] Clay Finck: They resume analyzing in detail when the prices start falling. Don’t analyze your holdings only when they fall. Just because the stock price of an existing holding is going up doesn’t necessarily mean that nothing negative is happening in its business. Some really, really good points there. You may want to rewind and listen to that bid to make sure you caught it all.

[00:29:29] Clay Finck: A couple of good and recent examples of questioning your investments when they drop is Meta and Alibaba. Many investors have been forced into questioning whether the thesis on these companies were broken or if Mr. Market was becoming irrational and offering the companies at bargain prices. There’s quite a bit of controversy in both of these names and can make for interesting case studies in hindsight, after we see it play out after a few years, then he explains how an investor’s biggest edge is the ability to delay gratification and have that long-term time horizon.

[00:30:03] Clay Finck: The ability to have that long-term orientation is now a bigger advantage than ever before. 50 years ago, the average holding period for stocks on the New York Stock Exchange was seven years. Today it’s barely four months because the financial community has an ever-increasing focus on the next quarter.

[00:30:23] Clay Finck: A long-term orientation is a structural competitive advantage for an investor and one that is likely to strengthen over time as we experience information, data, and noise overload driven by social media. The very fact that most of the talent and resources on Wall Street are focused on competing in the short-term marina is what leads to a big opportunity for those who can look three to five years out and quietly consider the bigger picture end quote.

[00:30:50] Clay Finck: Then he touches on the fact that many fund managers are tempted to operate and optimize for that short-term performance because they’re really pressured by their clients. If they disappoint in the short term, then they risk losing their client’s funds and then potentially losing their jobs. So this focus on the short-term combined with high expense ratios is what leads to long-term underperformance for investors in these funds.

[00:31:14] Clay Finck: Then you compare that mindset to someone like Munger, who really isn’t worried at all about the short-term performance or the short-term volatility. He’s really focused on that long-term result. Rewinding back to Munger’s partnership days from 1962 through 1975. Munger’s partnership achieved an average annual return of 19.8%, while the index only gained 5.2% per year.

[00:31:40] Clay Finck: Although Munger’s partnership was much more volatile, long-term investors benefited tremendously through investing with him. Another key reason that people tend to think short-term is because their decisions are driven by fear. John Maynard Keynes referred to this as a spontaneous urge to action rather than inaction and not as the outcome of a weighted average of quantitative benefits multiplied by probabilities.

[00:32:04] Clay Finck: Gautam explains that critical thinking is always difficult, but it’s impossible when we’re scared. There are no room for facts when our minds are occupied by fear. During those times, focusing on the long term provides a behavioral edge and helps investors avoid making hurried mistakes when the amygdala in their brain triggers a fight or flight response. In his book Seeking Wisdom, Peter Bevelin writes, it is a natural tendency to act on impulse.

[00:32:33] Clay Finck: Cue the motion before a reason. The behaviors that were critical for survival and reproduction in our evolutionary history still apply today. Then later, Gautam writes, the path to lasting wealth is deferred gratification, savings and compound interest. Develop the habit of saving in such a way that you enjoy your present reasonably well, and also ensure a bright future tomorrow.

[00:32:57] Clay Finck: Save enough so that you’re able to live a better lifestyle in the future than you’re living today. This discussion reminds me quite a bit of Ramit Sethi’s book, I Will Teach You to Be Rich and how he talks about cutting expenses ruthlessly in areas that don’t add much value to our life, and spending more on areas that do add a lot of value.

[00:33:15] Clay Finck: For me personally, I’m more than happy to spend a good amount of money on a nice gym or quality foods. Other people enjoy spending a lot of money on travel. When it comes to things like a car, which for most of my day I’m really not in my car. I don’t commute to work, so I don’t really worry too much about having the nicest car, and I put more focus on other areas of my life that I value more, and I still ensure that I have a good balance and a good savings rate to ensure I’m continuing to invest.

[00:33:43] Clay Finck: Recently I’ve realized I spend a good amount of my time around lunch, going and grabbing Chipotle or going to a restaurant that’s local. I’d spend 10 or 15 minutes driving each way, plus waiting to get my food. So it really added up from a time and cost perspective. Recently I started cooking more at home, just making gradual small tweaks that add up over time and can really make a big difference.

[00:34:05] Clay Finck: So, I really like that point from Ramit Sethi’s book as well. I know this is a stock investing podcast, but since the greatest investment we can make is in ourselves, I believe that our health is extremely important to understand and take care of. Without our health, we have nothing. And there are so many things out there in the world that encourage us to think short term with regards to our health, whether it be all the overly processed foods at the grocery store, all the fast-food chains on every block, or the American culture of consuming alcohol at all these events.

[00:34:36] Clay Finck: There’s a time and a place for all these things in moderation. But I think it’s interesting to think about and got pulled an excerpt from this book called Sapiens I wanted to read that explains the gorging gene theory. This is really interesting from the book. We need to delve into the hunter gatherer world that shaped us, the world that we subconsciously still inhabit.

[00:34:57] Clay Finck: Why, for example, do people gorge on high calorie food that is doing little good to their bodies? Today’s affluent societies are in the throes of a plague of obesity, which is rapidly spreading to developing countries. It’s a puzzle why we binge on the sweetest and greasiest foods we can find until we consider the eating habits of our forager for bears. In the savannahs and forests, they inhabited, high calorie sweets were extremely rare, and food in general was in short supply.

[00:35:28] Clay Finck: A typical forager 30,000 years ago had access to only one type of sweet food, which was ripe fruit. If a Stone Age woman came across a tree groaning with ripe figs, the most sensible thing to do was to eat as much of them as she could on the spot before the local baboons picked the tree bare. The instinct to gorge on high calorie food was hardwired into our genes.

[00:35:52] Clay Finck: Today we may be living in high-rise apartments with overstuffed refrigerators, but our DNA still thinks we are in Savannah. That’s what makes us spoon down an entire tub of Ben and Jerry’s when we find one in the freezer and wash it down with jumbo Coke. So again, it’s really interesting to think about these things that are just so bad for us, but they taste and feel so good to consume in the moment.

[00:36:16] Clay Finck: One way I’ve sort of tried to hijack this was to find things that are good for me that still might feel good in the moment. Like fruit’s a great example of this, in my opinion. It’s so delicious to me. I eat fruit pretty much every day, and I almost always feel really good after a workout, so I try and do a workout most days as well.

[00:36:35] Clay Finck: Turning back to investing just like how we’re all hardwired to want the food that’s bad for us. We’re also naturally prone to chasing stocks that are very risky after they’ve already risen substantially, and they’re trading now at unsustainable levels. To round out the chapter on delayed gratification, Gautam explains that the key to achieving big results is through small, daily positive actions.

[00:36:59] Clay Finck: He references a book called One Small Step Can Change Your Life: The Kaizen Way by Robert Maurer. Gautam writes, the difference between those who fail and those who succeed is the courage to act repeatedly. Most people, when faced with the change will feel at least some element of fear. Very often that fear can get in the way of actually making the change.

[00:37:21] Clay Finck: The idea of Kaizen is to make such small changes in your life that your brain doesn’t even realize that you are trying to change, and therefore it doesn’t get in the way. Usually, if we try to tackle a big change all at once, like completely cutting out sugar or learning how to invest in the stock market or creating a reading habit.

[00:37:41] Clay Finck: It might work for a while, but when taking on a big change, we will give up soon. This is because the big changes trigger the brain’s subconscious fears, which end up hindering us. For instance, when it comes to investing in the stock market, we overwhelm ourselves with big questions like, how can I pick the best stock for my portfolio?

[00:37:59] Clay Finck: Or how will I ever become a successful investor when others have failed. Instead, use Kaizen and focus on small questions like what little step could I take today towards learning how to pick stocks effectively? If you want to form the habit of reading one annual report a day, start with reading one page of an annual report a day, then increase it to two pages and then three, and so on.

[00:38:22] Clay Finck: So, the key to building these positive habits is to really start small. Something so small that your brain won’t step in, and it won’t prevent you from making the change. Going on a five- or 10-minute walk to start exercising and then gradually adding in other things or making it longer is much easier.

[00:38:40] Clay Finck: The reason that so many New Year’s resolutions fail is because it’s a big sudden change that people are trying to make, when they should be making slow, gradual changes that our minds and bodies can adapt to much easier. The same thing applies to quitting bad habits. Say if you were like Buffett and you drank six Coca-Colas a day and you wanted to quit, very few people are going to be capable of quitting cold turkey on the spot.

[00:39:04] Clay Finck: The most sustainable way to quit a bad habit is to do so gradually. That rounds out section two in chapter 11, bringing us to section three on common stock investing. Chapter 12 is titled, Building Earning Power Through a Business Ownership Mindset. Benjamin Graham stated that investing is most intelligent when it’s most businesslike.

[00:39:24] Clay Finck: Warren Buffett wrote about having a business owner mindset in his 1977 shareholder letter. He writes, our experience has been that pro rata portions of truly outstanding businesses sometimes sell in the securities market at very large discounts from the prices they would command in negotiated transactions involving entire companies.

[00:39:45] Clay Finck: Consequently, bargains in business ownership, which simply are not available directly through corporate acquisition, can be obtained directly through stock ownership. When prices are appropriate, we are willing to take very large positions in selected companies. Not with any intention of taking control and not foreseeing, sellout, or merger, but with the expectation that excellent business results by corporations will translate over the long term into correspondingly excellent market value and dividend results for owners. This is an unorthodox view; one we believe to be sound. Ownership in public companies is great for your common everyday person because it allows them to have their money start working for them very easily. As investors, your money is working for you 24/7. When done correctly, you become wealthier with each passing second, as the intrinsic value of the businesses increase with time. Gautam then explains a number of other benefits to investing in public equities. This includes the ability to invest small amounts of money and the ability to easily diversify into different businesses. Another fantastic advantage is to be able to ride alongside some of the greatest managers in the world.

[00:40:58] Clay Finck: I would never be able to start a business with someone as brilliant as Warren Buffett, Elon Musk, or Mark Leonard, but the stock market allows me to do that for zero additional cost, and this is just a massive opportunity for your regular, everyday person. We also have the opportunity to play the game on our own terms.

[00:41:16] Clay Finck: We can choose which day we want to enter or exit the market. We can choose whatever industry we want. We can play our own game. Short-term, long-term options, whatever you are attuned to, traders can trade, long-term investors can buy and hold great companies. Stocks remove so much of the headache around running a business yourself.

[00:41:35] Clay Finck: Before the stock market existed, the thought of exiting the ownership of a business with a click of a button would’ve been unthinkable. Yet the stock market allows for just that, and you can even exit your position and get the money in your bank account within a matter of days. Things can change really quickly whether you’ve realized the management actually lacks integrity, or you all of a sudden need the money or the business is going downhill, or maybe you found another opportunity that is just simply too good to pass up.

[00:42:03] Clay Finck: That opportunity to act really quickly is really valuable as well. The big underlying message from Buffett and Graham for this chapter is that stocks are ownership in real businesses, and they’re acclaimed to a piece of a real businesses profits, which grow over time as the business reinvest back into itself and into new projects in order to generate those higher profits.

[00:42:25] Clay Finck: When you think like a business owner, you start to care more about the results of the business rather than which way the stock has moved that day. As shareholders, you’re probably only seeing the company’s business results every quarter, so you might check in on the company four times a year. Whether the stock price is up or down every other day really shouldn’t concern you because if you’re thinking like Buffett, you’re thinking about owning a business like you purchase a farm or you purchase a rental property that you plan to own and collect income off of into perpetuity.

[00:42:54] Clay Finck: I’ll go through a couple more chapters here before we round out the episode. Chapter 13 is another shorter chapter titled, Investing Between the Lines. It discusses some ideas from a book called Investing Between the Lines by Laura Rittenhouse that covers how we can separate the facts from the fluff in annual reports, earnings calls, and company filings.

[00:43:15] Clay Finck: The first item to look for is that the company is good stewards of capital, meaning do they have good returns on capital? Has the stock performance reflected those good returns? And as management discussed, the good capital allocation decisions they’re making? Gautam says that CEOs who are good capital allocators typically offer commentary about returns on investment return, on invested capital, and or return on assets.

[00:43:38] Clay Finck: The strength or weakness of a CEO’s capital discipline is expressed in the commentary about book value or market value. You also want management that talks about free cash flow. A lot of managers would rather point to an earnings figure that is either misleading or can be easily manipulated. Free cash flow is the actual cash that the business has produced over a period, which is much more difficult to manipulate over the long run.

[00:44:04] Clay Finck: He also wants to see management that shares meaningful financial goal statements to show that they’re serious about efficient capital allocation. Also consider what the CEO’s incentives are, how they’re compensated, and if they’re incentivized to produce high returns on capital. Incentives drive everything.

[00:44:21] Clay Finck: In the past, I’ve talked about how executives that own a lot of stock in the company have their interests aligned with shareholders, whereas those who are receiving substantial stock options may be more incentivized to deliver short-term business performance rather than that long-term growth and shareholder value.

[00:44:38] Clay Finck: Then he talks about how he wants management to be candor in their communications. I talked about this in my episode covering Warren Buffett’s 12 investment principles. Gautam writes, candor is the language of trust, and it means being authentic with your words as Buffett puts it, we will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value.

[00:45:02] Clay Finck: Our guideline is to tell you the business facts that we would want to know if our positions were reversed, we owe you no less. Identifying managers who act in this manner, I believe can be really difficult. One thing to look for if you’re trying to identify this is to see what management says when they make mistakes.

[00:45:19] Clay Finck: When they make a poor acquisition, do they talk as little as possible or do they frequently mention their mistakes? Managers who frequently point out their mistakes, I believe, are much more likely to be trustworthy. Buffett is a prime example of this. Gautam rounds out this chapter by stating, if you feel that you are not smart enough to understand what’s written in the corporate communications, then don’t worry.

[00:45:41] Clay Finck: This is not your problem. It is the management’s responsibility to write the letter in a manner that can be easily comprehended by the average reader. To evaluate the quality of the management, you don’t need privileged access to insider information. The secret is right in front of you, in the words of every shareholder letter, annual report, and other corporate correspondence.

[00:46:03] Clay Finck: Once you learn how to read between the lines in the corporate communications, you can make a better assessment about management quality and their intentions. Remember, analyzing words is just as important as analyzing numbers. The final chapter I’ll be covering in today’s episode is chapter 14 on the significant role of checklists in decision making.

[00:46:23] Clay Finck: Charlie Munger says that checklist routines avoid a lot of errors. You should have all this elementary wisdom, and then you should go through a mental checklist in order to use it. There is no other procedure in the world that will work as well. People tend to be overconfident in their abilities, and a checklist is just a simple way to keep us in check to make sure we aren’t breaking any of our own rules.

[00:46:46] Clay Finck: Good checklists are brief, precise, efficient, and they’re easy to use. Checklists, provide critical rules and reminders on the most important steps in our investment processes. Buffett has his own checklist of disqualifying rules, where if a business has any of these features, then he automatically disqualifies it from his investible universe.

[00:47:06] Clay Finck: Potential things that Buffett doesn’t like in the company is he doesn’t like the CEO, the company has too many tail risks, or it has low margins or examples. Then Gautam goes into detail on some of the things to look out for in a company. There’s too much to cover for this podcast, but you can tell from what he explains in the book.

[00:47:24] Clay Finck: Gautam is the type of person who definitely does not let the little things get past him. He will check every last detail of a financial statement to make sure it all makes sense to him, and everything balances when he’s comparing all the financial statements in the ins and outs of a company. I did like his commentary on free cash flow in particular.

[00:47:44] Clay Finck: He says free cash flow is the discretionary surplus that can be distributed to reward shareholders. The higher the proportion of the free cash flow that comes from operating activities, the better. If free cash flow is negative and the dividend is always funded by debt. Then the investor should not take any comfort from a high dividend yield.

[00:48:03] Clay Finck: If a company is not ever able to generate free cash flow, then it may be the equivalent of a perpetual Ponzi scheme wherein it simply robs Peter to pay Paul. Remember, intrinsic value is derived from the cash that can be taken out of a business during its lifetime. When a company reports profits but bleeds cash, always believe the cash. Always.

[00:48:26] Clay Finck: The most common symptoms of falsified earnings are negative free cash flow, accompanied by rising debt, increasing shares outstanding and bloating receivables, inventory, non-current investments and intangibles. I found that very useful in determining what to look out for when analyzing the cash flow statement in particular, some really important points that he mentions here in this chapter.

[00:48:48] Clay Finck: Some red flags to keep out for in terms of the management team, exorbitant salaries, perks and commissions, relatives being promoted within the company who lack adequate qualifications, frequently changing auditors, changing the company name to include buzzwords from hot sectors and the engagement in overly promotional activities.

[00:49:08] Clay Finck: If the management team seems to care a lot about trying to pump the stock price, then odds are they are burning cash and constantly need to raise money. Then Gautam walks through Charlie Munger’s psychological checklist of the standard causes of human misjudgment to help us sift through any potential biases we may be encountering.

[00:49:27] Clay Finck: I’ll walk through a few of these here before we round out the episode. The first one he lists is the bias from mere association. This bias automatically connects a stimulus with pain or pleasure, so almost automatically liking or disliking something by association. For example, someone might associate a technology company with growth and a positive liking.

[00:49:49] Clay Finck: Say someone discovers a niche online retailer and assumes that because it’s growing, it could be the next Amazon and increase by a hundred times. Just because a company might seem similar to Amazon doesn’t mean the outcomes will be the same. Another one I think is really important is the bias to stay consistent.

[00:50:06] Clay Finck: This bias leads us to remain consistent with prior commitments and ideas, even in the phase of discomforting evidence. This also ties into sunk cost fallacy. The more time we spend researching something, the less likely we are to abandon it. When we have made an investment, we tend to seek evidence to confirm that we’ve made the right decision and to ignore the information that shows we may be wrong.

[00:50:30] Clay Finck: Remember that financially it is much better to be right than to be consistent. To try and combat this, try to prove yourself wrong, rather than being determined with being right. Seek the truth from first principles. Karl Popper stated that the aim of an argument or a discussion should not be victor, but progress.

[00:50:51] Clay Finck: Another one is social proof or bias from authority. These are really common biases. Either we invest because someone similar to us has invested, or we invest purely because a super investor or the crowd has bought into the company. There are many others that I won’t be diving into for this discussion.

[00:51:08] Clay Finck: If you want to learn more about these, you can either purchase Gautam’s book, The Joys of Compounding, or search for Charlie Munger’s Standard Causes of Human Misjudgment. Trey Lockerbie actually recorded an episode with Gary Mishuris on episode 447, if you’re interested in learning more about cognitive biases in particular.

[00:51:27] Clay Finck: The reason understanding psychological biases is so important is because we as humans are very emotional creatures. A lot of times we make decisions based on our gut instinct, which might at times be incompatible with reality. Gautam recommends building your own checklist based on personal experiences, knowledge, and previous mistakes, rather than relying on the checklist of others.

[00:51:50] Clay Finck: Outside of checklists, there’s another tool we can utilize as investors, which I will be diving into in next week’s episode, episode number 539.

[00:51:59] Clay Finck: Alright, so that wraps up today’s episode. This episode was part two of covering Gautam’s book, The Joys of Compounding. If you happen to miss last week’s episode, which was part one, be sure to go back and check that out if you haven’t checked it out already.

[00:52:14] Clay Finck: That’s episode number 534. Also be sure to click follow in the bell icon on the podcast app you’re on so you don’t miss part three, covering this amazing book next week. With that, thank you so much for tuning in, and I hope to see you again next time.

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