Human nature is always keen to defy odds and break barriers as per modern pop culture. The narrative also emphasises on the next billion $ start-up, rags to riches story of entrepreneurs, serial entrepreneurs, conquering uncharted territories, transporting humans to space stations etc. The nature of these businesses are generally highly capital intensive viz to build infrastructure, rail roads, airlines, power generating companies, cars, space travel business etc. For a business to generate returns to create value for the shareholders it has to build an advantage. Capitalism is all about profit for the owners of the business.
In perfect competition, as per economic theory there is intense competition which impacts the “profit pool” and returns thereof. In such a situation the advantage gets diluted depending on the industry structure and shareholder’s returns are difficult to sustain leading to creative destruction. Large players like SEARS, Nieman Marcus, JC Penny et al in USA have filed for bankruptcy owing mainly due to the structure of the industry, changing preferences,the ecosystem shifting from physical to ecommerce and the impact of Amazon.
Investing in common stocks is what Charlie Munger refers to as a simple notion akin to a pari-mutuel system of the race track. The pari-mutuel system is the stock market and everybody goes on to bet and the odd’s change on what’s bet. In the case of race track you always have to pay 17% to the house irrespective of winning or losing and same is true in the case of MFs with albeit lower fees. Hence, stock investing is clearly a game of probabilities AND hence the rules of investing will be dependent on understanding the odds of winning.
In the Origin of Strategy, Bruce Henderson founder of BCGelucidates how Prof Gause of Moscow University, known as the father of mathematical biology, published a paper in which he put two very small animals (protozoans) of the same genus in a bottle with adequate supply of food. He found out that if the animals were of different species they could survive and persist together. If they were of the same species, they could not. No two species can co-exist that make living in the identical way.
Similarly, for both investing and business, whenever you follow the herd there is “reversion to the mean.” (The NBFC universe in India is comprising of 22000 companies – How many of them are true winners?)
Investing in common stocks is a true and sure way to maximise returns and wealth creation for a retail investor. However, to become a successful investor Charlie Munger asserts one needs to understand elementary economics, elementary accounting principles and an understanding of psychology to keep it simple. Warren, Charlie and the leading investors have been able to beat this pari-mutuel system.
CharlieMunger quotes the case of John Arigalla who is famous to have built his real estate portfolio. This real estate plot was purchased in 1960’s in the valley housing the likes of Google and Intuit is worth US$ 2.5 bn today. John focused on his “circle of competence” which was just around the Stanford Campus. In this case John knew everything about the real estate market in this area and this generated huge tailwind from a single idea. It’s not the width of the circle but the Edge of your competency that will drive a huge advantage.
Morgan Housel has tweeted saying“Avoiding stupidity is better than seeking brilliance.” We were not surprised to see a few such case of investors stuck with 40 plus stocks in their portfolio and the owners had absolutely no idea or understanding about the businesses resulting in either loses or below-average returns. These investors also suffered from multiple psychological biases viz:
- Association bias – who is buying a company, timing rather the understanding the underlying economics.
- Endowment effect – value of my owned stock higher to its market value leading to not selling it.
- Commitment and Consistency bias –choices these investors made to believe strongly in the decisions they have already taken in order to avoid cognitive dissonance etc.
The above factors impaired their judgement to stop loss and look for better avenues for returns. Warren Buffet asserts that for a know-nothing investor it’s better to invest in index funds than to own stocks.
By Value Investors – Tanvi Mehta, Ramaswamy Ranganathan and Sudaarshan R