29 June 2024

On today’s episode, Kyle Grieve and Clay Finck continue their conversation on Investing: The Last Liberal Art by Robert Hagstrom. We discuss details on why using the right explanation for a business is so important to a good investment thesis, simple ways to improve your reading to get more out of the books and content that you consume, how to use simple mathematical concepts to improve your decision making in real-time, how to understand better System I and System II thinking and how it directly applies to investing, some of the latest mental models Kyle has learned from interviewing recent guests, and a whole lot more!

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  • How to use the proper explanations in your analysis to determine the right comparable best.
  • Why Tesla is so misunderstood.
  • Why the economics of Dino Polska make it an invalid comparison to other grocers.
  • The power of narratives in investing and how we can guard ourselves from getting overly optimistic.
  • How to optimize reading for learning.
  • How to use Bayes theorem to tip odds in your favour and change your position sizing.
  • Why value and prices become disconnected, and how human psychology plays into this.
  • Why intuition (system I thinking) is so difficult to rely on in the stock market.
  • How to make thinking in mental models a habit.
  • Some of the latest mental models Kyle has learned from interviewing some of his latest guests.
  • And so much more!


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

[00:00:00] Kyle Grieve: Mental models can be used from nearly any discipline to help you think better. However, many investors get paralyzed by over analysis when they try to think in terms of mental models. After all, you have to have a full understanding of them at a surface level, and then you need to learn to layer them on top of each other when trying to solve problems.

[00:00:17] Kyle Grieve: It sounds easy, but it’s not an intuitive task. Today, Clay and I will continue our conversation on Robert Hagstrom’s book, Investing: The Last Liberal Art. We’ll explore philosophical mental models such as why it’s so important to use the right description when analyzing a business. We’ll have a look at the early days of Amazon and how a very prominent investor thought about the Amazon business indifferently and succeeded in his process.

[00:00:40] Kyle Grieve: We’ll examine the world of literature for ways to supercharge your lessons from reading books. We’ll also discuss the importance of narratives in investing and how you can use them to your advantage, while also avoiding potentially risky investments. Turning to the world of mathematics, we’ll look at Bayes theorem.

[00:00:55] Kyle Grieve: This is a mathematical concept that you may have never thought about, but probably calculate regularly on an unconscious level. Understanding at a conscious level will help you make better, higher quality decisions regarding your investing, especially as it relates to valuation. Then, we’ll look at some of the great concepts in the world of decision making.

[00:01:13] Kyle Grieve: We’ll look at System 1 and System 2 thinking, and how they can add or subtract from investors decision making processes. We’ll examine why our intuitive System 1 shouldn’t be relied on very much in investing, and specifically why that is. Lastly, I’ll go over my own methods for learning mental models, and how I’ve tried to make them into a habit.

[00:01:33] Kyle Grieve: I’ll also share some of the most impactful mental models I’ve learned from chatting with some of the wonderful guests on TIP. This episode is a wealth of information if you’re on a path of learning and gathering wisdom. Now, let’s get right into this week’s episode.

[00:01:50] Intro: Celebrating 10 years and more than 150 million downloads. You are listening to The Investor’s Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now for your host, Clay Finck and Kyle Grieve.

[00:02:22] Kyle Grieve: Welcome to The Investor’s Podcast. I’m your host Kyle Grieve and today Clay and I will continue our chat on Robert Hagstrom’s book, Investing: The Last Liberal Art. So, in our chat from a few days ago, we discussed some of the background to why I like these mental models that we’ve discussed in quite a lot of depth, and then we kind of kicked off the discussion of the very first few concepts that Robert wrote about in his book.

[00:02:43] Kyle Grieve: So, these concepts were physics, biology, sociology, and psychology. Today, we’re going to continue the discussion on mental models and talk about philosophy, literature, mathematics, and decision making. The section on philosophy was one of the most difficult sections for me to get through and I think Robert sums up why that may be in the introduction to the chapter.

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[00:03:04] Kyle Grieve: So Robert discusses why philosophy is both the easiest and the hardest areas of knowledge to understand. It’s easy because it deals with familiar issues that everybody has to deal with on a daily basis. But, he points out that it’s also the hardest because philosophy doesn’t come pre packaged with concrete answers that you would find in areas like physics, mathematics, or biology.

[00:03:26] Clay Finck: And that’s exactly why I loved my math classes in high school and wasn’t too fond of the philosophy stuff because there was no right answer.

[00:03:34] Kyle Grieve: The first philosophical example that really stood out to me in regards to philosophy was his points on Benoit Mandelbrot. So he wrote this great book called The Misbehavior of Markets, which is about fractals and the stock market.

[00:03:49] Kyle Grieve: In a chat at the Santa Fe Institute, Mandelbrot blurted out that failure to explain is failure to describe during a chat on market efficiency. I want to loop this into a wonderful example that Robert covers while trying to explain Amazon in its early days. So Robert looked at how bears and bulls described the Amazon business differently.

[00:04:09] Kyle Grieve: Bears claimed that Amazon should be compared to a business like, you know, Barnes Nobles and Walmart. Amazon at the time sold much of what brick and mortar businesses like Barnes Noble and Walmart would sell so, you know, it kind of made sense to make that comparison. So bears would have said that it was nonsensical for Amazon to be selling at these expensive multiples that it was selling at when comparables were selling at a fraction of its cash flow multiples.

[00:04:33] Kyle Grieve: But Robert made a really good point that when you looked at the business model of Amazon, It was different and this kind of goes to that point of failure to describe. So Amazon bulls would say that comparing to Barnes and Nobles and Walmart was just the wrong comparison. Dell was actually a better comparison.

[00:04:52] Kyle Grieve: So Robert writes, if you step back and look at Amazon, the company’s business operations are more similar to Dell than Walmart. Dell assembles and ships personal computers from various distribution centers located around the country. Orders for computers taken online negate the need for large and costly sales force.

[00:05:10] Kyle Grieve: Amazon, like Dell, also takes orders online. Also like Dell, Amazon ships products to their customers from one of their distribution centers, bypassing expensive brick and mortar retail locations. The business model allows both companies to operate with negative working capital, They get money from customers before they have to pay suppliers slash manufacturers, and thus both companies are able to achieve returns on capital well above 100%.

[00:05:37] Kyle Grieve: So with hindsight, we know that the bulls had the correct description of Amazon now, and owners of the stock have done tremendously well if they’ve held through all the ups and downs. But I think the point here about using the proper description is so important because it can help us to determine if we are comparing one business to another business that actually makes sense.

[00:05:56] Kyle Grieve: If we compare two businesses where let’s say company A has a PE of 35 and company B has a PE of 10. Then obviously we’re going to conclude that company a is ridiculously overpriced and probably skip it. But maybe we’re not comparing it properly. Maybe it should be compared to company C in a separate industry trading at a PE of 50.

[00:06:14] Kyle Grieve: And therefore a is actually incredibly undervalued.

[00:06:18] Clay Finck: So the section on philosophy, it really reminds me of the conversation I had with Chris Mayer. Late last year, we discussed this book titled, how do you know, which dives into very similar concepts and is very much a philosophy book, which is something I really appreciated about it because I just learned so much from it.

[00:06:34] Clay Finck: One takeaway from that is that we use these words to describe the world, describe companies and businesses, and it might sound good and it might sound like it makes a lot of sense, but we have to keep a close eye on reality and ensure that it matches with how reality is and, and how we view the company.

[00:06:53] Clay Finck: One example that comes to mind here is Tesla. When you talk about this Amazon example, I have no zero strong opinions on Tesla, but I just can’t help but think of this as a more modern day example. You oftentimes hear investors simply compare Tesla’s car sales to the number of car sales at these other traditional manufacturers, think GM, Ford, and some of these other players.

[00:07:18] Clay Finck: And many people come to the logical conclusion that just simply based on the number of cars they’re selling, the stock is far overpriced. And they’re like, all of their revenue today comes from car sales. And then, you know, this comparison just doesn’t make any sense at all. And all of the Tesla bulls, are viewing the company.

[00:07:34] Clay Finck: Just through a totally different lens. Again, I don’t own shares in Tesla, haven’t looked into the business super closely, but I did do an episode on the Elon Musk biography back on episode five 93, the audience really enjoyed that one. And after you read that book you understand that Tesla is far from a typical car company.

[00:07:53] Clay Finck: So the first item that comes to mind here with regards to Tesla is that they’re actively working towards the future in terms of technology, AI, manufacturing, energy, they’re really trying to innovate in so many of these different areas. And one way they’re benefiting from this innovation is becoming more of a technology company through these increased inefficiencies in manufacturing.

[00:08:15] Clay Finck: So as Tesla grows, they’re able to produce more cars at a lower cost. And then they’re continually figuring out ways to add automation, to drive down the cost, to produce a electric vehicle. And then the biography talks a lot about how vertical integration is an important part of their business model and producing as many parts in house that they can.

[00:08:35] Clay Finck: And what they’ve also been doing is bringing the prices of their cars down as they achieve these higher efficiencies in the manufacturing process, which reminds me of the scale economy shared model that Nick sleep shared, who was also an early investor in Amazon. And then you could also think about how some of these amazing businesses have a lot of optionality.

[00:08:54] Clay Finck: So in the case of Amazon, AWS produced 90 billion in revenue in 2023, which didn’t even exist or was even on investors radar 25 years ago. So Tesla bulls, of course, would argue that there’s just a ton of optionality and you to look at the insurance. You look at robo taxis, monetizing their self driving software monetizing their energy, energy business and so on.

[00:09:19] Clay Finck: So one of the mind blowing stats I found on Tesla is that they’re cumulative miles driven with their full self driving technology. It’s over 800 million miles. And when you look at that chart, it’s not just like an exponential chart. It’s like a hockey stick growth, where it was like nothing just a few years ago.

[00:09:38] Clay Finck: And that just gives Tesla an immense amount of data that their competitors just won’t have. And with machine learning, their technology learns from that. And then it gets exponentially better over time. And I think when viewing some of these disruptive businesses, it’s important to remember that a company like Amazon or a company like Tesla has opportunities in front of them that are very asymmetric and they deal with these exponential figures and our minds aren’t used to thinking in this manner, you know, where our minds naturally think linearly, so naturally it doesn’t make a lot of sense that Tesla could one day be a 10 trillion company because no company has ever done it.

[00:10:16] Clay Finck: And yeah, our minds just can’t really wrap our heads around what sort of asymmetric potentials in front of us. But also it’s very difficult to figure out the probabilities associated with what that’s going to look like, which is why the stock is also so volatile. And you don’t have to look at these more extreme examples either.

[00:10:33] Clay Finck: Kyle and I own a company called Dino Polska, which is just a grocery store that Many people like to compare to other grocers and just say it’s simply expensive based on these various metrics But no other grocer has the economics that they have or have near as attractive growth So it’s just not really an apples to apples comparison with some of these ways you can compare the businesses So this mental model can apply to really in any industry when you find a company that behaves much differently than their competitors.

[00:11:03] Kyle Grieve: I think Dino is such a great example that Clay just kind of brought up.

[00:11:06] Kyle Grieve: So I actually wrote a piece recently for the TIP mastermind community where I did actually compare Dino Polska with Jerónimo Martins, just a little background. Jerónimo Martins owns Badronka, which is one of Dino’s primary competitors. So basically I wrote that comparing the two businesses was essentially pointless.

[00:11:24] Kyle Grieve: And this is for some of the reasons that Clay just pointed out. Dino has very high returns on invested capital and it can reinvest 100 percent of its profits back into the business. Jerónimo Martins is, is a good company. I’m not, I’m not denying that, but it’s more mature. It has a return on invested capital that is half of Dino’s and it only reinvest 10 percent of its profits.

[00:11:45] Kyle Grieve: So even though these two businesses optically look the same, they sell, you know, similar products. They’re both brick and mortar. The businesses are just simply different. Therefore, they require different descriptions. So I just wanted to add that. The next philosophical bucket that I want to cover was on narratives.

[00:12:02] Kyle Grieve: The reason narratives are so important, especially in investing, is because narratives are such a powerful tool. Stocks can move on a strong narrative alone, but narratives are most powerful when there’s statistics that support them. So there was a really good book that I read recently by Aswath Damadaran, and it’s called Narrative and Numbers.

[00:12:19] Kyle Grieve: So Aswath’s premise is that stories without numbers are just fairy tales, and numbers without stories to back them up are exercises in financial modeling. So I’m not here to say which is best between being a narrative base or a number based investor, but I can comment on my own strategy and what I’ve learned.

[00:12:36] Kyle Grieve: So I think a very good story is incredibly important for the development of a good investment thesis. So I know a good narrative is very important to the convergence of the stock price and the intrinsic value of a business. So there’s a small cap that will remain unnamed, which I own, that required a story to play out for more people to buy into that story as the future unfolded.

[00:12:58] Kyle Grieve: But I knew that the narrative wasn’t enough for me to get interested. I needed data to back that narrative up, to give it a higher weighting and to really get some conviction behind it. So I researched whether the idea had that data backing it up, and it most certainly did. And so far, the thesis has turned out very, very well for me because the narrative was based up by statistics.

[00:13:19] Kyle Grieve: So I’m getting obviously the narrative is carrying a lot of what’s happening with the share price, but also it’s all true. So I do believe that narratives are very important, but I also think that statistics or data or whatever you want to call it need to be there in order to back up the story.

[00:13:34] Clay Finck: Narratives and markets are just so interesting. People make up narratives or make up stories because we all just have this intense desire to just really make sense of the world. The reality is we can’t really know why things happen exactly the way they do. We can all make up this narrative or story that sounds good, but we can never really know for sure.

[00:13:55] Clay Finck: I’m reminded of the chapter Morgan Housel wrote in his book, Same as Ever. I believe it was titled Best Story Wins. In that chapter, he wrote, The best story wins, not the best idea or the right idea or the most rational idea. Just whoever tells a story that catches people’s attention and gets them to nod their heads is the one who tends to be rewarded.

[00:14:18] Clay Finck: And during my interview with Morgan, he had said the best product that Elon Musk has ever made is not a Tesla car. It’s not a Falcon rocket. It’s Tesla stock. The best product he’s ever made is the ticker TSLA because it’s literally one of the most incredible and captivating stories that anybody ever told.

[00:14:35] Clay Finck: And I think this is something that transcends really to all areas of life, because stories play such a key role in so many aspects of how we live, you know, think about the work that we do, working with our coworkers, think about our relationships, our friends, our family, and think about when you’re looking at companies and looking at like a CEO and a management team to, if you don’t have managers that can motivate people, then how can you expect a company to be good at what they do?

[00:15:03] Clay Finck: Anyone can just show a group of people all the numbers in the world to try and make sense of something. But numbers don’t always resonate with people. It’s stories that really resonate with people and it’s what people cling to. But as you mentioned, the numbers are also really important. You know, numbers are based in reality, right?

[00:15:21] Clay Finck: And I think I like the approach you laid out that kind of couples these two together, you know, having a good story, but also having the numbers and the data that can back that up and support the thesis. And I think It’s just another reminder to be open to new ideas and new ways of looking at things.

[00:15:38] Clay Finck: These asymmetric opportunities in these asymmetric returns are often found in businesses or in ideas that look at an industry or look at the world through a different lens that is just generally misunderstood by others. And Hagstrom points out that the world is really changing as fast as ever. So we really need to be flexible in our thinking and open to these new ideas.

[00:15:59] Kyle Grieve: Yeah, exactly, Clay. And I just want to go over that Tesla example because I thought it was excellent. And I’m, I’m like you, I have no skin in the game and Tesla and I haven’t spent too much time on the stock as well, but I do think the story of Tesla stock is absolutely incredible. And so this kind of actually reminds me of of another mental model that George Soros came up with called reflexivity.

[00:16:19] Kyle Grieve: It’s not really a philosophical mental model, but I do think it relates to narrative. So I just want to talk about it briefly here. Reflexivity is when investors perception of what’s going on can actually influence what’s going on and in turn influence their perceptions all over again. So to Morgan Housel’s point about the Tesla stock, it would be interesting to see if Tesla would still be successful today if Tesla remained private.

[00:16:42] Kyle Grieve: A big reason that nearly everybody in the world has heard of Tesla is from constantly seeing it in the news about the stock, about the run up in the stock’s price. We can’t really quantify how much the stock has helped Tesla’s operations, but we definitely do know that the story of the stock has improved investors perceptions in the business.

[00:17:00] Kyle Grieve: And you know, that’s probably added a few extra Tesla customers along the way.

[00:17:04] Clay Finck: On that point of reflexivity. It’s important for people to understand when Tesla’s stock price goes up, that enables them to be able to do things like issue shares and further capitalize their business and make their business actually stronger.

[00:17:17] Clay Finck: So like the better story Elon can tell, and the more people he can get to believe that story, no matter how realistic it is, as long as people believe it. That, you know, further enhances their ability to raise capital, whether that be from issuing debt, issuing equity or whatnot. And I think that’s what a lot of other people tend to miss.

[00:17:35] Clay Finck: They just look at the numbers, they look at the production, they look at how much money they’re making, but the story is also a very important aspect to it.

[00:17:43] Kyle Grieve: So now I want to move on to the literature portion of the book, which I found very informative, but also the concept that was probably the most malleable.

[00:17:51] Kyle Grieve: So It’s worth noting here that Charlie did not read fiction books, whereas, you know, obviously literature covers both fiction and non fiction. But Charlie clearly developed his own methods for the books that he wanted to read and how to keep his thinking very, very broad. So one of Charlie’s idols, Benjamin Franklin, said in his autobiography that people should spend less time arguing and more time searching out smart new ways of looking at the world.

[00:18:17] Kyle Grieve: I think this literature section will help broaden our abilities to learn how to do just that.

[00:18:22] Clay Finck: So I’m with Charlie Munger in that I also don’t read fiction either, but I resonate with what Hagstrom talked about how Developing this mindset of continuous learning and pulling these great ideas from others can honestly feel like a pretty daunting task, but I like how he outlined how he would go about trying to do this So he explains that the truly big ideas are already out there.

[00:18:43] Clay Finck: They’re written down. They’re just kind of waiting for us to discover them and make use of them for ourselves so There’s plenty of information everywhere. You got books, podcasts, all these different resources we can pull from and then unlimited information on the internet and some people like to flex, I think, on the number of books they read, but as someone who doesn’t read a book a week, I think what’s probably more important is the ability to retain these key ideas and actually make use of them, which is what Kyle and I will be getting into here.

[00:19:15] Kyle Grieve: Right. And that leads to the first topic that Robert covers, which is this wonderful book by Mortimer J. Adler called How to Read a Book. So you might be thinking it’s silly to read a book on how to read, but after reading Hegstrom’s book, I went out and actually bought Adler’s book and it was really, really good if you want to really, really understand how to deepen your understanding of a book.

[00:19:35] Kyle Grieve: So Adler’s primary concept on reading a book isn’t just to read for the sake of information gathering, which I think Clay just alluded to here. Right. We actually want to read to gain a better understanding of the subject at hand. So Hagstrom covers a very simple way to differentiate between when we are reading for information versus when we are reading for understanding.

[00:19:54] Kyle Grieve: If you are finding that the content is really simple to go through and understand, that usually means that we’re just reading for information. So, you know, think about reading popular news like the Wall Street Journal or the New York Times, Financial Times or Barron’s. But when you’re reading and have to really stop and think about the thoughts, ideas, and concepts of a book, that is a good signal that you are reading for understanding.

[00:20:16] Kyle Grieve: And I know this happens to me regularly. Well, where I’ll be going through a book and I’m like, that seems like a really important concept, but maybe I didn’t grasp it. And I need to go back and read it maybe a few times. That means obviously I’m really, really trying to deepen my understanding. I know personally that I focus more and more on deepening my understanding of a topic.

[00:20:34] Kyle Grieve: And when I read for information, I find it’s often, you know, in one ear out the other. Yes, it’s, it’s helpful to some degree, but it really is just surface layer content. So This is part of the reason why I think rereading books that have highly impacted me is so powerful. With every time I reread a book, I’m really cementing those core ideas in my mind and spending more and more time trying to understand them and apply them to, you know, my stocks, my own life and my own situation.

[00:21:02] Clay Finck: I think back to Stig and Monish’s recent episode, Stig had asked Monish how he takes notes, whether he takes notes on stuff. And I thought it was interesting Monish essentially said he, he never. Is taking notes. He just focuses a hundred percent on the material or the person speaking and just soaks it all in, so to speak.

[00:21:21] Clay Finck: And he doesn’t let his attention go towards other things. And I think that we all read, understand, and retain information differently. So we need to find the way that probably works best for us. And I actually spoke with a brain expert here on the show. His name is Jim quick, and he also wrote a book on how to learn effectively.

[00:21:39] Clay Finck: I picked up a few tips from his book that I wanted to share here. That might be helpful to the listeners. So the first lesson I wanted to share here is what he called the forgetting curve. So our natural ability to concentrate. Wanes anywhere between 10 to 40 minutes of doing a task, and you get diminishing returns on your, you know, your effort after that.

[00:22:00] Clay Finck: So he suggests working in different spurts, say like 30 minutes, and then take a five minute break to give your brain a rest and maybe go on a short walk or get up for a bit and not do something like check your phone or check emails or. And the second tip is to review that which we want to retain.

[00:22:17] Clay Finck: So maybe you end up taking notes on some of the key points on a chapter or on a podcast or whatnot. And then you go back and review those notes or key takeaways to help increase the retention of what you read, which is something you just alluded to just going back and rereading it as you’re going through it.

[00:22:31] Clay Finck: And I’d imagine that a lot of people, they read a book, they put it down, and then they just go on to the next book and just sort of forget about the previous one they read. But I think going back and revisiting some of the key points can really be helpful in retaining and making sure you don’t forget some of those key lessons.

[00:22:47] Clay Finck: And then the third piece here I wanted to mention was that this was also mentioned by Adler in Hagstrom’s book is asking yourself the right questions. And, you know, I see your notes here that you’re going to be getting to this, but Jim Quick talks about how our brain is a deletion device and asking ourselves the right questions can help our brain pick up the answers we’re looking for, because it tells our brain what’s important and it helps it sort of filter through the important information and Delete what we do not as important.

[00:23:21] Kyle Grieve: Yeah, I love that point about the deletion device. So getting continuing on with that. Why don’t we just get into the Adler system here and talk a little bit about the questions that he thinks are so important? Adler basically breaks down just 4 key questions to keep in mind while you’re reading a book to deepen your understanding.

[00:23:38] Kyle Grieve: So number 1 is what is the book about as a whole? Number 2 is what is being said in detail number 3. Is the book true in whole or in part? And for what of it? There’s a lot more detail that Hagstrom talks about that is worth reading in his book. But the main gist here is that when you’re reading a work of non fiction, you should be focused on the key concepts that you’re learning from that book and trying to figure out if they are true or if they’re more accurate than a different author or what you currently believe.

[00:24:08] Kyle Grieve: It can also help you think about the author. What’s the author trying to tell you in what they’re writing? And is that information usable to yourself? Sometimes it might not be usable at all. So you can compare what they’re saying to other authors who are talking about a similar subject. Maybe they don’t agree with each other.

[00:24:24] Kyle Grieve: And hopefully you can come up with your own insights on which author is more right or wrong on a specific topic. And then you can use that information to make better decisions in the future. There’s a really great example of this kind of framework playing out that Charlie Munger wrote about in Poor Charlie’s Almanack.

[00:24:39] Kyle Grieve: Charlie is talking about some of the concepts that he learned from reading Steven Pinker’s book, The Language Instinct. So one of Charlie’s biggest takeaways from that book was that language is embedded deep in the human genome. So this is a concept that Charlie felt Pinker did a really good job of explaining.

[00:24:54] Kyle Grieve: And in the book, Pinker couldn’t understand why one of his contemporaries, Noam Chomsky, just couldn’t agree with him on his premise. So here’s what Charlie said. Well, the junior professor is clearly right, and Chomsky’s hesitation is a little daft. But if a junior professor and I are right, how has geniuses like Chomsky made an obvious misjudgment?

[00:25:14] Kyle Grieve: The answer is quite clear to me. Chomsky is passionately ideological. He is an extreme egalitarian leftist who happens to be a genius. And he’s so smart that he realized that if he concedes this particular Darwinian point, The implication threatens his leftist ideology. So he naturally has his conclusions affected by his ideological bias.

[00:25:36] Kyle Grieve: And that gets into another lesson in worldly wisdom. If ideology can screw up the head of Chomsky, imagine what it can do for people like you and me. So I felt like this was just a really good example of Charlie reading, you know, a book. And then coming to his own conclusions about the general gist of the book, he then compared it to another author writing about similar things and came up with his own conclusions of who seemed to make the most compelling argument and why.

[00:26:00] Clay Finck: So that example points to an idea that Hagstrom talked about, which is that when we read, we want to try and go in with a clean slate and rather than looking for confirmation bias or looking for information that. Aligns with our current reality. We wanna read it and determine whether what they’re saying is true or not.

[00:26:19] Clay Finck: Adler also said that you can’t understand a book if you refuse to hear what it’s saying. I also like the point he made that critical thinking and critical analysis. It’s really a fundamental skill to success and investing. So the skill of critical thinking is directly linked to the skill of being a good reader.

[00:26:40] Clay Finck: He writes that good readers are good thinkers. Good thinkers tend to be great readers and in the process learn to be even better thinkers. So it’s no wonder that some of the greatest investors we know today are just avid readers because Reading in itself enhances your cognitive ability and enhances your analytical skills.

[00:26:59] Clay Finck: He also talks about how reading non fiction and reading fiction is just a totally different experience. For example, reading an annual report or reading some write up done by an analyst on an individual company, versus reading a novel that just tells a story. I think fiction appeals much more to our imagination much than it does to our intellect, and the content is really highly subjective, and it’s impossible for an analytical thinker to analyze, which can at times make it more difficult to read in some ways, I think, for some people.

[00:27:36] Clay Finck: I think back to when I read Zen and the Art of Motorcycle Maintenance last year, I got quite frustrated sometimes because I felt like I was just reading all these pages and not getting a lot out of it, but I really wanted to get through the book and I just did my best to hop along for the experience of kind of the story he was telling in it.

[00:27:53] Kyle Grieve: Yeah, I felt the exact same way on that book as you did, Clay. The last part on literature that I want to discuss here is some fiction examples that Robert mentioned. He talks about some of the great detective stories and references three of the best known fictional characters here. So I just want to go through these three characters because I do think it’s really applicable to investing.

[00:28:12] Kyle Grieve: The first one is Auguste Dupin. He has two main points. One, develop a skeptic’s mindset. Don’t automatically accept conventional wisdom. And two, conduct a thorough investigation. The next is someone everyone’s going to know, which is Sherlock Holmes. So he had four main points here. One, begin an investigation with an objective and unemotional viewpoint.

[00:28:33] Kyle Grieve: Two, pay attention to the tiniest details. Three, remain open minded to new, even contrary information, and four, apply a process of logical reasoning to all that you learn. The last fictional character is Father Brown, who I wasn’t really familiar with until I read about him through Robert Hagstrom, but, so his three points are, one, become a student of psychology, two, have faith in your intuition, and three, seek alternative explanations and re descriptions.

[00:28:59] Kyle Grieve: So I enjoyed all these lessons. The themes that really stand out to me between the three of them are skepticism, contrarianism, open mindedness, and the importance of psychology. I think all of these areas are super important and should be utilized in our investing, and analysis, and as well as our problem solving.

[00:29:17] Kyle Grieve: So if we look at one of Charlie’s most successful investments in BYD, we knew that he was skeptical about the general stance on China at the time that he bought it. It was a contrarian move to buy a business in a communist country that very few people understood. The only reason Charlie found the business was because he kept an open mind about China and the opportunities it offered in the future.

[00:29:37] Kyle Grieve: And I think he was really able to understand the psychological makeup of BYD CEO Wang Xuanfu before the market did. And I think this is why he and Berkshire were able to earn such good returns on that investment.

[00:29:51] Clay Finck: Yeah, the best investments are those in which most people disagree with you and you’re correct in your contrarian viewpoint.

[00:29:58] Clay Finck: So in 2016, Apple was purchased by Buffett. It was at an earnings multiple of say 10 or 12 and the market viewed it more like a hardware company. Buffett recognized that it was really much more than that. And he, eventually the market came to agree with him. And now he’s made six X’s money since 2016. But buying Apple today at a earnings multiple of 30 isn’t necessarily a contrarian bet.

[00:30:21] Clay Finck: And being open minded is required for you to develop that contrarian viewpoint. And oftentimes you have to dig well underneath the surface and get past that surface level to really get to the essence of a business and truly understand it. I believe Li Lu helped Charlie Munger With the BOID investment, or maybe they collaborated on that.

[00:30:42] Clay Finck: Li Lu he’s he practically turns into an investigative journalist when he finds an investment idea. He likes being a great investor really has a lot of parallels to being an investigative journalist because you’re just trying to find out every single thing you can about a company and try and uncover all the information you can and who’s running the business, all the industry they operated and just literally everything.

[00:31:04] Clay Finck: And what’s also funny is that. Apple was an example that was just hiding in plain sight in 2016. We all had an iPhone. We knew that we probably were going to be using iPhones for at least a number of years ahead. And the market essentially didn’t view it as a strong brand like a Starbucks or a Nike, which we’re trading at multiples of 25 or 30.

[00:31:26] Clay Finck: So it’s points to the fact that a contrarian bet, it doesn’t have to be a stock nobody’s ever heard of. It just has to be something where your view significantly differs from the consensus. And just because there are dozens of analysts covering it doesn’t mean that they can’t get it wrong.

[00:31:41] Kyle Grieve: So turning to mathematics here, I want to start by covering the simple idea of evaluation.

[00:31:46] Kyle Grieve: So Robert Hagstrom points out here that the formula for evaluating stocks was accidentally created by Aesop in his tale of the hawk and the nightingale about 2600 years ago. So the gist of that story was that the hawk caught the character called Nightingale. Nightingale basically pleaded for the hawk to release him as he was small and he was trying to say that there’s larger game that could be found elsewhere.

[00:32:08] Kyle Grieve: So the hawk replied, I should indeed have lost my senses if I should let go food ready it ready to my hand for the sake of pursuing birds not even in sight. So Warren Buffett knew of the story and to complete the evaluation picture, he added three simple questions to answer to find the value of any asset.

[00:32:25] Kyle Grieve: One, how certain are you that there are indeed birds in the bush? Two, when will they emerge and how many will there be? And three, what is the risk free interest rate? Buffett then said, if you can answer these three questions, you will know the maximum value of the bush and the maximum number of birds you now possess that should be offered for it.

[00:32:43] Kyle Grieve: And of course, don’t literally think birds, think dollars. So Hagstrom’s very simple method for this calculation is outlined in the Warren Buffett way. In the book, he takes a business’s owner’s earnings and then divides them by the risk free rate. So owner’s earnings simply are net income plus depreciation amortization, less maintenance capex.

[00:33:02] Kyle Grieve: Hagstrom gives an example of this calculation for the Washington Post. So the business in 1973 was at only an 80 million market capitalization, but Buffett said that the business was worth 400 to 500 million. Buffett made a series of adjustments. He basically, he understood the newspaper business and he knew that Washington Post in particular would have, would have had earnings that approximate the owner’s earnings because depreciation and amortization would essentially equal maintenance capex.

[00:33:31] Kyle Grieve: He understood that the Washington Post had latent pricing power and could charge more. He also understood that Washington Post during that 1973 period had depressed operating margins that were likely to increase in the next few years. With all those adjustments, Buffett essentially came to a number of approximately 33 million in owner’s earnings.

[00:33:52] Kyle Grieve: And then if we divide that by the long term treasury yield at the time, we got a market cap of 485 million and that’s kind of how he arrived at that figure.

[00:34:00] Clay Finck: Yeah. Coming into the world of investing as a beginner, I thought, you know, as a numbers person, it was just all about the numbers, the revenue growth, the earnings growth, the PE ratios, and really the more I’ve been a part of this game of investing, the more I’ve come to appreciate.

[00:34:16] Clay Finck: The qualitative factors and how those are probably much more important over the long run. So a member of our tip mastermind community, that’s an equity analyst. He recently gave a presentation on MasterCard and he had mentioned that his job, that the vast majority of his time is spent on qualitative factors.

[00:34:34] Clay Finck: So studying the business, studying the industry, studying the management team. But that’s not to say that the numbers obviously aren’t important. If you get the qualitative factors right, then usually the numbers tend to take care of themselves over the long run. I’m reminded of a blog article that Chris Mayer wrote.

[00:34:51] Clay Finck: He shared this brilliant chart that I wanted to talk through here. It really talks about what drives returns over certain timeframes. So really what the charts getting at is over the next quarter, over the next year, a stock price is primarily driven by the change in the sentiment and the change in the multiple.

[00:35:10] Clay Finck: Those are things that are really difficult, if not impossible to predict, but as you extend that time horizon out, it’s really the returns of a stock are really driven by return on incremental invested capital. So what sort of return is the management team getting on their investment? And, you know, that really gets to all these qualitative aspects of, you know, how is a business evolving over time?

[00:35:34] Clay Finck: How is the industry dynamics changing over time? And then over the really long term, he points to the culture and the people within a business, and that is just purely qualitative to a large extent. And it just can’t be distilled down to a simple number. And that’s not to say that valuation, for example, isn’t important.

[00:35:55] Clay Finck: It’s just one piece of the analysis. And at the end of the day, buffet and most other value investors are trying to determine the intrinsic, intrinsic value, which is the sum of the cash that a business is expected to generate, and then discount it back to today. Yeah, the long term cash generation is really driven by these qualitative factors and you can’t just simplify it down to just numbers.

[00:36:18] Kyle Grieve: So the next part in the math section that I found really interesting was the concept on Bayesian analysis. So the theorem is quite simple. When we update our initial belief with new information, we get a new and improved belief. Robber gave a really, really good example of understanding Bayesian analysis, so let’s imagine that you and a friend have spent the afternoon playing your favourite board game and now at the end of the game are chatting about this and that.

[00:36:43] Kyle Grieve: Something your friend says leads you to make a friendly wager that with one roll of a die you will get a 6. So straight odds here are 1 percent probability. But then suppose your friend rolls a die again, quickly covers it with her hand and takes a peek. I can tell you this much, she says, it’s an even number.

[00:37:02] Kyle Grieve: With this new information, your odds now have changed to one in three, a 33 percent probability. While you consider whether to change your bet, your friend teasingly adds, and it’s not a four. Now your odds have changed again to one in two, a 50 percent probability. With this very simple sequence, you have performed a Bayesian analysis.

[00:37:19] Kyle Grieve: With each new piece of information, it’s affected the original probability. So how can we connect this to the world of investing? When I’m looking at a potential investment, Often what I’ll do is I’ll assign probability to end to a specific outcome. So let’s say we have a 33 percent bear case, 33 percent base case and 33 percent bull case.

[00:37:40] Kyle Grieve: Maybe the bear case is dependent on the business having, you know, some sort of headwind that may or may not happen. Let’s say a year goes by and now the bear case is extremely unlikely for the sake of simplicity. We’ll just say it has a zero probability, even though this rarely actually happens in the real world.

[00:37:57] Kyle Grieve: So now, we have a 50 percent chance of our base case and a 50 percent chance of the bull case. This is a great asymmetric bet, as our downside is now zero and the odds are heavily in our favor. If you understand how this works, I think Bayesian analysis is a very, very handy tool to add to your toolbox.

[00:38:14] Clay Finck: Yeah, I think Bayesian analysis is a really powerful mental model. It’s essentially continuing to update our assumptions and then continuing to update our probabilities. To use an example here, let’s say you find a great company as a strong history of success and you expect to continue to do really well.

[00:38:31] Clay Finck: You purchase shares in that business, but the business starts to become disrupted by competitors and their growth comes to a halt. So now things have changed and it probably isn’t what you expected. And this can be a difficult situation because when you, you think about Bayesian probabilities, you might’ve entered a position thinking that there’s a 75 percent chance of success or of the bull case.

[00:38:55] Clay Finck: But now that growth has slowed and now that you have this new information, maybe the odds of success are now down to 50 percent for example, and maybe eventually it gets to a point where you think the original thesis is busted and it’s time to exit the position. So Bayesian probability is really what’s happening here when you decide that you were wrong on the investment and then you take your losses.

[00:39:16] Clay Finck: So to use a more recent real time example Kyle and I have talked about Dino Polska and they’ve actually seen slowing growth in recent quarters and it’s traded down a bit. And the question I ask myself is, has things changed in the most recent quarter? They opened 32 stores in the quarter from a year ago, they opened 54 stores.

[00:39:36] Clay Finck: But when you look back at history, you’ve seen accelerated store growth. So yeah, yeah. You know, we have, of course, need to look into what’s happening here, and it might sound like bad news, but they’re actually investing in building out four new distribution centers, which are used to supply the stores.

[00:39:50] Clay Finck: And this is actually great news because it essentially means that management is preparing for the next leg of growth. So investors just need to be patient and let management do what they’re going to do, which is execute on that growth. And focusing on the long term and not pushing for the short term quarterly headline numbers.

[00:40:07] Clay Finck: So in that case, the Bayesian probabilities really don’t change for me. And I still foresee continued growth and a hundred percent reinvestment rate, high returns on incremental capital going forward and transitioning here to another part of the mathematics chapter. From time to time, I’ve heard some investors talk about how we’re now in a stock pickers market.

[00:40:28] Clay Finck: And then the, the reasoning is that. These really big tech companies that we all know about have driven the gains in the stock market for the last 10 to 15 years. And eventually they aren’t going to be able to pull the weight they once did. We’ve seen a lot of multiple expansion in many of them, and that could lead to So we could call it like a sideways market type environment for the index.

[00:40:49] Clay Finck: And we’re all familiar with the bull market bear market, but sideways markets are when Buffett and some of the other great investors like really shine. So there was a period from 1975 to 1982 where the Dow was flat. So we can call that a sideways market just because we may be entering entering this type of environment doesn’t mean that we should necessarily avoid stocks.

[00:41:12] Clay Finck: During that time period, 18 percent of stocks doubled over a three year rolling period. So even though the market overall wasn’t really moving, there were still a good number of stocks that did well. And then if you extend that out over a five year period, 38 percent of stocks doubled. And Hackstrom points out that we can’t just look at an index or an average and apply that to every stock because there’s a significant amount of variation within the market.

[00:41:38] Clay Finck: And I would argue that just about in any market environment, there’s always, always going to be opportunities out there.

[00:41:45] Kyle Grieve: So the final subset of mathematics that I want to cover is regression to the mean. So the Roman, Quintus Horatius Flaccus wrote, Many shall be restored that are now fallen, and many shall fall that are now in honor.

[00:41:57] Kyle Grieve: So this simple sentence perfectly illustrates regression to the mean. Regression to the mean, in my eyes, has many similarities to the points on equilibrium that we’ve discussed a few days ago. Another way to look at it through the lens of investing is that what is hated will once again be loved and what is loved will once again or will eventually be hated.

[00:42:16] Kyle Grieve: So in that light, it’s easy to see the use case for investing. We know that the stock market is mostly efficient and that stock prices usually track intrinsic value most of the time. This is regression to the mean. So Francois Rochon, who Clay recently interviewed, had a wonderful illustration of how regression to the mean can work.

[00:42:36] Kyle Grieve: So he took the sum of the earnings per share and the dividend yield for all the businesses in his portfolio each year. He calls this owner’s earnings. It’s worth noting that this isn’t the same as Warren Buffett’s owner’s earnings. So He has this very simple chart that he put out in his annual report, and he basically annualizes the numbers since the inception of his fund in 1996.

[00:42:58] Kyle Grieve: So when you look at the owner’s earnings, they’re 12. 9%. And can you guess what the market returns of his portfolio? Yes, it’s 12. 9%. It’s pretty impressive. So he ran the numbers as well for the S& P 500, and they came out as owner’s earnings of 8. 6 percent and a return of 9. 6%. Now, how does this relate to regression of the mean?

[00:43:18] Kyle Grieve: Roshan really understands that over the short term value and price can become disconnected. So in, in the chart that he has on his annual, he shows the difference between changes in owner’s earnings and the difference in market prices. And since 1996, there was only one year. Where there was zero difference between the increase in the intrinsic value of his business and the increase in the market price.

[00:43:42] Kyle Grieve: So every other year there were these swings that were widely, you know, prices were maybe going up 20, 30 percent up or down, whereas the intrinsic value maybe was going up in that 12 ish percent range. So the point in the long one here is that market will regress upwards or downwards towards the increase or decrease in intrinsic value of your portfolio.

[00:44:02] Clay Finck: This ties in really well with Howard Marx’s book, Mastering the Market Cycle. So when you look at a lot of great businesses, their intrinsic value just tends to increase over time as their profits increase year after year. So what you tend to see is the stock price will typically oscillate around that intrinsic value.

[00:44:22] Clay Finck: And really what causes that is human psychology and human behavior. Howard had said on our show that humans tend to take things too far. So stock prices rarely stop at the intrinsic value when it’s going up. It tends to exceed it. And eventually it turns the other way and oscillates back below the intrinsic value.

[00:44:41] Clay Finck: And this is something Kyle and I also covered in our previous chat. So. What’s interesting though, for what you pointed out for the Franchois Rochon example, is that almost always, essentially always over a long enough time period, the intrinsic value is the dominating factor in the long run. So one of the statistics from Marx’s book that is just amazing to me is that it’s pretty common knowledge that The return of the stock market tends to be in that 8 to 12 percent range, depending on what time period you look at, but the market hardly ever delivers returns within that range.

[00:45:19] Clay Finck: And that’s human psychology and human behavior at play. So from 1970. Through 47 year time period. There were only three years where the market returned between eight and 12%, which just seems bonkers. It’s because we’re all so used to that eight to 12 percent return, you know, it tends to be what people expect, but it’s in from a year to year basis, it’s almost never a reality.

[00:45:44] Clay Finck: So we’re told that the market’s going to return around 10%, but it hardly ever. Actually delivers that. And I think it really highlights the impact of cycles and how the average returns are much different from the returns we tend to see year to year. And I also think that once you understand this. You’ll likely be much more eager to invest when stocks are down as opposed to when they’re up because you know eventually the intrinsic value is going to tend to dominate over the long run and things always seem to naturally swing back, that pendulum seems to come back the other way eventually.

[00:46:20] Kyle Grieve: So I want to start the part on decision making here by using one of the three questions from the cognitive reflection test that Robert cites in the introduction to his chapter. So, if a bat and a ball cost 1.10, then how much does the ball cost? There’s a very good chance that your answer is going to be wrong here.

[00:46:37] Kyle Grieve: But even the brightest minds at MIT, Harvard, and Princeton got 50 percent of the time, so don’t beat yourself up about it. The first time that I was exposed to this question, I can admit that I got the answer completely wrong as well. The first time I read it was in Daniel Kahneman’s Thinking Fast and Slow.

[00:46:53] Kyle Grieve: And so the primary point of that book was that we have two systems of thinking. Kahneman calls them system 1 and system 2. When we were thinking about a question like the bat and ball problem, we default to our automatic system 1, To find out the answer, but there’s a problem with that system. One often does not provide the right answer, so it’s worth noting that system.

[00:47:13] Kyle Grieve: One is very powerful and necessary. It’s a more intuitive system, but intuition very often does not work out. And intuition works very well in very specific conditions. So system 1, for instance, if we look back at history, if we see an animal that’s going to try and eat us, it tells us to run away.

[00:47:30] Kyle Grieve: Obviously that was very, very important. But these days, obviously that intuition is not very useful and obviously gets us into a lot of trouble with certain things. Getting back to that bat and ball problem. If we want the correct answer, we should probably actually rely on our more effortful system 2.

[00:47:45] Kyle Grieve: So this system is where slow, deliberate, deep thought occurs, and we can at time come up with much better answers relying on system 2 versus relying on system 1. So one part of the book that I highlighted was Kahneman’s conclusion on intuitive thinking. Intuitive skill exists mostly in people who operate in simple, predictable environments and that people in more complex environments are much less likely to develop this skill.

[00:48:10] Clay Finck: That example of the bat and ball is just so funny because it really just helps you realize in real time system 1 and system 2 thinking happening within you and we can be so quick to jump to incorrect conclusions and feel married to that conclusion in a way. And I think back again to when we were in school, we’re sort of conditioned to answer questions quickly and always just be working against the clock on a problem, which essentially encourages system 1 thinking and getting to an answer quickly.

[00:48:40] Clay Finck: Rather than taking a step back and ensuring that we’re thinking through it correctly. So that point on intuitive skill. Is really interesting to Kahneman accepted the idea that army officers, firefighters, physicians and nurses, these are all fields where you see many of the same things repeated over and over again.

[00:49:00] Clay Finck: So people in these fields can naturally default to system 1 thinking. But investing, unfortunately, is much, much more complex than a lot of people are led to believe. An intuitive skill is much less common in this arena as a result. So we need to develop the skill of really thinking through things closely and not coming to conclusions too quickly.

[00:49:23] Clay Finck: Through system 1 thinking, and it’s pretty clear that all the successful investors I’ve chatted with, they are all extremely deep thinkers that study businesses very, very thoroughly. So success is no accident when it comes to investing. One way to ensure that we’re using more system 2 thinking is to do something like utilize a checklist that requires you to understand the business really well before making decisions on it.

[00:49:51] Clay Finck: And it’s easy to act on a stock when you see. High revenue growth and optically low valuation multiple, but oftentimes these surface level ideas that require system 1 thinking aren’t really going to move the needle for you. You know, you might get lucky and it ends up working out, but it’s the system 2 thinking that’s going to drive a lot of your performance, I think.

[00:50:13] Clay Finck: Lawrence Cunningham had a quote in his book, Quality Investing, that I think sums up the power of checklists pretty well. He wrote, a good checklist should enumerate all the desired attributes for an investment and ideally the steps required for full due diligence. It should also incorporate lessons learned from previous mistakes and be regularly updated accordingly.

[00:50:35] Kyle Grieve: So Clay, your point here about how school encourages system 1 thinking really resonated with me. Thank you. I always found in school that I would finish a test earlier than other people, and I would always be proud that I answered every single one of the questions, but unfortunately, I wouldn’t always get all the answers right.

[00:50:50] Kyle Grieve: So, if I’d been given more time and had that ability to have less pressure and really come up with the right answers and use system, more of my system 2, then perhaps I would have gotten the correct answer and gotten better grades. But I digress. So the next thing I want to discuss is hedgehogs and foxes.

[00:51:06] Kyle Grieve: So Hagstrom points out that 2600 years ago, a poet named Archilochus who I probably am butchering there wrote that the fox knows many tricks, the hedgehog only one. So you may be thinking, what does this have to do with decision making? So that was kind of a question that the great Philip Tetlock, author of Super Forecasters, tried to address.

[00:51:26] Kyle Grieve: In one of his studies on expert political judgment, he separated forecasters into two groups. So one was Hedgehogs and one was Foxes. Both groups didn’t perform well, but that wasn’t the interesting takeaway. The interesting takeaways was what he found that there was just more success in forecasting in the fox category compared to the hedgehog category.

[00:51:47] Kyle Grieve: So the next thing he sought out was what was the reasoning for this? Why were, why did the hedgehogs underperform? He came up with two primary conclusions. So, one was that hedgehogs tended to fall in love with their pet theories, and number two was that hedgehogs were slower to change their mind. So, in contrast, Tetlock concluded that the foxes had three superior advantages.

[00:52:08] Kyle Grieve: Number one, their initial estimates are closer to base rates. Number two, they are more apt to adapt their decisions as quickly as new information is released. And finally, number three, they adapt to the pull of just confirming evidence. So I think it’s quite obvious in the world of investing that being a fox is probably going to be a more superior choice than being a hedgehog.

[00:52:30] Kyle Grieve: And the points above are all highly relevant to investing, especially that second and third point. As investors, it’s obviously super important for us to be able to change our minds based on new information that we have at our disposal. If you can’t change your mind on a stock where the thesis is completely changed, then you’re likely going to hold really poor investments for long periods of time.

[00:52:51] Kyle Grieve: So I just wanted to make one kind of argument here about the hedgehog characteristics. So there’s one that I actually think is somewhat beneficial to being a long term investor. That is the point that hedgehogs are slower to change their mind. So I actually think for me being slower to change my mind has become more and more of a benefit than a detractor.

[00:53:11] Kyle Grieve: So let’s say I buy into a stock that I think is going to perform very well over a multi year time period during that multi year time period that I’m holding the stock, there’s going to be so many small events and noise. And you know, things that just don’t really matter for that business that are going to affect the price of it.

[00:53:29] Kyle Grieve: It’s going to go up, it’s going to go down. And if I’m really quick and I see, okay, the price has gone down, I’m really quickly to sell it because I’m scared. Well, that’s not really going to help me in the longterm. So I think slowing down and really thinking about the decisions and really thinking about where you might be right or wrong is is actually really, really smart.

[00:53:49] Kyle Grieve: So it’s kind of this push and pull. Sometimes you have to be quick. Sometimes you have to be slow.

[00:53:54] Clay Finck: I love the fox and hedgehog comparison because it reminds me of John Huber. In the way he invests. I thought it was so interesting that John is really looking for three types of investments. So you have your typical compounders or higher growth businesses think like a copart, which he owns.

[00:54:14] Clay Finck: The second is blue chips that are out of favor. So Apple in 2016, Amazon in recent years. And then the third is bargains or special situations. So this is very much like a Fox type approach where he’s, you know, he’s not just looking for one type of company. And, you know, a lot of investors I think just look for one type of company and this is really a hedgehog approach.

[00:54:35] Clay Finck: And I think John is really flexible to acting opportunities that he thinks are best within the market and weighing the opportunity costs with what the market’s giving him. So quality investing is what Kyle and I have talked a lot about on the show. It’s gained a lot of steam over the past decade or show.

[00:54:52] Clay Finck: But John points out that Buffett, for example, he rarely pays over 15 times earnings for a public company. Oftentimes he pays 10 times earnings or less. I think John recognizes the power of owning great businesses, but is also cognizant to the fact that. Investors are starting to realize this as well, and he needs to find companies that the market doesn’t yet find to be great yet.

[00:55:16] Clay Finck: So to your point, foxes are better at recognizing really base rates. And while it might work out to pay, say 30 or 40 times earnings for a great company, he knows the base rates of success. Might not be as good relative to the other opportunities in the market. So another thing I picked up from John that I think really applies well here to decision making is that he spends a lot of time writing and journaling.

[00:55:42] Clay Finck: And I think that really helps him clarify his thought process. And then he also spends a lot of time just giving his mind space to think. So he might write or read something and then go for a long run. And his mind really has time to process. What it is he was writing or reading about, and it’s clear that that has been a really powerful tool to help him clarify his thinking and really give him his mind space to think about these difficult problems.

[00:56:08] Clay Finck: And I like how Hagstrom sort of summarized the difference between the approach of the hedgehog and the fox. He writes, hedgehogs start with one big idea and flow through no matter the logical implications of doing so. And foxes, they stitch together a collection of big ideas. They see and understand the analogies and then create an aggregate hypothesis from there.

[00:56:31] Clay Finck: So foxes are just the perfect representation of using these mental models and then implementing them within our toolkit.

[00:56:40] Kyle Grieve: So I think that most people would associate high levels of intelligence with high levels of rationality, but Keith Stanovich in his book, what intelligence tests miss the psychology of the rational thought would tell you that the two are definitely not correlated.

[00:56:54] Kyle Grieve: So in the book, he created the term disrationalia, which is the inability to think and behave rationally despite having high intelligence. So reading about disrationalia made me think of a really good book I recently finished called When Genius Failed by Roger Lowenstein. So the book talks about long term capital management’s rise and fall.

[00:57:14] Kyle Grieve: The business was chock full of talent and brains, and unfortunately, that wasn’t enough to produce long term success. So Buffett summed this up incredibly well in 1998. The whole long term capital management, I hope most of you are familiar with it, the whole story, is really fascinating because if you take John Merriweather, Eric Rosenfeld, Larry Hillenbrand, Greg Hawkins, Victor Heghani, and the two Nobel Prize winners, Merton Schulz, If you take the 16 of them, they probably have as high of an IQ as any other 16 people working together in one business in the country, including Microsoft or whatever business that you want to name.

[00:57:50] Kyle Grieve: So an incredible amount of intellect in that room. Now, you combine that with the fact that 16 had had extensive experience in the field they were operating in. They weren’t a bunch of guys who made their money, you know, selling men’s clothing, and then all of a sudden went into the securities business.

[00:58:05] Kyle Grieve: They had in aggregate the 16, probably 350 or 400 years of experience doing exactly what they were doing. And then you throw in the third factor that most of them had virtually all of their substantial net worth in the business. So they had their own money up hundreds and hundreds of millions of dollars of their own money up super high intellect working in a field they knew and essentially they went broke.

[00:58:27] Kyle Grieve: That to me is absolutely fascinating. Buffett further went on to say, but to make money they didn’t have and didn’t need, they risked what they did have and did need. So Stanovich said here that there are two primary causes of disrationalia. One, process problem. Two, content problem. I’m going to let Clay cover that in a little more detail.

[00:58:48] Clay Finck: Yeah, so piggybacking on what Stanovich was saying there, he believes that humans generally process information poorly. So some people are slow and thoughtful in their decision making, think the systems 2 thinking, and then other people tend to really use very little effort and just make the snap decision.

[00:59:06] Clay Finck: So that’s really system 1 thinking, and most people tend to default to using Lower levels of concentration simply just to preserve energy. Or in other words, most people are just wired to be lazy thinkers and they take the easy way out when solving problems. And as a result, their solutions aren’t really the best.

[00:59:24] Clay Finck: So they use system 1 instead of system 2 thinking. I think one way to try and apply more system 2 thinking is just to ask yourself the hard questions. When you ask yourself the right and the hard questions, your mind starts to look for that answer. And it can be difficult to dig past that initial reaction we have, but it’s what you really need to try and do.

[00:59:46] Clay Finck: And then the second issue was not having them. The right content to make proper decisions. Stanovich refers to the gap between what you currently know and what you need to know. He refers to this as the mind wear gap, which can really be obtained through the study of broad subject matters, which also is what he refers to as the meta curriculum.

[01:00:09] Clay Finck: And this is why value investors always emphasize continuous learning. We should always be looking for new knowledge and new tools to add. And Hagstrom explains that even when we’re able to find inefficiencies in the market, we still shouldn’t let that stop us from acquiring new building blocks of knowledge to add to our repertoire.

[01:00:29] Clay Finck: So he uses a number of examples to explain why this is. But the one I liked the most is that it’s like a company continuing to spend on research and development. So in the short term, it might look good to not spend on research and development because it boosts the short term earnings and then potentially boost the stock price.

[01:00:49] Clay Finck: But over the long term, there’s so much to be gained from research and development. You know, it can bring new innovations, ensure the company’s staying ahead of its competitors ahead of the curve. And it also gives them an embedded asymmetry of discovering something that they would have never discovered otherwise.

[01:01:06] Clay Finck: And, you know, it allows them to just gives them a ton of opportunity for growth over the long run. So the same mental model we can really apply to ourselves, you know, continuing to learn new things and be on the lookout for, you know, ways in which we can improve as investors.

[01:01:22] Kyle Grieve: That’s most of the mental models from the book, but there’s a couple more things that I wanted to chat about.

[01:01:27] Kyle Grieve: So, in the chat that we, that Clay and I had a couple days ago, I covered that I wanted to go over a couple ways that have helped me with thinking in mental models, and more importantly, making that really into a habit. I’ve kind of been running this system now since the last quarter of 2023, and I’d like to share it with you about how I’m trying to make thinking and mental models more of a habit.

[01:01:47] Kyle Grieve: The first thing I’m really trying to do is actively trying to learn more about these mental models and many of them that we’ve gone over today. So I think that you can pick and choose kind of how much time you want to spend on a new mental model. Maybe it’s a week at a time, maybe it’s a month at a time or whatever that you think is both reasonable and doable.

[01:02:05] Kyle Grieve: So I’ve been using a lot of different resources to learn just mental models. So obviously there’s the book that we went over today, investing the last liberal art by Robert Hagstrom. There’s a wonderful three part series called the great mental models by Farnham street. There’s Farnham street blog, which it does a wonderful job of going over tons of the mental models in the book and giving you different perspectives.

[01:02:27] Kyle Grieve: There’s Poor Charlie’s Almanack by Peter Kaufman. There’s two books by Michael J. Mobison that I really like, Think Twice and More Than You Know. Awesome books. And then, you know, once you know some of these mental models, you can literally just type it into Google or YouTube and you can get, you can get down some very, very deep rabbit holes there as well.

[01:02:44] Kyle Grieve: So, there really is, it’s easy. You can, if you wanted to, you could just use Google and, and learn all these mental models for, and pay zero dollars. But the books I find sometimes just give you a little bit of a, of an edge and lead you in the right direction. The trick here though, if you do decide to go down a rabbit hole, it’s not really necessary.

[01:03:00] Kyle Grieve: You don’t need to spend 40 hours trying to understand some obscure physics concept. I mean, like we’ve kind of been discussing here, you just need to know the big idea behind some of the, the most important ideas from different subjects. So once you start hammering away at those mental models and start learning them and understanding them a lot better, The next step and probably the more important step is that you want to make using them as part of your thinking into a habit.

[01:03:27] Kyle Grieve: So to do this, I’ve kind of figured out two ways. Number one is to journal about it. And then number two is just actively thinking about it. So you don’t have to do either of them. You can do one or the other. I think it’s pretty hard to not get better at this if you don’t do one of them. I think active thinking is probably going to be the best.

[01:03:44] Kyle Grieve: So if you, but let’s say you journal. If you journal, you know, you can make a prompt every time you journal or maybe once a week or once every few days, whatever, and just connect it to mental model. So what I would do, I would just think about some mental model that I was learning. Then I would connect it, whether that’s to a business I own in my portfolio, a business, maybe that I’m researching, but then also just to my entire life.

[01:04:06] Kyle Grieve: I would, I might be thinking about, let’s just say I’m thinking about the mental model of inversion, which we didn’t go over, which is probably my favorite one. Yeah. But I might be thinking about inversion and friendship, for instance, nothing literally to do with investing. So basically what I would do is I would just invert what being a good friend is, try to find out how to be a crappy friend, and then just try to avoid that all costs.

[01:04:26] Kyle Grieve: And I would maybe write down what some of those things are. Some of them might be really obvious, but it also kind of gets your mind thinking about maybe some of the less obvious things. You know, if you don’t want a journal, because I know a lot of people don’t, that’s totally cool. You could also just, you know, set a timer for whatever, five minutes, 10 minutes, however much time you want, and just think about the exact same thing, you know, make the prompt about whatever mental model you’re using, then just try to connect it into whatever’s happening in your life, whether, you know, that’s friends, family, business.

[01:04:53] Kyle Grieve: Relationships whatever. So I think if you do this for a long time, you will really start thinking about things like your life, family, work, stocks in a different way. And you’re going to actively start trying to connect your life to the mental models that you are using and that you’re obviously starting to understand better and better.

[01:05:12] Kyle Grieve: You’ll notice links between the models. You’ll try and find ones that work, but most don’t and see that you’re finding the right one or if you’re trying to stick a square peg into a round hole. So, like, for instance, you know, let’s say, you know, 20 different mental models and you’re thinking about a problem, you might run through those mental models and you might be okay.

[01:05:30] Kyle Grieve: Well, you know, does critical mass it does that have literally any bearing to the problem I’m trying to solve? And most of the time you’re going to say no, and you just move on to the next one. And I think this is where Charlie was so good. He knew so many of them. He could just run, run down through them and instantly know which ones he used.

[01:05:46] Kyle Grieve: So this isn’t an easy process. I’m not going to lie and say that you can snap your fingers and tomorrow you’re going to have, have the same abilities that Charlie Munger has. But I do think that the more and more you practice it, you’re going to really, really cement your ability to think this way. Like I was saying about Munger, I think he’s a genius.

[01:06:03] Kyle Grieve: Like, I just think he, he thinks in a different way. I don’t think I’ll ever get to his point, but you know, if I can get to 25 percent of how good he was, I think that I will be wildly, wildly more successful. And so my whole point here is basically in just trying to systematize thinking and mental models.

[01:06:19] Kyle Grieve: And I think as you do it more and more, like for me, I’m noticing I’m I’ll think about a problem and I’ll automatically start thinking about mental models without even having to prompt myself to do it. So my hope is that, you know, doing this over many, many decades is just going to continue refining that process.

[01:06:35] Clay Finck: And Munger had all these models just in his head supposedly. So he’s just thought about this so, so much in all that he’s read and all the, all the work he’s done and just thinking through problems wisely. So you’ve been sort of doing this exercise for six months or so. I’m curious what some of your favorite mental models have been that you’ve reviewed over that time and kind of honed in on.

[01:06:59] Kyle Grieve: Yeah, absolutely. So there’s been a lot, so I’ll just go over a couple of the more recent ones. So I’ve actually learned some really good ones from the guests that I’ve had on the show pretty recently, actually. So through researching and chatting with Annie Duke on a TIP 623, I learned a lot about what she calls her kill criteria.

[01:07:17] Kyle Grieve: So this is basically just a simple way to create criteria that will kill an idea. So she covers a ton of different examples in her book quit, but I really enjoy talking to her because we got to really specifically look at these kill criteria through the lens of investing. For me personally, I know that I’ve held on to a couple of investments for just too long.

[01:07:37] Kyle Grieve: And I think if I had This mental model of cri kill criteria, I could have used it to kill my hypothesis probably sooner and probably would have avoided keeping these losers in my portfolio for as long as I ended up doing it. So just giving an example of what a kill criteria might be. We obviously talked a lot about, you know, pulse gun is going to continue on with that theme.

[01:07:58] Kyle Grieve: So let’s say Dino Polska’s store count started decreasing that to me is pretty much a kill criteria. I mean, maybe there’s some very, very good reason for that, but my hypothesis is built on growth and the business’s ability to continue reinvesting. So if they’re closing stores, well, that probably isn’t a very good thing.

[01:08:19] Kyle Grieve: So that might be a kill criteria, in which case it would signal maybe an exit from the business and then finding another opportunity to invest in. Thank you. Another set of mental models I learned was speaking from Vitaliy Katsenelson on TIP617, so Vitaliy and I talked very extensively about some of the stoic tools that he’s used to help just navigate a really complicated world.

[01:08:42] Kyle Grieve: So we discussed four tools, but There was one I think that had the biggest impact and that was the dichotomy of control. So basically the dichotomy of control, it’s super simple. It’s just, there’s certain things we can control. There’s certain things we can’t control. I think that if you view the world in that lens, it really helps you become much, much more resilient, which is what a lot of stoicism is about.

[01:09:04] Kyle Grieve: So dichotomy of control is incredibly valuable in investing. You know, obviously in investing, we, there’s tons and tons and tons of things that we have no control over and, but we do also have control over a number of things. So, for instance, I have no control over what the market thinks about the stocks in my portfolio.

[01:09:23] Kyle Grieve: You know, one day they might love them, one day they might hate them. Most of the time, probably going to be completely neutral on them. Knowing that, why should I be upset when the prices fluctuate on these things that I have no control over? That the answer is I shouldn’t, but I can get upset about what I can control.

[01:09:40] Kyle Grieve: What I can control is things like what businesses are in my portfolio. I’m looking for businesses that I have a high certainty are going to continue to increase their intrinsic value and I can buy them at either a reasonable price or super cheap. So that is what I can control. That’s kind of what I focus on.

[01:09:58] Kyle Grieve: So if a business is no longer increasing its intrinsic value, or maybe the intrinsic value is decreasing again, I have the ability to remove that stock from my portfolio and replace it with a better option. So I think that dichotomy of control is, is super important and understanding just in the market, there are so many variables that we have no control over.

[01:10:18] Kyle Grieve: And, you know, obviously you just kind of have to live with that and, and that’s kind of a feature of the market and, and focus on what you can control and focus on just trying to find really good investments that fit your own investing philosophy and your own investing criteria.

[01:10:32] Clay Finck: Yeah. So I’m glad you mentioned just like you’ve been pulling these mental models from the guests we’ve had on the show because it sort of makes you realize, you know, finding these mental models and implementing them into our lives.

[01:10:43] Clay Finck: Like, it’s something us and our listeners just naturally do. You know, we’re bringing on many great investors. We’re talking about many of these great books that authors have put out and yeah, I mean, all of us are sort of in this journey together of finding all these mental models, finding the ones that, you know, make the most sense to us to kind of add to our tool kit and then going from there.

[01:11:02] Clay Finck: And the one you mentioned with Vitality is super powerful of there’s so much that’s just outside of our control. And, you know, you can really get hung up in these things that you have no control over because. You know, life inherently is just really, really hard. And, you know, once you kind of develop that stoic mindset and develop, Hey, here’s the things I can control.

[01:11:23] Clay Finck: Did I make a mistake that I can learn from? And yeah, just trying to differentiate of the things we can’t control. Like, can you really do anything about it? I think sometimes it’s just like, it’s just the role of luck playing in. And, you know, there’s not much we can learn, but a lot of times you can learn something when you get that feedback externally. So yeah, 100 percent in terms of managing a portfolio, sticking to your circle of competence, I think is really important. And sticking with businesses, you know, well, a lot can go wrong when you get into stuff that you don’t know.

[01:11:53] Kyle Grieve: Well, so that’s all we have for you on today’s episode on investing the last liberal art.

[01:11:59] Kyle Grieve: Thank you very much for tuning in.

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