[00:01:54] 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.

[00:02:15] Clay Finck: All right. Jumping right back into the book, we’re starting with chapter 15, covering journaling as a powerful tool for self-reflecting. One thing I love about this book is that Gautam doesn’t just pull quotes and ideas from people like Warren Buffett and Charlie Munger at the start of this book, he has one quote from Benjamin Franklin, observe all men thyself most, and one from Lao Tzu, who’s an ancient Chinese philosopher. It is wisdom to know others. It is enlightenment to know one.

[00:02:43] Clay Finck: He then dives in to talk about the brain and how a significant part of our memories are mostly fiction because our brain is continually optimizing and conserving energy. When we recall information, this gets simplified and it’s likely leaving out and possibly oversimplifying key information.

[00:03:00] Clay Finck: This reconstruction of our memories happens every time we access it. So it’s something that’s continually happening and it’s continually simplifying this information that we’re recalling. And this is why journaling is so, so important. To be a great investor, you need to make quality decisions. And journaling allows us to record why we made a certain decision, and then in hindsight, analyze what we got wrong.

[00:03:23] Clay Finck: Gautam recommends having a notebook that tracks all of your important decisions. This allows us to compare what we originally expected to happen with, what actually happened, to identify the flaws in our thinking. Even if the outcome is good, you may come to realize that the reasons an investment played out well aren’t the reasons that you originally anticipated.

[00:03:42] Clay Finck: In hindsight, everything seems so obvious. Of course, stocks would soar in 2020 after the Fed printed so much money, but how many of us actually believed that as stocks were going down in March of 2020? A journal helps us avoid having hindsight bias. It allows you to continuously learn from your own mistake.

[00:04:01] Clay Finck: The significant intrinsic value of learning from one’s personal mistakes and even more important learning vicariously from others’ mistakes over an investing lifetime is grossly underestimated. One behavioral issue with investors is the planning fallacy, which leads us to making forecasts that are overly optimistic.

[00:04:20] Clay Finck: One reason we tend to do this is because of availability bias, which is us forecasting into the future based on the information available to us, such as what has happened in the past. Availability bias leads us to ignoring the unknown unknowns. One way to work through this is to conduct a pre-mortem, which is to investigate a bad outcome before it even happens.

[00:04:42] Clay Finck: This can help us combat our tendency to overestimate the likelihood of a bright future for a company. He writes, before you buy a stock, visualize that a year has passed from the date of your purchase, in that you have lost money on your investment, even in a steady market. Now write down on a piece of paper what went wrong in the future.

[00:05:01] Clay Finck: This prospective hindsight technique forces you to open up your mind to think in terms of a broad range of outcomes, to consider the outside view, and to focus your attention on those potential sources of downside risk that did not intuitively come to your mind the first time you thought about buying.

[00:05:17] Clay Finck: Value investors always think about the potential downside risks when first evaluating a potential investment. When making an investment, always ask what can go wrong? What will my reaction be if those things go wrong? What are the risks? How likely are the risks? How big are the risks? And can I bear them if they come true?

[00:05:37] Clay Finck: Gautam considers the journal he purchased for $10 to be one of the best value investments he has ever made. He uses it to keep track of his investing decisions and then how has investment philosophies developed over time. He would also take note of media commentary and investor behavior during various market panics and gyrations.

[00:05:56] Clay Finck: He says, writing apart from being a communication tool is a thinking tool too. It is almost impossible to write one thing and simultaneously think something. When you force yourself to handwrite something, it channels your thoughts in the same direction. Journaling turns out to not just be a tool for thinking, but also a highly effective medium for focusing our thoughts.

[00:06:18] Clay Finck: The more you write, the more precision of thought you build. Writing is a thinking exercise, and it acts as the shield against the rusting of our mind. It is also a useful tool for retaining what we’ve read, and it deepens our understanding. An added benefit of journaling is that it deepens commitment. The very act of writing things down deepens our resolve to make good things happen in our lives.

[00:06:41] Clay Finck: It is like a personal declaration that acts as a constant motivator. Journaling has therapeutic benefits too. Writing aids self-reflection, which is a great way to ease any unhappiness in our lives. It also improves our memory because we remember more when we write down our thoughts and learnings. This brings us to chapter 16, which I’ve really, really enjoyed.

[00:07:00] Clay Finck: It’s titled, Never Underestimate the Power of Incentives. Gautam, let me tell you, he really delivered in this chapter. Benjamin Franklin stated if you want to persuade, appeal to interest and not to reason, and Jesse Livermore said that my main life lesson from investing is that self-interest is the most powerful force on earth and can get people to embrace and defend almost anything.

[00:07:25] Clay Finck: When you understand incentives, it really changes the way you view the world. A lot of times when someone is selling me something, my mind almost immediately goes to the incentives and I ask myself questions like, what benefit does this person get if I buy this product or consider the difference in outcomes when I buy or don’t buy something, or I buy the higher ticket item versus the lower ticket item.

[00:07:48] Clay Finck: Nassim Taleb tied incentives to investing, stating, never ask anyone for their opinion, forecast, or recommendation, just ask them what they have or don’t have in their portfolio. Gautams opens up this chapter by stating we do that for which we are rewarded and avoid that for which we are punished. And incentives are at the root of most of the situations we face, and yet we often fail to account for them.

[00:08:13] Clay Finck: The iron rule of life is that you get what you reward for. People follow incentives the way ants follow sugar. Then a bit later, it is imperative that we think deeply about the incentive systems we create because ignoring the second or third-order effects of an incentive system often leads to unintended consequences, also known as The Peltzman Effect.

[00:08:36] Clay Finck: An example is monetary rewards that were offered to help exterminate unwanted animals such as rats and snakes. What authorities failed to foresee was that people would start to breed the rats and these snakes. It not only is important to have symmetrical incentives, but also it is crucial to not allow the gaming of the system.

[00:08:56] Clay Finck: Human beings have the tendency to game systems for their benefit regarding incentives. Munger has stated that almost everyone thinks he fully recognizes how important incentives and disincentives are in changing cognition in behavior. But this is not often. So, for instance, I think I’ve been in the top 5% of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power.

[00:09:22] Clay Finck: Never a year passes that I get some surprise that pushes a little further my appreciation of incentive superpower. What comes to mind for me here as an investor is how a company’s management team is compensated if a management team is incentivized with stock options. Well, if you understand how stock options work, you know that anyone who holds these options, they want to maximize the value of the shares in the short run because there’s an expiration date at which those options are exercised.

[00:09:49] Clay Finck: It creates this sort of asymmetric upside opportunity where there’s a big payout, say one year from now, or potentially no payout at all. So, there’s really no downside risk. So, this incentivizes them to maximize short-term earnings. And that’s really critical to understand because if they want to maximize the short-term earnings, that may be taking long-term sacrifices.

[00:10:10] Clay Finck: And then you can think about the management team that owns a bunch of shares in the company. This aligns the interests of the management team. With the long-term shareholder base, the management now has the downside risk assuming that they hold those shares for a really long time, they have skin in the game.

[00:10:27] Clay Finck: For me personally, I would want a CEO to be similar to Buffett and have 99% of their net worth invested in the company. So, they are deeply incentivized to give it their all and give their full attention to the company. Munger believes that the most important rule of management is to get the incentives right and Buffett has long been opposed of stock options because he believes that this creates broken incentives for managers and it’s really against the interest of the long-term shareholders.

[00:10:54] Clay Finck: Not only does Buffett want the management team to own shares in the company, but he also wants to tie their compensation to the key value drivers of the business. If they do their job well and they allocate capital effectively, then they should receive bonuses to recognize that job well done. In the case of GEICO, executives were compensated based on two key variables.

[00:11:14] Clay Finck: First was the growth in their auto policies, and second was the underwriting profitability on their auto business. Whether you’re a parent, a manager, an employee, a teacher, a salesman, or you take on many other roles, thinking about incentives between you and others is necessary to create win-win relationships.

[00:11:34] Clay Finck: Incentives encourage desirable behavior and disincentives to prevent them. Gautam explains incentive-caused bias is so pervasive that it occurs in almost every profession. Outsider CEOs avoid long-term value-creating investments in research and development because their compensation is based on them meeting or beating their quarterly Wall Street estimates.

[00:11:56] Clay Finck: Lawyers make clients litigate more than necessary. Doctors prescribe expensive branded drugs instead of generics. Contractors engage in the gaming of cost plus arrangements. Auditors overlook accounting irregularities, investment makers price IPOs to extract maximum value for their clients because that is the basis of which they get paid.

[00:12:18] Clay Finck: The real power of incentives is the ability to manipulate the cognitive process. An otherwise decent individual may act immorally because he or she is driven by the perverse incentives prevailing in the system. Because incentive-caused bias operates automatically at a subconscious level. You may be fooled into believing that what is good for you is also good for the client.

[00:12:41] Clay Finck: And so, you may find yourself selling addictive and harmful products like tobacco and alcohol or overpriced insurance just for the money. So as investors, we can use the power of incentives and recognize the role they play through these septal clues. When I did my initial research on a specific company, I mentioned the company to Stig, and he didn’t ask about any of the things I mentioned about the company.

[00:13:04] Clay Finck: And one of the very first things Stig mentioned to me was he asked what the insider ownership was within the company. Right away, I had noticed that during my initial research, I had forgotten about how important that was. Stig also thinks very hard about the incentives within our own company and how we’re all compensated at TIP.

[00:13:23] Clay Finck: He wants to set a compensation structure that rewards that which benefits the company, and then disincentivize behaviors that hurt the company. Gautam talks a little bit about investment firms and how people in the financial industry act as commissioned salesmen. They want to make the sale rather than provide the best product for their clients.

[00:13:41] Clay Finck: Fees are killer for investors, as many in the audience know, and those selling the fund will likely do whatever they legally can to understate the fees. Be wary of firms that advertise their hot funds, create new sector funds to try and sell you more, or they don’t do a good job of educating their clients.

[00:13:59] Clay Finck: Gautam states that ultimately the best way to overcome incentive-caused bias is to achieve financial independence because this independence empowers you to see things as they really are. Only free people can be honest, only honest people can be free.

[00:14:15] Clay Finck: Chapter 17 covers the importance of being directionally right with our investments.

[00:14:20] Clay Finck: Rather than running a complex model with all these different inputs, when you purchase a company, you want it to be really obvious to you and your investment thesis should really be pretty straightforward. Buffett simply wants to buy a business that he believes is trading well below his assessment of the company’s intrinsic value.

[00:14:38] Clay Finck: We shouldn’t obsess over whether a business will earn $2 or $2 and 5 cents in the next quarter. Focus instead on finding a big gap between the current price and the value you have placed on the long-term earning power, using conservative estimates to create a margin of safety, just in case your initial assessment is wrong.

[00:14:57] Clay Finck: A spreadsheet can only do so much for us. It’s not very useful in modeling things like trust, integrity, goodwill, reputation, or execution capabilities. Investing is part art and part science, and nuanced judgment is required. Gautam even admits in his book that he’s never opened a spreadsheet to help him make an investment decision, which I personally find quite surprising.

[00:15:21] Clay Finck: Munger is the same way as he stated. We never sit down, run the numbers out, and discount them back to the net present value. The decisions should be obvious to us. Maybe I’m too much of an amateur, but I personally always run the numbers on a company to put my expectations on paper and then see what my potential downside risk might be.

[00:15:40] Clay Finck: I think that’s the way that, you know, TIP taught me from listening to so many of the previous mastermind episodes with Preston and Stig and others. You know, they’re explaining their TIP finance tool and they’re coming up with their IRR. Anyways, everyone is going to have their own approach that they are comfortable with, and that’s gonna likely change over time.

[00:15:59] Clay Finck: I guess this is my way of saying to just recognize your own limitations, capabilities and your own skillset. Buffett cautions investors from using precise numbers when calculating the value of a business. Rather, he’s more focused on the range of potential outcomes and the probabilities he would assign to those outcomes.

[00:16:17] Clay Finck: The more uncertain a businesses, the higher the possibility there is that your calculation of business value is far off the mark. Tying this into human behavior, Gautam writes, over the years, I have come to appreciate the fact that investing is a field of simplifications and approximations rather than an extreme precision and quantitative wizardry.

[00:16:37] Clay Finck: I also have realized that investing is less a field of finance in more a field of human behavior. The key to investing success is not how much you know, but how you behave. Your behavior will matter far more than your fees, your asset allocation, or your analytical abilities. Then he covers a bit about calculating intrinsic value here.

[00:16:58] Clay Finck: One example he gives is calculating a company’s intrinsic value by projecting out the free cash flows for 10 years and then applying a terminal multiple to the business at the end of year 10. You can then calculate the internal rate of return off of those cash flows, and then compare that to your other investment opportunities such as other stocks or high-grade bonds.

[00:17:19] Clay Finck: I actually did a similar calculation for this on Constellation Software on YouTube. You can find that on the We Study Billionaires YouTube channel. If you’re interested in seeing what that looks like and what all of the assumptions are in calculating the intrinsic value there, Gautam explains that if your expected return for stock is less than its top-rated bond, then it would be irrational to own the stock at the current price.

[00:17:43] Clay Finck: So this is why interest rates are so important when valuing stocks. All else equal, if interest rates rise, then one would generally expect stock prices to decline. If a stock has an expected rate of return of say 5%, and interest rates go from 2% up to 5%, those that would be holding the stock may consider selling it because they can get the same expected return in bonds, but with much less downside risk.

[00:18:07] Clay Finck: Stocks generally are much more uncertain. This brings us to his chapter, which is all about intrinsic value. Titled Intelligent Investing Is All About Understanding the Intrinsic Value. He states the process of determining the intrinsic value of a business is an art form. You cannot follow rigid rules to plug data into a spreadsheet and hope that it spits out the value for you.

[00:18:30] Clay Finck: Stocks are worth what people are willing to pay for them, and no shortcuts will give you an exact equilibrium value. Intrinsic value is a moving target that is constantly changing as fundamental data comes out and investors update their expectations based on knowledge and past experience. In the past, I believe Buffett has described the intrinsic value as what an informed buyer would pay to purchase the entire business.

[00:18:53] Clay Finck: As we’ve talked about many times on the podcast, the intrinsic value of an asset or a business is the sum of the cash flows expected to be received over its remaining useful life, discounted for the time, value, money, and the uncertainty of receiving those cash flow. When determining your earnings figures, Gautam encourages value investors to use owners or earnings, which is Buffett’s definition of the earnings attributable to shareholders rather than your gap EPS figures that are reported by the company.

[00:19:22] Clay Finck: Many times, there’s a big difference between the gap earnings and the cash that is actually produced by the business. Another issue with gap earnings is that for companies heavily reinvesting in the business, sometimes these investments are treated as expenses. In the P&L statement, and this ends up understating the earnings figures used to calculate Buffett’s owner’s earnings amount.

[00:19:43] Clay Finck: This is why for a company like Amazon, you would have to normalize the earnings to determine if Amazon were not investing so much in the future. What would their earnings potentially look like today? Amazon in 2022 actually reported a net loss largely because of all these investments they’re making to maximize that long-term shareholder value.

[00:20:02] Clay Finck: Understanding this is critical and it’s missed by many value investors. A lot of times, old school value investors have been attracted to low PE, low price-to-book companies because the high PE companies look expensive at face value. Investors like Bill Miller were able to look many layers deeper and understand that a company like Amazon was actually pretty profitable and they’re continually reinvesting to produce potentially enormous growth in the future.

[00:20:30] Clay Finck: Bill Miller saw that as Amazon stock dropped by 90% after the tech bubble, the metrics of the business actually continue to improve. Then he mentions this idea I talked about during my episode covering Terry Smith’s investment approach, who’s what I would call a quality investor, someone who wants to purchase high-quality companies.

[00:20:49] Clay Finck: Gautam writes, the key point is that for businesses that will grow their earnings even at a moderate pace, but for a very long, The optically high PE multiples that determine many value investors, in reality, are actually pretty low. This means that if you buy a strong, loaded business at what appears to be a high price based on the current year earnings, you will end up compounding your money at a higher rate than the discount rate you use to arrive at your fair price.

[00:21:16] Clay Finck: The longer the competitive advantage period, the more likely a business is worth a lot more than what the market thinks. Durability of the moat is the key factor. The market tends to underappreciate companies that have really strong moats because the durability often allows for the company’s runway to last longer than many expect for long-term investing.

[00:21:37] Clay Finck: The focus should be shifted from entry, PE multiples to duration of the competitive advantage period. Gautam discusses a few other interesting ideas in this chapter. He discussed the importance of understanding the maintenance CapEx that a company has and how businesses with high maintenance CapEx should have lower valuation multiples. Because of the lower multiple, this might trick investors into thinking these businesses are actually cheap companies. He mentions in another Buffett quote about how not all earnings are created equal as well. Companies with high capital expenditures might have a tougher time if there’s high inflation because their capital expenditures expenses continue to rise.

[00:22:17] Clay Finck: Compare this to a company like Adobe, which is very asset-light. They would have a much better time weathering through periods of higher inflation. When we value a business, it’s easiest to do so if we have a good understanding of the capital expenditures required within the business. It helps a lot if the business has stable operations and the cash flows are stable rather than super volatile, ’cause it’s much easier to predict and project out in into the future.

[00:22:42] Clay Finck: He also has some great points here around discount rates and calculating the value of a business. Business school teaches people to use the weighted average cost of capital, which is a weighted average of the cost of equity and the cost of debt. This never really made sense to me personally to use, and Buffett and Munger are in the same boat.

[00:23:00] Clay Finck: They just look at it from a opportunity cost perspective. The long-term average for the S&P 500’s returns is around 9 to 10%, and you can use that as a good alternative proxy as anyone can go out and buy the S&P 500. Bruce Greenwald instructs students in his classroom to use a 10% discount rate in their calculations and just not even think about it too much.

[00:23:21] Clay Finck: This can be used as a baseline to revise up or down based on a company’s risk profile and other things related to the company. Companies that have a much more uncertain future should have a higher discount rate than a company that is much more stable and predictable and much more certain. I personally almost always use a 10% discount rate when I calculate the intrinsic value of a business.

[00:23:42] Clay Finck: Ideally, we want to be able to put a range on a company’s intrinsic value and only purchase businesses that are trading at the lower end of our estimates. This will ensure a margin of safety in case you’re wrong or if your thesis plays out differently than what you originally expected. The way Gautam thinks about it is he’s taking a weighted average of the future potential outcomes, and he cautions against businesses that have a wide range of possible outcomes, and he wants to make sure he’s highly certain that he’s making a favorable bet and doesn’t want to risk the loss of capital.

[00:24:14] Clay Finck: He says in businesses like oil, for example, or any business that involves extracting stuff from below the Earth’s surface, the range of potential outcomes can be pretty big. He also cautions against what are called value traps and having the mentality of only purchasing low PE companies constantly buying and selling cheap securities and waiting for them to increase to their intrinsic value, not only leads you to continually incurring capital gains taxes, but it also prevents you from owning high quality businesses with long runways.

[00:24:45] Clay Finck: He states most of the time, switching from a high PE stock to one with a low PE proves to be a mistake. Value traps are abundant and all pervasive. I have learned to respect the market’s wisdom. Everything trades at a level it does for a reason. High quality tends to trade at expensive valuations, and junk or poor quality is frequently available at cheaper valuations.

[00:25:09] Clay Finck: It took me many years to learn this big market lesson. Expensive is expensive for a reason, and cheap is cheap for a reason in the stock market, prices usually move first in the reported fundamentals follow. A plummeting stock price often turns out to be an accurate harbinger of deteriorating fundamentals for a company.

[00:25:28] Clay Finck: Think about this before you jump into it. Avoid investing in the melting ice cubes. What appears to be cheap or relatively inexpensive can continue becoming cheaper if industry headwinds intensify. An irrational fall in price makes a stock cheaper. Irrational fall in price makes a stock more expensive.

[00:25:48] Clay Finck: Many of the high dividend yield stocks in expensive markets eventually turn out to be value traps and destroy wealth. Value traps are businesses that look cheap but are actually expensive. Then to round out the chapter, he lists four common sources of value traps, the first being cyclicality of earnings.

[00:26:07] Clay Finck: For example, an oil business might have a low PE, but their earnings are about to fall off a cliff leading to the stock price collapsing with those earnings. If one normalizes the earnings, it might not appear to be as cheap on a PE basis. The second one he lists here is app risk. He uses the example of a taxi business that appears really cheap based on the past earnings until Uber or Lyft comes along and totally disrupts them.

[00:26:33] Clay Finck: Third is poor capital allocators on the management team. Sometimes a business might have a low multiple because the management team invests internally and projects that don’t give a high return to investors, maybe sometimes they even produce negative returns, which is destroying value for the shareholders.

[00:26:49] Clay Finck: And finally, fourth is governance issues. You obviously don’t want to partner with a manager that is a crook. Unethical managers have a way of siphoning cash from the business, so be wary of businesses run for social purposes, or they’re owned by shady promoters. Thomas Phelps stated that, remember that a man who can steal from you will steal from you.

[00:27:09] Clay Finck: Chapter 19 covers the three most important words in investing those three words being margin of safety. Howard Marks immediately comes to mind when I say those three words as he’s been on our show multiple times. You know, preaching this margin of safety concept. Seth Klarman stated that a margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.

[00:27:40] Clay Finck: Now, one of the classic examples of investing without a margin of safety were those who believed that the Nifty 50 could never go down in the early 1970s. Jeremy Siegel writes The Nifty 50 were a group of premier growth stocks such as Xerox, IBM, Polaroid, and Coca-Cola that became institutional darlings in the early 1970s.

[00:28:02] Clay Finck: All of these stocks had proven growth records, continual increases in dividends and high market caps. These last characteristic enabled institutions to load up on these stocks while significantly influencing the price of their shares. The Nifty 50 were often called one decision stocks buy and never sell because their prospects were so bright.

[00:28:23] Clay Finck: Many analysts claim that the only direction they would go is up. Since they had made so many people rich, few, if any investors could fault a money manager for buying them. At the time, many investors did not seem to find 50, 80, or even a hundred times earnings at all. An unreasonable price to pay for the world’s preeminent growth companies.

[00:28:44] Clay Finck: Then Gautam shows a chart of the Nifty 50 stocks in their returns starting from June of 1970. McDonald’s had a PE of 85 and they had a return of 1% over the following 10 years. Disney had a PE of 75 and had a return of minus 3% over the next 10 years. And remember that during the 1970s, this was a period of higher inflation.

[00:29:06] Clay Finck: So, the real returns on these is far negative. Had you bought during the height fees in 1970, Lawrence Hamtil reflected on the Nifty 50 bubble stating, the lesson from this exercise, I believe, is that investors should always be conscious of starting valuations when placing their bets. With few exceptions, eventually valuations that are simply too high will drift back down to more reasonable levels, often at the expense of poor intermediate term performance.

[00:29:34] Clay Finck: This appears to be true no matter how revolutionary the business appears to be. No matter how much potential you believe it has. Of course, if your conviction is such that you plan on holding the shares for multiple decades, valuation may indeed matter less to long-term returns, but that is assuming you follow through on your commitment over several years of subpar performance.

[00:29:55] Clay Finck: That is much easier said than done. The easier said than done piece here he mentions, I think is so critical. It’s easy to buy into the hype of a gross stock, but it’s incredibly difficult to sit on it for five years or more if the stock is going nowhere while the rest of the market is going up and gross stocks are correcting.

[00:30:14] Clay Finck: There was a quote I’ve read one time that said that everyone’s a long-term investor until they get punched in the mouth. All fast-growing companies eventually have that growth slow, and it can really lead to a painful transition for investors and potentially even result in something like a lost decade for that stock or that type of industry or sector.

[00:30:33] Clay Finck: Remember that a company can do exceptionally well with their growth, but the stock can still go nowhere if you’re buying at a really high price. Our goal as value investors should be to compound at a moderate but steady rate of return over a long period of time. This is vastly superior to generating a sharp outperformance for a year or two, but these outlier high returns just aren’t sustainable, and they aren’t really reliable.

[00:30:58] Clay Finck: Over Buffett’s career, he had an average annual rate of return of nearly 20% per year since he took ownership of Berkshire Hathaway in 1960. Achieving any more than 20% per year over a long-time horizon is simply not sustainable. Most of us aren’t like Buffett unless you happen to be one of those handful of people that happen to be as brilliant as him.

[00:31:19] Clay Finck: Gautam mentions that only 5% of Indian enlisted companies above some sort of size threshold, only 5% were able to grow their earnings by more than 20% annualized. Over the previous 10 years from 2018, 55% of companies had earnings decline. Investing success over long periods of time is really extraordinarily difficult.

[00:31:41] Clay Finck: And when a bull market comes, it tricks investors into thinking that investing is really easy. Consider a thought experiment where one investor earns 20% for two consecutive years and another investor earns 100% in the first year, and a negative 30% in the second year. I find this so interesting because intuitively you’d think that the second investor does better than the first.

[00:32:04] Clay Finck: But the overall returns for the first person who compounded at 20% annually actually has the better return. Unfortunately, a lot of inexperienced investors realize this the hard way, myself included in some cases earlier on in my investing journey. I think this is a good example of highlighting the importance of not losing money.

[00:32:24] Clay Finck: One single year of a big loss can undo many years of good decisions in the past. This is why Buffett’s number one role of investing is to not lose money, and his second role is not to forget rule number one. This is why Buffett pays so close attention to price when he’s buying a business. He won’t buy unless he’s certain that there’s a large margin of safety in his purchase to make sure he’s not gonna lose any money.

[00:32:48] Clay Finck: Many traditional value investors opt for finding value in stocks that are statistically cheap, otherwise referred to as deep value. While other investors have chosen to offer growth at a reasonable price and paying up a bit for quality, the investment styles are different, but the objective is actually the same.

[00:33:05] Clay Finck: They’re both trying to buy something for less than it’s worth. As I discussed during my episode covering Terry Smith who focuses on quality businesses, it is worth paying up a bit for a high-quality business. A business that’s growing. Their intrinsic value at 18% per year should be trading at a much higher multiple than a business that’s growing at just 6% per year.

[00:33:25] Clay Finck: This is why Buffett eventually came around to the Charlie Munger school of thought that it’s much better to pay a fair price for a wonderful business than a wonderful price for a fair business. Gautam acknowledges that high quality businesses can help increase your margin of safety, given that you have a long enough time horizon with your purchase.

[00:33:43] Clay Finck: Owning quality businesses is the best form of long-term investing, in my opinion. I’m still early on in my investing journey, and I have many years ahead to let my investments grow. I know that chasing after cigar butts trading for cheap might outperform in the near term, but over the long term, I think that quality businesses that compound their capital at high rates of return, and they have that long runway for growth ahead, I think these businesses are best positioned to outperform over the long run.

[00:34:10] Clay Finck: Gautam says that when we invest in short-term opportunities such as a commodity, a cyclical, or a special situation type play, we want to pay really close attention to the price. And when we invest in long-term opportunities, we want to pay really close attention to the quality of the business and the quality of the management team.

[00:34:28] Clay Finck: Then Gautam discusses Buffett’s transition from Graham’s cigar butt approach to Phil Fisher’s approach of finding high quality business. The Graham and Dodd investor believed in the concept of mean reversion. They believe that bad things will eventually happen to good businesses, and good things will eventually happen to bad businesses.

[00:34:44] Clay Finck: Phil Fisher recognized that there were actually some cases where mean reversion really didn’t apply. Ironically, Benjamin Graham’s profits from GEICO, which was a really high quality company. It exceeded his profits from all of his other investments, combin. In 1948, Graham’s investment partnership purchased 50% of GEICO for $712,000.

[00:35:06] Clay Finck: By 1972, the position was worth 400 million. That’s a 560 fold increase, or a 30% annualized return from 1948 through 1972. He also references a study here done by Credit Suisse in 2013 that provided strong evidence of outperformance by quality companies with high return on invested. It found that great businesses tend to remain great, or some of them become good businesses.

[00:35:33] Clay Finck: Only 9% of the companies in their study went from being a great business to being in the quartile of the poorest quality businesses. Similarly, poor companies also tended to remain poor companies. It’s rare to see a turnaround situation as Buffett says. Only 6% of companies in the study went from the lowest quartile to the highest quartile of performance.

[00:35:54] Clay Finck: So great businesses tend to remain great and poor businesses tend to remain poor. Gautam writes, the key finding of this study was that despite being recognized as successful businesses, the fourth quartile of businesses continued to deliver outstanding investment results over the long. But if markets were efficient, this should not have happened.

[00:36:13] Clay Finck: The prices of such stocks should have been bid up to such a point that the buyers could not earn exceptional returns, but they did. Markets systematically underpriced quality over long periods of time. I hadn’t heard about this study, but it only confirms my own personal bias towards favoring a high quality company versus a company that is simply cheap based on the numbers.

[00:36:35] Clay Finck: This brings us a Chapter 20 titled, Investing In Commodity and Cyclical Stocks Is All About The Capital Cycle. Commodities are definitely not in my domain of expertise, so it was interesting to read a traditional value investor’s take on investing in commodities. In order to understand commodity investing, you need to understand the capital cycle.

[00:36:55] Clay Finck: The capital cycle is similar to the concept of the mean reversion. Gautam writes, a capital cycle is based on the premise that the prospect of high returns will attract capital, which results in increased competition just as low returns repel it. The resulting ebbs and flow of capital affects long-term returns of stockholders in what often are predictable ways, terms the capital cycle when investing in commodities and cyclicals.

[00:37:22] Clay Finck: Look for industries that are in major down cycles and they’re starved for capital. Gautam likes to find individual companies that are selling at a huge discount to intrinsic value. They have manageable debt levels, and they’re capable of surviving another couple of years in this downturn. He wants to buy when pessimism levels are high, and the more inefficient companies are going bankrupt or shutting down their operations.

[00:37:44] Clay Finck: As he sees the capital cycle start to turn, he starts adding to his position. Investors who are able to time the capital cycle well are able to achieve really high risk adjusted returns. I just think that timing these cycles right, involves a ton of research and a little bit of luck, to be honest. So for me personally, I like to focus on the quality investing approach and leave the commodity investing to people a lot smarter than me.

[00:38:09] Clay Finck: One major red flag to keep an eye out for in a cyclical industry is high levels of capital investment. The levels of capital investment are the most direct sign of a capital cycle that is about to harm investors. Edward Chancellor states that you don’t just need supply to increase to destroy returns, capital expenditures will do it.

[00:38:28] Clay Finck: These types of industries are all about supply and demand. Demand is simply unknowable, but Gautam explains that supply can be forecasted accurately. Where investors sometimes get tripped up is forecasting demand based on recent trends. Then he includes a section that talks about capitalizing on opportunities in the market as well.

[00:38:47] Clay Finck: Because profiting from cyclicals is all about seizing the opportunities when you see them. Quote, the importance of satiable intellectual curiosity along with a deep passion for continuous learning cannot be overstated in the investing profession. And investing. All knowledge is cumulative, and the insights we acquire by putting in the effort today often help us in a serendipitous way at some point in the future.

[00:39:12] Clay Finck: Work hard today to let good luck find you tomorrow. Opportunities in the stock market can spring to life on short notice. Take advantage of them. You must be prepared and ready to act. Make sure you properly allocate your time playing offense as well as defense. Playing defense means monitoring the companies you already own and playing offense means scanning the other thousands of listed companies for new and superior ideas.

[00:39:37] Clay Finck: There’s a lot of truth to the expression. The harder I work, the luckier I get. Buffett was reading Bank of America and IBM reports for decades before he ever bought a share. Similarly, the work I am doing today may not pay off immediately, but I am confident that it is going to pay off at some crucial time in the future.

[00:39:55] Clay Finck: As has happened many times before in the past when a unique insight seemingly fired up in my mind out of nowhere, driven by cumulated experiences, it helps me connect the dots in a rapid manner. He also shared his personal experience with investing in a commodity sector, which I found really interesting.

[00:40:13] Clay Finck: He ventured into the graphite electrodes industry in India, which he described as a game-changing investment, and it catapulted him within touching distance of financial independence. He purchased a company that ticked all of the boxes for him of what to look for in an investment. It was a company called Graphite India, which he purchased in August of 2017.

[00:40:34] Clay Finck: It was the highest quality company with the strongest balance sheet in the sector, and he believed this company positioned him to make a killing during the next cyclical upturn. The first two weeks he owned it, the stock actually declined. While a lower quality company he had analyzed had shot up by 50%.

[00:40:51] Clay Finck: Rather than feeling bad for himself, he fully embraced learning everything he could to make sure he was making the right decision. You’ve read and reread multiple books on commodity investing and did all of this research on the graphite electrode industry. Heve realized critical insights such as the fact that high-cost producers counterintuitively tend to go up far more in the upcycles than the low-cost producers.

[00:41:14] Clay Finck: And most of the time, the sector leaders move up first and become expensive. Then the attention typically turns to the secondary players in the industry bidding up those prices as. There are many more lessons that I won’t be diving into here, but another one I wanted to highlight is that commodity stocks are not long-term investments.

[00:41:32] Clay Finck: They generate alpha in portfolios over short time periods, and timing is really critical, and you really need to do extensive research if you’re wanting to play this game. Gautam was also inspired by Charlie Munger’s belief that when you find a rare opportunity that you’re nearly absolutely certain as a bargain, you should allocate in size towards that opportunity.

[00:41:53] Clay Finck: So, Gautam, after his extensive research moved his money into what he previously saw as a lower quality opportunity in the graphite electrode space to a company called HEG in late 2017. He ended up making 270% on his investment in less than five months in what was a really sizable bet for him at that time.

[00:42:13] Clay Finck: He later re-entered that position to achieve another 64% gain through August of 2018, after he had realized that the stock still had more room to run. This resulted in a profit of more than 350% on his initial investment in the company. Gautam said that he had never achieved what Peter Lynch calls a 10 bagger, where a holding would increase by 10 x over his investment career.

[00:42:35] Clay Finck: He had smaller wins that compounded many times over to help him realize his dream of achieving financial freedom. Quote, for a successful investing career, what matters is the long-term compounded annual growth rate and the overall portfolio value with the least possible risk, not the number of investments you took to achieve.

[00:42:54] Clay Finck: So, if you were skeptical or maybe biased towards avoiding the commodity sector, maybe this could be a little bit of a wakeup call to not dismiss the opportunities too early. If you’d like to learn more, I’d encourage you to check out this chapter in Gautam’s book in The Joys of Compounding. It’s a really great chapter.

[00:43:09] Clay Finck: This brings us to chapter 21, discussing spinoffs. Again, this is an area I’ve personally never ventured into, but Gautam makes a pretty compelling case to at least consider them and study. During one of Mohnish Pabrai’s meetings with Charlie Munger, Munger explained that investors would do well, focusing on three things.

[00:43:27] Clay Finck: First is watching what other great investors are doing using the 13F filings. Second would be to analyze cannibals, which are companies that are buying huge amounts of their own stock. And third is to carefully study spinoffs. What Gautam discovered about spinoffs is their high base rates of success.

[00:43:45] Clay Finck: There was a study done by a consulting firm, The Edge and accounting firm, Deloitte, that studied spinoffs from 2000 through 2014 with the parent companies having a market cap of at least $250 million. The study found that the worldwide asset class of spinoffs generated more than 10 times the average gains of the MSCI World Index during the first 12 months that the spinoff company was independent from the parent company.

[00:44:10] Clay Finck: In India, which is the market that Gautam focuses on, spinoffs generated an average excess return over the market index of around 36%. He explains, quote, a profitable opportunity often arises when a promising but small size company, demerged from a large size parent is listed and has residual institutional holding.

[00:44:32] Clay Finck: During its initial weeks and months of trading, you often observe for selling by institutions that cannot hold the new stock in their portfolios because of certain rigid institutional mandates, such as being allowed to only invest in certain sectors or restrictions on market cap. Whenever someone sells in desperation, they tend to sell cheap.

[00:44:52] Clay Finck: As a buyer, I love to be on the opposite side of such trades in which the other party is being forced to liquidate holdings at any price, regardless of the underlying value. The time to buy is when those investors are in a hurry to dump shares at any price. Then later spinoffs represent live case studies on time arbitrage in which the patient investor is paid for merely waiting and letting the procedural formalities take their due course.

[00:45:20] Clay Finck: Now, much of the time spinoffs occur because the sum of the parts is more than the whole. So, a larger business may want to spin off unprofitable businesses, or they might recognize that there’s more value to be discovered by spinning off a company that deserves a higher multiple than the parent company.

[00:45:36] Clay Finck: He says that sometimes you’ll find profitable opportunities when the parent company trades at a lower valuation, and then the spinoff company should trade at a higher multiple. But the market doesn’t fully appreciate or realize how much this business is really worth. Seth Klarman, Joel Greenblatt and Peter Lynch have all expressed the huge opportunities available in spinoffs.

[00:45:57] Clay Finck: Klarman has written about how spinoff companies often don’t publicize the attractiveness of their business and the undervaluation because they prefer to initially fly under the radar. This is because management receives stock options based on the initial trading prices until the options are actually granted to the management team.

[00:46:15] Clay Finck: They prefer to have the stock trading at a lower price. Klarman is quoted as saying spinoffs are an interesting place to look because there’s a natural constituency of sellers and there’s not a natural constituency of buyers. Joel Greenblatt is widely known for investing in spinoffs as he wrote about them in his book, You Can Be a Stock Market Genius.

[00:46:34] Clay Finck: He explained five different reasons why spinoffs may occur. First is that conglomerates tend to trade at what is known as a conglomerate discount. By separating the unrelated businesses, management can unlock value. In other words, the sum of the parts is greater than the whole. We’ve done plenty of episodes talking about the intrinsic value of Berkshire Hathaway.

[00:46:55] Clay Finck: As value investors, we tend to be conservative in our estimates of intrinsic value, and typically Berkshire is trading at a pretty decent discount to their intrinsic value, which is partially due to that conglomerate discount that is applied to the company by the market. Buffett probably enjoys this at times as they’re able to repurchase their shares at pretty favorable prices.

[00:47:14] Clay Finck: The second reason spinoffs occur is to separate a bad business from a good business. Third is to realize value for a subsidiary that can’t be easily sold. Fourth is a way to recognize value by avoiding selling the business and then incurring a tax bill. And fifth, to resolve a regulatory hurdle where they need to split up the company in order to be acquired by another business.

[00:47:37] Clay Finck: Greenblatt and Gautam also highlight the brilliance of capitalism. Gautam writes, once a spinoff is complete, its management is freed from the bureaucracy of the parent and is empowered to make changes that will create shareholder value. Because if management owns a significant portion of the spinoff stock, they will benefit directly.

[00:47:56] Clay Finck: Greenblatt tends to look for spinoffs that institutions aren’t interested in. They have high levels of insider ownership, and he looks for spinoffs where value is unlocked in either the parent company or the spinoff. Gautam also recommends studying the relevant SEC filings to check whether spinoffs management will have a substantial options package.

[00:48:16] Clay Finck: Gautam understands the power of incentives and he recommends looking up the spinoffs form 10-12B filing for those companies in the US and search for the term executive compensation to see how many shares of new management team will have in the transaction. Peter Lynch wrote him one up on Wall Street that spinoffs often result in astoundingly lucrative investments.

[00:48:36] Clay Finck: And quote, once these companies are granted their independence, the new management free to run its own show can cut costs and take creative measures that improve the near term and long-term earnings. Lynch, especially like spinoffs of those with insider buying, insiders have a ton of reasons they want to sell a company, but there’s really only one reason they want to buy and it’s because they believe the price of the shares will go up.

[00:48:59] Clay Finck: Even better is when you see a cluster buy, which is when three or more managers make open market purchases in a short period of time. Old school value investor, Jay John, studied the first-year performance of spinoffs in the US from 2001 through 2011, which had insider buying within a week of being spun off.

[00:49:17] Clay Finck: 11 out of the 12 spinoffs in the study beat the S&P 500 by a large margin. Live Nation Entertainment, for example, increased by 87% in the first year, and Genworth Financial increased by 46%. Round out this portion on spinoffs, I’ll leave you with one more piece here from Gautam. Spinoffs received little attention from Wall Street are usually misunderstood and thus mispriced by investors.

[00:49:42] Clay Finck: All this bodes well for future returns. And then at the end, the key takeaway from this chapter, apart from strongly incentivized management, the initial forced selling and spinoffs often leads to some attractive opportunities.

[00:49:56] Clay Finck: That wraps up today’s episode. This episode was part three of covering Gautam’s book, The Joys of Compounding.

[00:50:02] Clay Finck: If you happen to miss parts one and two covering the book, be sure to check those out as well. Those are episodes 534 and 530. If you’re enjoying this series, consider sharing it with your friends. We really appreciate you supporting the show and wouldn’t be able to provide it for free without loyal listeners like yourself who help us continue to spread the word.

[00:50:21] Clay Finck: With that, thank you so much for tuning in, and I hope to see you again next week for Part four.

[00:50:27] Outro: Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com.

[00:50:43] Outro: This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.