The Joys of Compounding: The Passionate Pursuit of Lifelong Learning

Reviewed by: Adriano Almeida

November 13, 2020

By Gautam Baid, June/2020(456p.)

This was one of the best books I have ever read on investing. The author Gautam Baid is not someone I had heard of before, but he is a good writer and researcher who knows how to synthesize the ideas of others into a coherent narrative. I would highly recommend this entire book to anyone interested in the topic of investing, but I am not going to dive too deeply into the actual content in the body of this review. Instead, I included below a long list of annotated passages, tables, and one of the largest and most precious collections of investment quotes that I have come across in any book.

Gautam doesn’t share much about his professional career in the book, but he provided more color in this interview from January 2020: “I am the youngest of the four siblings in my family and my parents, my two elder sisters and my elder brother reside in Kolkata, India. Prior to my relocation to the US in 2015, I served for seven years at the Mumbai, London and Hong Kong offices of Citigroup and Deutsche Bank as Senior Analyst in their healthcare investment banking teams.” … “I was so keen for a career shift that I relocated to the US (one of my relatives who is an American citizen sponsored my green card) without any job in hand!” … “I ran out of whatever little money I had brought with me from India and to take care of my living expenses in US, I did not want to sell even a single share from my portfolio of Indian stocks as I did not want to interrupt the process of compounding. So, I took up a minimum wage job as a front desk clerk at a hotel in San Francisco where I used to work during the graveyard shift.” One fine night during November 2016 while working at the hotel, I randomly clicked on the “quick-apply” button on a job application on LinkedIn during the course of my routine online job search. I unexpectedly received an interview call for the job and that too for a senior role in an investment firm even though I had zero formal work experience in the stock market!. … I was offered the role of Portfolio Manager and it was like a dream come true for me. Today, even after achieving financial freedom, I continue to work in my job because I just love the work that I get to do and the icing on the cake is that I get paid for getting to learn and improve every day.”

Gautam mentions in the interview that he was offered a Portfolio Manager job, yet this note that ran in the Utah Business Journal claims he joined Salt Lake City-based Summit Global Investors as a Senior Analyst. As Summit’s website indicates, Gautam is a part of a 5-man team who co-manage US and Global equity portfolios by combining fundamental analysis with a quantitative Multi-Factor Model (MFM). Founded in 2010, the firm manages about $1.3B across three strategies (US Large Cap, US Small Cap, and Global) – all of which have underperformed their benchmarks over the last 5 years. Either way, Summit (SGI) is mentioned only once in the book (in a brief disclaimer), to say that Gautam’s views are his own and not associated with his employer’s. His twitter account, which has over 70k followers, is also explicitly disassociated with Summit, who’s CEO (David Harden) can be seen here making a bad market-timing call ahead of the election in this CNBC clip from October 29, 2020.

Judging by his boyish looks and clear brilliance, one might be excused for thinking Gautam is a prodigy, but that’s far from the case. “Throughout my childhood years, I was a weak student,” he explains early in the book. “I barely finished tenth grade. My scores were so abysmally low that it was a struggle for me to gain admission to a decent high school. It was only my subsequent awakening, driven by a major personal setback, that made me finally realize the virtues of hard work and determined effort, and that was the catalyst for my academic revival and professional career growth.” Instead of focusing on setbacks (which he apparently had several in his life), Gautam’s book offers precious insights and advice from the greats, on Becoming a Learning Machine (Section I), Building stronger Character (Section II), Common Stock Investing (Section III) and Portfolio Management (Section IV). I enjoyed the whole book and will certainly read it again, but I also think that it could have easily been split in two 200-page books.

Chapter 22 was my favorite, because it did a great job of explaining why stocks go up or down over time, and it synthesized very well why quality is the holy grail of long-term investing – a concept that is near to our hearts at Victori. “The time to evaluate quality is before the price action starts and not after it,” Gautam reminds us. “Making the correct qualitative judgment about a business, including the long-term sustainability of its success attributes, is more important than the entry valuation over a long-term holding period. Within reason, you can survive overpaying for a growing high-quality franchise. If you have to go wrong, go wrong on valuation but not on quality.”

In summary, this was a gem of a book that came from an unlikely and largely unknown author. While it can get a little heavy at times for those who are not enthusiasts, it’s lessons and insights go far beyond investing, and just the quotes alone are worth far more than the book. In addition to serving as a manual on value investing, Gautam’s book and life story inspire a passion for learning and the pursuit of happiness. As Munger would say and Buffett actually wrote, this book “deserves success.”

Best regards,

Adriano

Highlighted Passages:

Chapter 1: Introduction: The Best Investment You Can Make Is an Investment in Yourself

An hour’s time spent acquiring in-depth knowledge about an important principle pays off in the long run.

This is why good books are the most undervalued asset class: the right ideas can be worth millions, if not billions, of dollars over time.

Minimize your commute time to work and outsource all of the noncore time-consuming menial tasks to free up valuable time for self-development.

Section 1 – Achieving Worldly Wisdom

Chapter 2: Becoming a Learning Machine

When someone asked Jim Rogers what was the best advice he ever got, he said it was the advice he received from an old man in an airplane: read everything.

There is no better teacher than history in determining the future…. “There are answers worth billions of dollars in a $30 history book.” —Bill Gross

The rich invest in time, the poor invest in money. —Warren Buffett

For starters, I hardly watch television. I don’t even have a cable television connection. I get all my desired content on Netflix, YouTube, and Amazon Prime. I watch only those select few movies, documentaries, and shows that truly pique my interest. I ensure that I don’t spend a lot of time commuting to my workplace. I live in an area where I can walk to the grocery store, finish my purchases, and return home in less than twenty minutes. I have fully automated the monthly payments online for my phone, electricity, Internet, utilities, and meal plan bills.

You need to find writers who are more knowledgeable on a particular subject than you are. This is how you become more intelligent. Reach out to and associate with people better than you and you cannot help but improve.

Rarely do we stop to ask ourselves questions about what we consume: Is this important? Is this going to stand the test of time for even a year?

“The true scarce commodity of the near future will be human attention.” —Satya Nadella

In an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it. —Herbert Simon

The key lesson is that, in the pursuit of wisdom, we must read much more of what has endured over time (such as history or biographies) than what is ephemeral (such as daily news, social media trends, and the like). I agree with Andrew Ross, who says, “The smallest bookstore still contains more ideas of worth than have been presented in the entire history of television.”

Always respect the old. Apply the “Lindy effect” to reading and learning. According to Nassim Taleb, “The Lindy effect is a concept that the future life expectancy of some nonperishable things like a technology or an idea is proportional to their current age, so that every additional period of survival implies a longer remaining life expectancy.” So, a book that has stood the test of time and survived fifty or one hundred or five hundred years and is still widely read because it contains timeless wisdom is expected to survive another fifty or one hundred or five hundred years for that very reason—that is, its wisdom is timeless.

The man who doesn’t read good books has no advantage over the man who cannot read them. —Mark Twain

Also, share your latest book purchases with like-minded friends. It’s a lot of fun to co-read and exchange insights.

Adler and Van Doren identify four levels of reading: elementary, inspectional, analytical, and syntopical. Before we can improve reading skills, we need to understand the differences among these reading levels. They are discussed as levels because you must master one level before you can move to a higher level. They are cumulative, and each level builds on the preceding one. Here is how Adler and Van Doren describe these four levels:

Elementary reading. This is the most basic level of reading as taught in our elementary schools. It is when we move from illiteracy to literacy.
Inspectional reading. This is another name for “scanning” or “superficial reading.” It means giving a piece of writing a quick yet meaningful advance review to evaluate the merits of a deeper reading experience. Whereas the question that is asked at the first level (elementary reading) is “What does the sentence say?” the question typically asked at this level is “What is the book about?”
Analytical reading. Analytical reading is a thorough reading. This is the stage at which you make the book your own by conversing with the author and asking many organized questions. Asking a book questions as you read makes you a better reader. But you must do more. You must attempt to answer the questions you are asking. While you could do this in your mind, Adler and Van Doren argue that it’s much easier to do this with a pencil in your hand. “The pencil,” they argue, “becomes the sign of your alertness while you read.” Adler and Van Doren share the many ways to mark a book. They recommend that we underline or circle the main points; draw vertical lines at the margin to emphasize a passage already underlined or too long to be underlined; place a star, asterisk, or other symbol at the margin for emphasis; place numbers in the margin to indicate a sequence of points made in developing an argument; place page numbers of other pages in the margin to remind ourselves where else in the book the author makes the same points; circle keywords or phrases; and write our questions (and perhaps answers) in the margin (or at the top or bottom of the pages). This is how we remember the best ideas out of the books we read, long after we have read them—by making a book our own through asking questions and seeking answers within it. As Cicero said, “Nothing so much assists learning as writing down what we wish to remember.”
Syntopical reading. Thus far, we have been learning about how to read a book. The highest level of reading, syntopical reading, allows you to synthesize knowledge from a comparative reading of several books about the same subject. This is where the real virtue of reading is actualized. I usually read multiple nonfiction books in tandem. I pick the one that interests me the most at the time and read at least one full chapter. If it keeps my interest, I keep going for another chapter.

Something you perceived to be of low value in an old book transforms into something of significant value, unlocked by another book in the future.

Reading multiple books simultaneously, quitting those that are not engaging, and constantly picking up new ones is the antifragile approach to self-education.

The Matthew effect, in this context, refers to a person who has more expertise and thus has a larger knowledge base. This larger knowledge base allows that person to acquire greater expertise at a faster rate. So, the amount of useful insight that Buffett can draw from the same reading material would be quite high compared with most any other person, and again, Buffett would end up becoming smarter at a faster rate.

When you have something that you know is true, even over the long term, you can afford to put a lot of energy into it. —Jeff Bezos

When Jeff Bezos started Amazon.com, in 1995, he clearly identified the first principles that would guide his business philosophy—that is, long-term thinking and a relentless focus on the customer rather than on the competition. This led Amazon to focus on things that don’t change, such as customers’ preference.

“David was always there in the marble. I just took away everything that was not David.” – Michelangelo … This is the art of “reductionism.” Less is more. When we remove the things that aren’t truly representative of reality, we get closer to the ultimate truth. … Nassim Taleb calls this “subtractive epistemology.” He argues that the greatest contribution to knowledge consists of removing what we think is wrong. We know a lot more about what is wrong than what is right. What does not work (i.e., negative knowledge) is more robust than positive knowledge. … Thus, disconfirmation is more rigorous than confirmation.

To apply first principles thinking to the field of value investing, consider several fundamental truths. Understand and practice the following if you want to become a good investor:

Look at stocks as part ownership of a business.
Look at Mr. Market—volatile stock price fluctuations—as your friend rather than your enemy. View risk as the possibility of permanent loss of purchasing power, and uncertainty as the unpredictability regarding the degree of variability in the possible range of outcomes.
Remember the three most important words in investing: “margin of safety.”
Evaluate any news item or event only in terms of its impact on (a) future interest rates and (b) the intrinsic value of the business, which is the discounted value of the cash that can be taken out during its remaining life, adjusted for the uncertainty around receiving those cash flows.
Think in terms of opportunity costs when evaluating new ideas and keep a very high hurdle rate for incoming investments. Be unreasonable. When you look at a business and get a strong desire from within saying, “I wish I owned this business,” that is the kind of business in which you should be investing. A great investment idea doesn’t need hours to analyze. More often than not, it is love at first sight.
Think probabilistically rather than deterministically, because the future is never certain and it is really a set of branching probability streams. At the same time, avoid the risk of ruin, when making decisions, by focusing on consequences rather than just on raw probabilities in isolation. Some risks are just not worth taking, whatever the potential upside may be.
Never underestimate the power of incentives in any given situation.
When making decisions, involve both the left side of your brain (logic, analysis, and math) and the right side (intuition, creativity, and emotions).
Engage in visual thinking, which helps us to better understand complex information, organize our thoughts, and improve our ability to think and communicate.
Invert, always invert. You can avoid a lot of pain by visualizing your life after you have lost a lot of money trading or speculating using derivatives or leverage. If the visuals unnerve you, don’t do anything that could get you remotely close to reaching such a situation.
Vicariously learn from others throughout life. Embrace everlasting humility to succeed in this endeavor.
Embrace the power of long-term compounding. All the great things in life come from compound interest.

Knowledge is overrated. Wisdom is underrated. Intellect is overrated. Temperament is underrated. Outcome is overrated. Process is underrated.

Growth is overrated. Longevity is underrated.

Chapter 3: Obtaining Worldly Wisdom Through a Latticework of Mental Models

Price-to-earnings ratio is overrated. Duration of competitive advantage period is underrated.

A foundational principle that aligns with the world and is applicable across the geologic time scale of human, organic, and inorganic history is compounding. Compounding is one of the most powerful forces in the world. In fact, it is the only power law in the universe that exists with a variable in its exponent.

The notion of a critical mass—that comes out of physics—is a very powerful model.

“Life is just one damn relatedness after another.”

In short, thinking for yourself. You simply cannot do that in bursts of 20 seconds at a time, constantly interrupted by Facebook messages or Twitter tweets, or fiddling with your iPod, or watching something on YouTube. I find for myself that my first thought is never my best thought. My first thought is always someone else’s; it’s always what I’ve already heard about the subject, always the conventional wisdom. It’s only by concentrating, sticking to the question, being patient, letting all the parts of my mind come into play, that I arrive at an original idea. By giving my brain a chance to make associations, draw connections, take me by surprise…You do your best thinking by slowing down and concentrating.

Look at this generation, with all of its electronic devices and multitasking. I will confidently predict less success than Warren, who just focused on reading. If you want wisdom, you’ll get it sitting on your ass. That’s the way it comes. —Charlie Munger

Understand deeply. When you learn anything, go for depth and make it rock solid. Any concept that you are trying to master is a combination of simple core ideas. Identify the core ideas and learn them deeply. This deeply ingrained knowledge base can serve as a meaningful springboard for more advanced learning and action in your field. Be brutally honest with yourself. If you do not understand something, revisit the core concepts again and again. Remember that merely memorizing stuff is not deep learning.

“I’ve missed more than nine thousand shots in my career. I’ve lost almost three hundred games. Twenty-six times, I’ve been trusted to take the game-winning shot and missed. I’ve failed over and over and over again in my life. And that is why I succeed.” – Michael Jordan

“many of life’s failures are people who did not realize how close they were to success when they gave up.” – Thomas Edison

Munger’s speeches and essays are filled with the thoughts of the great thinkers from many different domains. Munger reserves a lot of time in his schedule for reading and has read hundreds of biographies. He explains why he does so: “I believe in the discipline of mastering the best that other people have ever figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.”

Chapter 4: Harnessing the Power of Passion and Focus Through Deliberate Practice

It’s the desire to learn that’s scarce. —Naval Ravikant

Take up one idea. Make that one idea your life—think of it, dream of it, live on that idea. Let the brain, muscles, nerves, every part of your body, be full of that idea, and just leave every other idea alone. This is the way to success. —Swami Vivekananda

Source: Thomas Oppong, “Ikigai: The Japanese Secret to a Long and Happy Life Might Just Help You Live a More Fulfilling Life,” Medium, January 10, 2018, https://medium.com/thrive-global/ikigai-the-japanese-secret-to-a-long-and-happy-life-might-just-help-you-live-a-more-fulfilling-9871d01992b7.

“Your goal in life is to find out the people who need you the most, to find out the business that needs you the most, to find the project and the art that needs you the most. There is something out there just for you.” —Naval Ravikant

Self-realization is closely linked to the concept of self-actualization, best known in the field of psychology in the context of Abraham Maslow’s hierarchy of needs. Self-actualized people are those who are fulfilled and are doing all that they are capable of. Maslow described the good life as one directed toward self-actualization, the higher need. Self-actualization occurs when you maximize your potential by doing your best.

“I fear not the man who has practiced 10,000 kicks once, but I fear the man who has practiced one kick 10,000 times.” —Bruce Lee

Focus on those investments for which the microeconomics are going to dominate the outcome. This approach will allow you to call upon your accumulated experience in analyzing companies and industries and to utilize the same to your advantage.

Today, an investor’s edge is less about knowing more than others about a specific stock and more about the mind-set, discipline, and willingness to take a long-term view about the intrinsic value of a business.

One of the best hacks in the investment field is learning to be happy doing nothing.

Investing isn’t just a process of wealth creation; it is a source of great happiness and sheer intellectual delight for the truly passionate investor. It is great to be passionate in life, but it is wise to be so only for things that are under our control, or else we risk being dejected because of unfavorable outcomes.

The only way to gain an edge is through long and hard work. Do what you love to do, so you just naturally do it or think about it all the time, even if you are relaxing…. Over time, you can accumulate a huge advantage if it comes naturally to you like this [emphasis added]. —Li Lu

Life is long if you know how to use it. —Seneca

We have two lives, and the second begins when we realize we have only one. —Confucius

“Our life is a matter of choices. Choose what makes you happy and your life will never go wrong. Some people die at age twenty-five but aren’t buried until they are seventy-five. Some people aren’t born until they are age twenty-five. Strive to be the latter. One day your life will flash before your eyes. Make sure it’s worth watching.” —Gerard Way

In his book The Little Book of Talent, Daniel Coyle wrote: From a distance, top performers seem to live charmed, cushy lives. When you look closer, however, you’ll find that they spend vast portions of their life intensively practicing their craft. Their mind-set is not entitled or arrogant; it’s 100-percent blue collar: They get up in the morning and go to work every day, whether they feel like it or not. As the artist Chuck Close says, “Inspiration is for amateurs.”

Section II—Building Strong Character

Chapter 5: The Importance of Choosing the Right Role Models, Teachers, and Associates in Life

It is a wonderful feeling to care for our parents. We have many ways to do this. Showing appreciation for little acts. Spending time together. Making small gestures of love and affection. This is all most parents want from us. It is what gives them great happiness. … My noble mother taught me the virtues of honesty, kindness, and empathy. My dear father constantly motivated me to push my limits and to improve. He has been a great friend, philosopher, and guide and has given me the greatest gift anyone could give: he believed in me. … Throughout my childhood years, I was a weak student. I barely finished tenth grade. My scores were so abysmally low that it was a struggle for me to gain admission to a decent high school. It was only my subsequent awakening, driven by a major personal setback, that made me finally realize the virtues of hard work and determined effort, and that was the catalyst for my academic revival and professional career growth. And this is why I instantly related to legendary investor Arnold Van Den Berg’s life, when I read his inspirational words: “I always had this image of myself that I wasn’t very smart, and the way I did in school proved that I wasn’t. But: Once I realized that if you dedicate yourself and you commit yourself, you can learn anything. I will admit this: whatever I learn takes me three times as long as anybody else. But if I spend three times as much time as anybody else, then I’m equal. I can learn it, just give me more time, more books.”

(if you want to know someone’s priorities in life, observe what they do between Friday evening and Monday morning),

Chapter 6: Humility Is the Gateway to Attaining Wisdom

True expert knowledge in life and investing does not exist, only varying degrees of ignorance.

I was born not knowing and have had only a little time to change that here and there. —Richard Feynman

Frank Wells was president of the Walt Disney Company from 1984 until his death in 1994. After Wells died, his son found a little piece of paper in his wallet that read “Humility is the essence of life.” Later, it was discovered that Frank Wells had carried that note with him for thirty years.

“Doubt is not a pleasant condition, but certainty is absurd.” —Voltaire

Morgan Housel offers a helpful suggestion to help us better empathize: “Start with the assumption that everyone is innocently out of touch and you’ll be more likely to explore what’s going on through multiple points of view, instead of cramming what’s going on into the framework of your own experiences. It’s hard to do. It’s uncomfortable when you do. But it’s the only way to get closer to figuring out why people behave like they do.” … Housel writes: “It goes like this. The more successful you are at something, the more convinced you become that you’re doing it right. The more convinced you are that you’re doing it right, the less open you are to change. The less open you are to change, the more likely you are to tripping in a world that changes all the time. There are a million ways to get rich. But there’s only one way to stay rich: Humility, often to the point of paranoia. The irony is that few things squash humility like getting rich in the first place. It’s why the composition of Dow Jones companies changes so much over time, and why the Forbes list of billionaires has 60 percent turnover per decade…. Humility doesn’t mean taking fewer risks. Sequoia takes as big of risks today as it did 30 years ago. But it’s taken risks in new industries, with new approaches, and new partners, cognizant that what worked yesterday isn’t what will work tomorrow.”

CERTAINTY. An imaginary state of clarity and predictability in economic and geopolitical affairs that all investors say is indispensable—even though it doesn’t exist, never has, and never will. The most fundamental attribute of financial markets is uncertainty. UNCERTAINTY. The most fundamental fact about human life and economic activity. In the real world, uncertainty is ubiquitous; on Wall Street, it is nonexistent.

The question of doubt and uncertainty is what is necessary to begin; for if you already know the answer there is no need to gather any evidence about it. I have approximate answers and possible beliefs and different degrees of certainty about different things, but I’m not absolutely sure of anything and there are many things I don’t know anything about. The first source of difficulty is that it is imperative in science to doubt; it is absolutely necessary, for progress in science, to have uncertainty as a fundamental part of your inner nature. To make progress in understanding, we must remain modest and allow that we do not know. Nothing is certain or proved beyond all doubt. You investigate for curiosity, because it is unknown, not because you know the answer. And as you develop more information in the sciences, it is not that you are finding out the truth, but that you are finding out that this or that is more or less likely.

One should not blindly chase “buzzing stocks” or get swayed by exciting “stories,”“narratives,” or “futuristic” concepts, because these kinds of businesses usually have unproven track records or they lack profitability and cash flow.

Inspired by the German mathematician Carl Gustav Jacob Jacobi, Munger explains, Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead—through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.

“If we have a business about which we’re extremely confident as to the business results, we’d prefer that its stock have high volatility. We’ll make more money in a business where we know what the end game will be if it bounces around a lot.”

“I learned early in my career that if you read the annual reports, you’ve done more than 90 percent of the people on Wall Street. If you read the notes to the annual report, you’ve done more than 95 percent of the people on Wall Street.” —Jim Rogers

“I’ve always said that if you look at ten companies you’ll find one that’s interesting. If you look at 20, you’ll find, two; if you look at 100, you’ll find ten. The person that turns over the most rocks wins the game…. It’s about keeping an open mind and doing a lot of work. The more industries you look at, the more companies you look at, the more opportunity you have of finding something that’s mispriced.” —Peter Lynch

Chapter 7: The Virtues of Philanthropy and Good Karma

Thanks to my senior’s timely warning, I was able to exit the stock a few days earlier, at a handsome profit. When I called my senior to thank him and ask why he had helped me by sharing such sensitive information, these were his words: “Because you always used to share helpful company and industry data with me from time to time, even when I never asked you for it. You helped me then; I helped you now.”

Chapter 8: Simplicity Is the Ultimate Sophistication

In an interview with Business Wire in November 2011, Buffett said, “If you understand chapters 8 and 20 of The Intelligent Investor (Benjamin Graham, 1949) and chapter 12 of The General Theory (John Maynard Keynes, 1936), you don’t need to read anything else and you can turn off your TV.

Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count [emphasis added]. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables. —Warren Buffett

“The goal of investment is to find situations where it is safe not to diversify.” – Munger

“We have a passion for keeping things simple. If something is too hard, we move on to something else. What could be more simple than that?” – Munger

Every investor should diligently study the white papers titled “What Does a Price-Earnings Multiple Mean?” and “The P/E Ratio: A User’s Manual” by Michael Mauboussin and Epoch Investment Partners, respectively.

“Let’s be honest. We don’t know for sure what makes us successful. We can’t pinpoint exactly what makes us happy. But we know with certainty what destroys success or happiness. This realization, as simple as it is, is fundamental: Negative knowledge (what not to do) is much more potent than positive knowledge (what to do).” —Rolf Dobelli

To make good investing decisions, you need to actively look for reasons not to buy the stock in question. Simplifying helps us make better decisions by breaking down complex problems into component parts. For example, I ask four inverted questions whenever I am looking at a stock. These questions break the mind-set of trying to find supportive bullish reasons and force me to actively seek out disconfirming evidence. 1. How can I lose money? versus How can I make money? If you focus on preventing the downside, the upside takes care of itself. 2. What is this stock not worth? versus What is this stock going to be worth? If you can identify the floor price or a cheap price for a stock, it’s far easier to make profitable decisions. 3. What can go wrong? versus What growth drivers are there? Rather than focusing just on the growth catalysts, think probabilistically, in terms of a range of possible outcomes, and contemplate the possible risks, especially those that have never occurred. 4. What is the growth rate being implied by the market in the current valuation of the stock? versus What is my future growth rate assumption? A reverse discounted cash flow fleshes out the current assumptions of the market for the stock. We can then compare the market’s assumptions with our own and make a decision accordingly.

From traveling with less personal luggage, eating less junk food and sugar, and using fewer apps on my mobile phone to having fewer stocks in my portfolio, I have embraced minimalism as a way of living. I already can see the immense benefits of clarity, focus, and efficiency that this has brought to my life. To me, minimalism is about living with less stress. The fact that it saves money is just an added benefit.

“There is no path to peace. Peace is the path.” —Mahatma Gandhi

Chapter 9. Achieving Financial Independence

“A journey of a thousand miles begins with a single step.” – Lao Tzu

The only definition of success is to be able to spend your life in your own way.

The Way to Wealth, published in 1758, is a summary of Benjamin Franklin’s advice from Poor Richard’s Almanack, published from 1733 to 1758. It’s a compilation of proverbs woven into a systematic ethical code advocating industry and frugality as a “way to wealth,” thereby securing personal virtue. Franklin’s advice is just as relevant today as it was more than 260 years ago. He advocated work ethic, industry, and enterprise in one’s daily affairs: “But dost thou love life, then do not squander time, for that’s the stuff life is made of.”

It doesn’t matter what you do during the day, because you earn enough money while you are sleeping.

Great wealth often inflicts a curse on its owners. It’s called the “hedonic treadmill,” and its function is to continually move the goalpost of your financial dreams, completely extinguishing the joy you thought you would get from having more money, once you attain it. People are constantly running on the hedonic treadmill; as they make more money, their expectations and desires rise in tandem, which results in no permanent gain in happiness.

This revelation was termed the Easterlin paradox. Once one’s basic needs have been met, incremental financial gain contributes nothing to happiness. This is because, in our minds, wealth is always relative, not absolute.

A research study posed the following question: Which new employee would be happier, the person making $36,000 in a firm where the starting salary is $40,000 or the one making $34,000 where the average is $30,000? Almost 80 percent said $34,000 would make them happier.

Chapter 10: Living Life According to the Inner Scorecard

According to Warren Buffett, there are two kinds of people in life: those who care what people think of them, and those who care how good they really are.

I think the concept of fiduciary duty is innate: people either have it or they don’t.

“For Bernie Madoff, living a lie had once been a full-time job, which carried with it a constant, nagging anxiety. ‘It was a nightmare for me,’ he told investigators, using the word over and over, as if he were the real victim. ‘I wish they caught me six years ago, eight years ago,’ he said in a little-noticed interview with them.”

Shane Parrish writes, “The little mental trick is to remember that success, money, fame, and beauty, all the things we pursue, are merely the numerator! If the denominator—shame, regret, unhappiness, loneliness—is too large, our ‘Life Satisfaction Score’ ends up being tiny, worthless. Even if we have all that good stuff!…It’s so simple. This is why you see people that ‘should be happy’ who are not. Big denominators destroy self-worth.”

Chapter 11: The Key to Success in Life Is Delayed Gratification

“I didn’t get to where I am by going after mediocre opportunities.” – Munger

Most managers are not willing to suffer upfront pain. So they focus on short-term results, which contributes to underinvestment in brand building, R&D, and other long-term growth initiatives, which in turn eventually leads to long-term pain. They cut current costs to prop up current earnings, rather than spend more now to gain much more later. Consequently, they hurt their chances of long-term success.

“You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.” —Seth Klarman

Anshul Khare once aptly remarked, “In the initial years…compounding tests your patience and in later years, your bewilderment.”

Similarly, investors in Adobe (which, as of October 2019, has delivered a CAGR of ~24% since its IPO in August 1986) had to undergo a period of thirteen years (2000–2013) during which they made nil return on its stock. Investing is hard. Very hard.

Investors tend to become complacent and stop questioning their existing holdings when their stock prices are going up. They resume analyzing in detail only when the prices start falling. Don’t analyze your holdings only when they fall. Just because the stock price of an existing holding is going up doesn’t necessarily mean that nothing negative is happening in its business.

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.”

In short, since 1950, there has never been any 20-year period when investors did not make at least 6 percent per year in the stock market. Although past performance is no guarantee of future returns, history shows that the longer the time frame, the greater are the odds of earning a satisfactory return.

It is human nature to seek instant gratification, and the market is dominated by individuals who simply do not want to wait for much larger rewards several years down the line. As a result, many investors end up engaging in “hyperbolic discounting,” heavily discounting the distant but large cash flows of high-quality businesses by applying high equity risk premiums, and they end up with much lower estimates of intrinsic business value than otherwise would have been the case. Consequently, even though those businesses may be fairly valued in the short term, they end up becoming grossly undervalued on a long-term basis. Professor Sanjay Bakshi illustrated this anomaly in his seminal October 2013 white paper on how quality businesses frequently end up getting mispriced by the market. (Any stock that has compounded at 15 percent to 20 percent for decades was, by definition, undervalued by the market for long periods of time.)

One Small Step Can Change Your Life: The Kaizen Way by Robert Maurer is one of my favorite books. It talks about the power of compounding small daily positive actions. This small book talks about the big idea of kaizen, which is Japanese for “taking small steps for continual improvement.” … The smaller steps get us to the desired goal because they can be incorporated more easily into our daily life. Small steps make delaying gratification easier and sustainable. So, whether it is quitting a bad habit or forming a good one, the idea is to start small, very small, and then to build on it over time. As the saying goes, “If we are facing in the right direction, all we have to do is keep on walking.”

Section III—Common Stock Investing

Chapter 12: Building Earning Power Through a Business Ownership Mind-Set

As an investor, your money is working for you 24/7. You are becoming wealthier with each passing second, alongside the increasing intrinsic value of your businesses.

As companies grow larger and more profitable, their stockholders share in the increased profits and dividends. Invest for the long term. Live fully today. Every day, millions of hardworking people around the world are doing great things at so many companies. As investors, we are thankful.

Chapter 14: The Significant Role of Checklists in Decision-Making

Charlie Munger has often been credited with popularizing the use of checklists in investing. In Poor Charlie’s Almanack, Peter Kaufman summarized Munger’s investing principles (risk, independence, preparation, intellectual humility, analytic rigor, allocation, patience, decisiveness, change, and focus) in a checklist form. This is a must-read for all investors.

Learn about the company and its competitors (both listed and unlisted) from company websites, filings, and information on the Internet. Read the past ten years’ worth of annual reports, proxies, notes and schedules to the financial statements, and management discussion and analysis (check for changes in tone and industry outlook) and observe the recent trends in insider shareholding.

[Cognitive dissonance] causes us to remain consistent with prior commitments and ideas, even in the face of disconfirming evidence. This includes confirmation bias—that is, looking for evidence that confirms our beliefs and ignoring or distorting disconfirming evidence to reduce the stress from cognitive dissonance. … If you find yourself in a hole, stop digging. … We are programmed to be lazy and are naturally inclined to follow the path of least resistance, that is, doing what is easy rather than doing what is required.

People will do many things to feel loved. They will do all things to be envied.

A good person can make a bad argument. A bad person can make a good argument. Judge the argument, not the person. Practice intellectual integrity.

Mental confusion from say-something syndrome. We often feel a need to say something when we have nothing to say. As the saying goes, “Better to remain silent and be thought a fool than to speak and remove all doubt.”

“You need a different checklist and different mental models for different companies. I can never make it easy by saying, ‘Here are three things.’ You have to derive it yourself to ingrain it in your head for the rest of your life.” – Munger

“Doing something according to pre-established rules, filters and checklists often makes more sense than doing something out of pure emotion. But we can’t have too many rules, filters or items without thinking. We must always understand what we’re trying to accomplish.”

Chapter 15: Journaling Is a Powerful Tool for Self-Reflection

When we remember something, we are simply pulling up a number of false details. Maybe we are even adding new errors with each act of recall. The presence of this feedback loop in memory reconsolidation compounds the problem over time. We tend to remember the things we want to remember and forget the things we would rather forget. As a result, a significant part of our memories is self-distorted fiction.

A decision journal helps you collect accurate and honest feedback on what you were thinking when you made decisions. This feedback helps you realize when you were just plain lucky. Sometimes things work out well for very different reasons than we initially envisaged. … This feedback loop is incredibly important, because the mind won’t provide it on its own. We don’t know as much as we think we know. We are fooled into thinking that we understand something when we do not, and we have no means to correct ourselves. Our minds revise history to preserve our view of ourselves. The story that we tell ourselves conjures up a linear cause-and-effect relationship between a decision we made and the actual outcome. The best cure for this cognitive malfunction is a decision journal.

In investing, conducting a premortem lets us take appropriate corrective action in a timely manner in the future. Before you buy a stock, visualize that a year has passed from the date of your purchase and 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. 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 a stock. Visualizing a range of scenarios for variables outside of one’s control also helps investors make better decisions for individual position sizing and portfolio construction.

Writing, apart from being a communication tool, is a thinking tool, too. It is almost impossible to write one thing and simultaneously think something else. When you force your hand to write something, it channels your thoughts in the same direction. Journaling turns out to be not just a tool for thinking but also a highly effective medium for focusing our thoughts. … Journaling has therapeutic benefits, too. Writing aids self-reflection, which is a great way to ease any unhappiness in our lives. Writing also improves our memory, because we remember more when we write down our thoughts and learnings.

Chapter 16: Never Underestimate the Power of Incentives

This just goes to show how the interplay of multiple behavioral biases results in extreme irrational outcomes. It is why Charlie Munger recommends, “Anti-gaming features constitute a huge and necessary part of system design. Also needed in the system design is an admonition: dread.” Incentives are not only financial but also include prestige, freedom, time, titles, power, and admiration. All of these are powerful incentives. And, according to Munger, few forces are more powerful than incentives: “Any time you create large differences in commissions where the guy gets X% for selling A, which is some mundane security, and 10 times X for selling B, which is something toxic, you know what’s going to happen.”

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.

Chapter 17: Always Think About the Math, but Avoid Physics Envy

“Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.” —Peter Lynch

“You don’t need a weighing scale to know that a four-hundred-pound man is fat.”

Personally, I have never opened a spreadsheet even once when making an investment decision. The most advanced technology I have ever used is a pocket calculator for basic math like addition, subtraction, multiplication, and division.

“Price is what you pay. Value is what you get.” – Buffett

The smarter you are, the better you are at constructing a narrative that supports your personal beliefs, rationalizing and framing the data to fit your argument or point of view. You may be smart, but not necessarily intelligent, because intelligence is the ability to arrive at accurate cause-and-effect descriptions of reality.

Suppose we want to know under what scenario we could earn a 15 percent annual return from this stock. What assumptions would be required to hold true to achieve this—and, more important, are they reasonable? A present market value of $1 billion and an annual return of 15 percent leads to $4 billion in market value in year 10. An exit multiple of 15× suggests owner earnings of $270 million in year 10. This implies an average annual growth rate of 21 percent in owner earnings (on the initial starting point of $40 million). A hypothetical profit margin of 15 percent suggests sales of $1.8 billion in year 10. This implies a 21 percent annual growth rate in sales for ten years. Now we can work with the various assumptions regarding required sales volume growth, trends in sales realization per unit, market share, and so on, and we can assess whether these are reasonable, given the past trends and track record of volume growth, pricing power, profit margins, market size, market share, and competitive advantage. … We cannot apply this model to fast-moving technology businesses, but we can apply it to moated businesses that meet basic human needs and aspirations in a relatively unsaturated market with a long runway for growth. These businesses usually experience a slower rate of change in their business models.

“We never sit down, run the numbers out and discount them back to net present value…. The decision should be obvious.”

Chapter 18: Intelligent Investing Is All About Understanding Intrinsic Value

In the past, Warren Buffett has described intrinsic value as private owner value, the price that an informed buyer would pay for the entire business and its future stream of cash.

“There is nothing more dangerous than an idea if it’s the only one you have.” – anonymous

The longer the competitive advantage period (CAP), the more likely a business is worth a lot more than what the market thinks. “Durability” of the moat is the key factor.

Ten dollars of earnings from a capital-light business like Moody’s, with its low reinvestment requirements, is obviously worth a lot more than the same earnings figure from a capital-intensive business like General Dynamics, so investors should capitalize each of them differently. Investors have to look at each business’s earning power, along with the future prospects of the business, to decide how much they are willing to pay to acquire that business’s future cash flows.

The traditional “value investor” mentality of buying cheap securities, waiting for them to bounce back to “intrinsic value,” selling and moving onto the next opportunity, is flawed. In today’s world of instant information and fast-paced innovation, cheap securities increasingly appear to be value traps; often they are companies ailing from technological disruption and long-term decline. This rapid recycling of capital also creates an enormous drag on our after-tax returns. In addition, by focusing on these opportunities, we incur enormous opportunity costs by not focusing instead on the tremendous opportunities created by the exceptional innovation S-curves we are currently witnessing. —Marcelo Lima, Managing Partner at Heller House.

I have learned to respect the market’s wisdom. Everything trades at the level it does for a reason. High quality tends to trade at expensive valuation and junk or poor quality is frequently available at cheap (or the harmful “optically cheaper on a relative basis”) valuation. It took me many years to learn this big market lesson: expensive is expensive for a reason and cheap is cheap for a reason.

“Remember that a man who will steal for you, will steal from you.”

Chapter 19. The Three Most Important Words in Investing

Time and again, the market teaches us that a big difference exists between a great company and a great stock.

A stable investor who earns 20 percent for two consecutive years comes out ahead of a flamboyant newcomer who earns 100 percent in a bull market year and loses 30 percent or more in the following year. (Most of the inexperienced investors realize this harsh math the painful way when junk stocks finally start crashing after a bull market, and only then do they begin to appreciate the significant importance of investing in quality.)

There always seems to be a strong divide within the investing community between “deep value” (statistically cheap securities) and “growth at a reasonable price” (high-quality compounders). It is true that many investors do well by buying great businesses at fair prices and holding them for long periods of time, whereas other investors prefer to buy cheap stocks of average or mediocre quality and sell them when they appreciate to fair value, repeating the process over time as they cycle through multiple new opportunities. The styles are different, but not as different as most people describe them to be. The tactics used are different, but the objective is exactly the same—that is, trying to buy something for less than what it’s really worth, or trying to locate the low-risk fifty-cent dollars. Both strategies are just different versions of Graham’s margin-of-safety principle.

“If you plan to hold a share for the long term, the rate of return on capital it generates and can reinvest at is far more important than the rating you buy or sell at.” —Terry Smith

Because the higher-quality compounder is worth a lot more over a long-term holding period than the lower-quality business, the former offers a larger margin of safety.

One way to reduce unforced errors in investing is to carefully choose the businesses that we decide to own. Investors are better off with a few solid long-term choices than flitting from one speculation to another, always chasing the latest hot stock in the market. (Better to have a few good, long-term friends rather than changing your friends every week for short-term advantage.) The gap between price and value ultimately will determine our returns, but picking the right business is possibly the most important step in reducing errors. Improving pattern recognition skills increases the probability of successfully identifying the right businesses to invest in. … companies with increasing intrinsic value over time are the clear winners.

The Graham and Dodd investor believes in mean reversion—that is, bad things will happen to good businesses and good things will happen to bad businesses. Buffett–Munger–Fisher investors invest in businesses with fundamental momentum, that is, a high probability of sustaining excess returns over long periods of time. These two ideologies often clash (mean reversion versus fundamental momentum) in the value investing community. For most businesses, mean reversion applies, but for some exceptional ones, it starts applying after a prolonged period of time, and until then, fundamental momentum applies.

Although Benjamin Graham is widely renowned as a deep value investor, the profits from his single growth stock investment, GEICO, were more than all his other career investments combined. In 1948, Graham’s investment partnership (Graham-Newman) purchased 50 percent of GEICO for $712,000. By 1972, this was worth $400 million. Graham had scored a Peter Lynchian five-hundred-bagger. He later wrote, “Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.”

Corporate profitability is sticky. Wonderful companies tend to remain wonderful, and poor companies tend to remain stuck in the mud. Our empirical evidence suggests that sustainable corporate turnarounds are difficult to execute…. Companies in defensive industries exhibit more stickiness in corporate profitability than firms in cyclical industries. However the persistence in performance remains highly significant and thus the reputation of the business tends to remain intact regardless of industry…. Firms with excellent profitability tend to outperform those with the worst return on capital. The outperformance improves if high-quality firms are purchased at a fair price. … This has been proven empirically not just in this study but in many others. Financial economist Robert Novy-Marx looked at New York Stock Exchange firms between 1963 and 2010 and at international firms between 1990 and 2009. He found the same persistence of high performance, not just in business fundamentals but also in stock market returns: “More profitable companies today tend to be more profitable companies tomorrow. Although it gets reflected in their future stock prices, the market systematically underestimates this today, making their shares a relative bargain—diamonds in the rough.”

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.” – Buffett

High quality always beats a bargain over time. Although there are certainly exceptions, in the long run, bargains never outperform solid investments. This simple yet profound principle can be applied to virtually every area of life. Crash diets, predatory pricing, dishonesty, and shortcuts can work well for a while, but they are never sustainable.

Chapter 20: Investing in Commodity and Cyclical Stocks Is All About the Capital Cycle

“The market is better at predicting the news than the news is at predicting the market.” – Gerald Loeb

A stock hitting a new high has no overhead supply to contend with and has much more of an open running field. Everybody has a profit; everybody is happy. In contrast, a stock near its fifty-two-week low has a great deal of overhead supply to work through and lacks upside momentum, because it is vulnerable to fresh bouts of selling by the old investors at every higher level.

Even if you do not end up investing in any of the breakout stocks, the positive takeaway from this exercise would be the fact that your mental database will have expanded by studying the annual reports, presentations, and conference call audio recordings and transcripts of the various companies in the industry. (Conference calls are a vital component of any serious investor’s research activity list.) For truly passionate investors, researching new companies is just delightful and never gets old. The importance of insatiable intellectual curiosity, along with a deep passion for continuous learning, cannot be overstated in the investing profession. In 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 time in the future. Work hard today to let good luck find you tomorrow.

I immediately read Sam Zell’s book Am I Being Too Subtle? which drilled the core fundamental concepts of demand and supply into my mind. I also reread Edward Chancellor’s book Capital Returns as well as the excellent chapter on commodity investing in Parag Parikh’s book Value Investing and Behavioral Finance. The right book at the right time will speak to you in a way that the right book at the wrong time just won’t. I had previously read Chancellor’s and Parikh’s books in 2016. I did not appreciate them at the time. I read them again in 2017, and they changed my life.

Peter Lynch calls the “bladder theory” of corporate finance: “The more cash that builds up in the treasury, the greater the pressure to piss it away.”

Chapter 21: Within Special Situations, Carefully Study Spinoffs

“In the broader sense, a special situation is one in which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance. In the narrow sense, you do not have a real ‘special situation’ unless the particular development is already under way [emphasis added].”

A global study conducted by consulting firm The Edge and accounting firm Deloitte looked at 385 global spinoffs from January 2000 to June 2014 involving parent companies with a market cap of $250 million or more. To qualify, transactions needed to be pure spinoffs, with shareholders of parent companies receiving shares of newly listed companies. The study found that the worldwide asset class of spinoffs generated more than ten times the average gains of the MSCI World Index during their first twelve months independent of the parent.

Investors often receive a blanket piece of advice like “Never add to a losing position” or “Do not ever average on the downside” or “Avoid catching a falling knife.” I simply recommend this: always think it over. 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. During its initial weeks and months of trading, you often observe forced selling by institutions that cannot hold the new stock in their portfolios because of certain rigid institutional mandates, such as being allowed to invest only in certain sectors or restrictions on market cap, and you end up with sizeable paper losses on your existing holding of the demerged company’s shares.

Greenblatt quotes a Penn State study that found spinoffs outperform the market by 10 percent per year. If you assume that the market will return 10 percent, then, theoretically, you can make 20 percent per year by just blindly buying spinoffs. … Say what you will about the risks of investing in such companies, the rewards of sound reasoning and good research are vastly multiplied when applied in these leveraged circumstances. Tremendous leverage would magnify our returns if spinoff turned out, for some reason, to be more attractive than its initial appearances indicated [emphasis added].

Section IV – Portfolio Management

Chapter 22: The Holy Grail of Long-Term Investing

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite—that is, consistently employ ever-greater amounts of capital at very low rates of return.” — Warren Buffett

A core test of success for a business is whether every dollar it invests generates a market value of more than that amount for the shareholders. Warren Buffett calls this the one-dollar test, and he explains it in his 1984 letter, “Unrestricted earnings should be retained only when there is a reasonable prospect—backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future—that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.” … For an increase in earnings to be evaluated properly, it always should be compared with the incremental capital investment required to produce it.

When Buffett talks about a dollar of retained capital creating a dollar of market value (he prefers to apply this test on a five-year rolling basis), he is talking about a dollar of intrinsic value. His implication is that the stock market will be a fairly accurate judge of intrinsic value over time. (A simple way to do a quick one-dollar test is to compare the change in beginning and ending market value of a company over a period of time to the change in its beginning and ending retained earnings values.) Basically, Buffett is saying that the market, over time, will reward those companies that create high returns on the dollars they keep (by giving them a higher valuation multiple) and will punish those companies whose retained dollars fail to earn their keep (by giving them a lower valuation multiple).

According to Charlie Munger, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 percent on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6 percent return even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.” [AA Note: Terry Smith repeats this quote several times in his 2020 book, which is a compilation of his letters and articles over the past decade since starting Fundsmith.]

The math behind Munger’s assertion is easy to follow. An 18 percent return on invested capital (ROIC) over a multidecade period will dominate a 6 percent ROIC in terms of shareholder returns. Simple. It’s simple but not easy. One of the biggest challenges in investing is determining the competitive advantage of a business and, more important, the durability and longevity of that advantage. Competitive advantage is defined as a company’s ability to generate “excess returns,” that is, ROIC less cost of capital. A sustainable competitive advantage is defined as a company’s ability to generate excess returns over an extended period of time, which requires barriers to entry to prevent competitors from entering the market and eroding the excess returns. This, in turn, enables excess returns on invested capital for long periods of time (also known as the competitive advantage period, CAP). Growing firms with excess returns and longer CAPs are more valuable in terms of net present value. The value of a company’s CAP is the sum of the estimated cash flows solely generated by these excess returns, discounted for the time value of money and the uncertainty of receiving those cash flows.

In a 1999 interview with Fortune, Buffett highlighted “moats” as the main pillar of his investing strategy: “The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.” In his 2007 letter, Buffett wrote what is considered by many to be the seminal piece on competitive advantage and value creation in which he discussed great, good, and gruesome businesses.

Great businesses are those with an ever-increasing stream of earnings with virtually no major capital requirements. They produce extraordinarily high returns on incremental invested capital. The truly great businesses are literally drowning in cash all the time. They tend to earn infinitely high return on capital as they require little tangible capital to grow and are driven by intangible assets such as a strong brand name with “share of mind,” intellectual property, or proprietary technology. Great businesses typically are characterized by negative working capital, low fixed asset intensity, and real pricing power.

Negative working capital means that customers are paying the company cash up front for goods or services that will be delivered at a later date. This is a powerful catalyst for a growing company, as the customers are essentially financing the company’s growth through prepayments. Best of all, the interest rate on this financing is zero percent, which is tough to beat. Negative working capital is common in subscription-based business models in which customers pay up front for recurring service or access. Because revenue is recognized when the service is performed, which is after the cash comes in, these businesses typically have operating cash flow that exceeds net income.

In the franchisor business model, the franchisor collects a royalty from franchisees in exchange for the use of the brand name, business plan, and other proprietary assets. The overall system grows as franchisees supply the capital to build new locations, enabling the franchisor to increase revenue and earnings without deploying additional capital. This business model is great if it can be scaled up, because it is capital light and throws off lots of free cash flow by simply leveraging the brand-name equity of the franchisor. This is why Buffett says, “The best business is a royalty on the growth of others, requiring little capital itself.” Firms that outsource their core manufacturing activities while focusing on design, marketing, and branding efforts also have low fixed asset intensity.

If the business provides a product or service that is differentiated, has high switching costs, or is critical to customers (while constituting a minuscule percentage of overall cost), it may be able to consistently raise prices at levels exceeding inflation. This method is the simplest way to grow earnings without additional capital, because the flow-through margins on price increases are usually quite high. Companies such as Bloomberg and See’s Candies have long histories of raising prices at or above inflationary rates, and Buffett considers this to be one of the most important variables when analyzing a business: “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.”

Great businesses are rare, scarce, and thus valuable. They are usually given rich valuation multiples by the market when longevity of growth is predictable with a high degree of certainty. Indeed, longevity of growth is becoming increasingly scarce in today’s world, which is characterized by rapid pace of change. The average time a company spent in the S&P 500 in the 1960s was about sixty years. Today, the average is barely ten years. Fewer than 12 percent of the Fortune 500 companies in 1955 were still on the list sixty-two years later in 2017, and 88 percent of the companies in 1955 had either gone bankrupt or had merged with (or were acquired by) another firm. If they still exist, they have fallen from the top Fortune 500 companies (as ranked by total revenues). This is Joseph Schumpeter’s “creative destruction” at its very best.

The market places a heavy weight on certainty. Stocks with the promise of years of predictable earnings growth tend to go into a long period of overvaluation, until such time that they are no longer able to grow earnings in a steady manner. Predictability of long-term growth matters more to the market than the absolute rate of near-term growth, so a stock that promises to grow earnings at 50 percent for the next couple of years, with no clarity thereafter, is given a lower valuation multiple by the market than a stock that has slower but highly predictable growth for a much longer period. Consistent growth increases valuation; consistent disruption decreases valuation. The longevity of growth is always given a greater weight by the market than the absolute rate of growth, so you often will notice stocks with 12 percent to 15 percent predictable earnings growth for the next ten to fifteen years getting current year price-to-earnings (P/E) multiples of 40× to 50×. This phenomenon perplexes most new investors, but with experience, they come to appreciate the finer nuances of the market and respect its wisdom. The expensive, high-quality secular growth stocks tend to remain at elevated valuations for extended periods of time because investors in such stocks generally are willing to sit out periods of high valuation until earnings catch up. Markets provide disproportionate rewards to companies that can promise years of sustainable earnings growth.

The principle of scarcity premium applies to the number of high-growth stocks available in an individual sector as well as in the overall market. A business with a perceived sustainable growth rate of 30 percent to 35 percent often ends up getting a 40× to 50× P/E (or an even higher valuation that generally keeps expanding throughout the entire duration of the bull run, as long as the high growth expectations are intact) if only a few companies in the market are able to achieve such high growth rates. In contrast, a business growing at 20 percent may not get more than 15× to 20× P/E if many 20 percent growers are available. (This is why looking at the P/E-to-growth ratio, also known as PEG ratio, in isolation can result in suboptimal return outcomes.)

When growth becomes scarce, the market breadth narrows, and demand–supply dynamics take over. During bearish phases, investors want certainty of growth (whereas during bullish phases, they are ready to take a leap of faith). During such periods of uncertainty, the market’s focus becomes extremely narrow, and valuations of the select few high-quality growth stocks in the market keep expanding until their growth rate remains at above-average levels relative to the majority of the stocks in the market. (Most investors remain in denial during this phase, as these expensive stocks keep becoming more expensive.) When growth finally starts decelerating, the valuation derating begins. The actual threat to a bull market stock is not excessive valuation but a sharp correction in its growth expectations by the investor community, because valuations remain expensive and then become excessive until such time as the company delivers above-average rates of growth. Markets love uninterrupted rates of high growth and accord rich valuations to companies that can convince the market that they have the ability to consistently deliver above-average rates of growth over longer periods of time.

Investors with a bias against high P/E stocks miss some of the greatest stock market winners of all time. Over ten years or more, a high P/E company that’s growing earnings per share at a much faster rate eventually will outperform a lower P/E company growing at a slower rate. This will be true even if some valuation derating occurs in the interim period for the former. If it comes to a choice between a 15 percent grower at 15× P/E and a 30 percent grower at 30× P/E, investors always should choose the latter, particularly when longevity of growth is highly probable.

As investors, we constantly try to identify “emerging moats” so that we benefit not only from the initial high growth years of the company but also from the subsequent valuation rerating as well. An example would be a lower-margin and working-capital-intensive business-to-business (B2B) company transitioning into a higher-margin business-to-consumer (B2C) company with superior terms of trade. Even if we miss the initial high growth phase but can identify these emerging moat businesses during their intermediate stages, a lot of wealth is created over time.

Good businesses are those that require a significant reinvestment of earnings to grow and produce reasonable returns on incremental invested capital. Many businesses fall in this put-up-to-earn-more category.

Gruesome businesses are those that earn below their cost of capital and still strive for high growth, even though that growth requires significant sums of additional capital and destroys value. These businesses usually are highly capital intensive and are subject to rapid technological obsolescence. They never make any real economic profits because they are subject to the “Red Queen effect”—that is, they keep investing more and more capital just to keep pace with competition and to remain at the same starting position, or they stop investing in new technology and are obliterated. (Debt, intense competition, and high capital intensity together make for a deadly concoction.) Buffett describes them best: “The worst business of all is the one that grows a lot, where you’re forced to grow just to stay in the game at all and where you’re reinvesting the capital at a very low rate of return. And sometimes people are in those businesses without knowing it.”

Consequently, the managements of these businesses often mindlessly mimic their competitors after falling prey to what Buffett calls the “institutional imperative.” They are not aware that they are constantly trying to run up a down escalator whose pace has accelerated to the point at which upward progress has halted. They are blindsided by the rapid growth rate at an industry level and fail to heed Benjamin Graham’s warning: “Obvious prospects for physical growth in a business do not translate into obvious profits for investors.”

Buffett learned this valuable insight from his teacher very well. In his 1999 interview with Fortune, he said, “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” The next time an analyst or so-called market expert touts the rapid growth rate of any industry as a justification for investing in the stocks within that industry, watch out. When all else is equal, a higher ROIC is always good. The same can’t be said for growth. Investing is all about individual stocks and their economic characteristics.

If you want to participate in the high growth rate of an industry that is characterized by poor profitability, do so indirectly through an ancillary industry that has better economics and lower competition (the best-case scenario would be if it’s a monopoly business and the sole supplier to all the players in the primary industry). For example, the organized luggage industry in India (characterized by moderate competition) could be used as a proxy to profit from the high traffic growth of airlines (characterized by hypercompetition).

Buffett sums up the discussion in his 2007 letter with a great analogy: “To sum up, think of three types of ‘savings accounts.’ The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.”

“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.” —Charlie Munger

Recall Buffett’s definition of the best business to own. I love the business Munger talks about, which cuts me a check every year from its owner earnings. Ideally, however, I am looking for a business that will forgo sending me a check because it has attractive internal reinvestment opportunities. In other words, I prefer a business that not only produces high returns on invested capital but also consistently reinvests a large portion of its earnings at similarly high returns. This is the holy grail of long-term value investing. At this point, a business has achieved true internal compounding power, which is the product of two factors: return on incremental invested capital and the reinvestment rate. This compounding power leads to huge value creation over time.

This phenomenon was discovered almost a century ago by Edgar Lawrence Smith and was subsequently brought to the attention of the mainstream investment community by John Maynard Keynes, who, in May 1925, reviewed Smith’s book Common Stocks as Long Term Investments. Keynes stated, “[This is] perhaps Mr. Smith’s most important point…and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to their shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus, there is an element of compound interest operating in favor of a sound industrial investment.”

The two big ideas are reinvested profit and compound interest. Typically, “compounding machines” enjoy a niche positioning or some durable competitive advantage that allows them to achieve high returns on capital for a long time. The key to investing in these reinvestment moats lies in the conviction that the runway ahead for growth is long and that the competitive advantages that produce those high returns will sustain or strengthen over time. When I look at high-ROIC businesses, I am really looking for return on incremental invested capital (ROIC), that is, the return a business can generate on its incremental investments over time. The growth of a company’s intrinsic value depends on the returns it can earn on its incremental invested capital. Whether growth is good or bad is contingent on ROIIC. For companies that have a large spread between ROIIC and cost of capital, high growth is good and adds a lot of value. All things being equal, for such companies, faster growth translates directly into a higher P/E multiple. The value of high-ROIIC companies is extremely sensitive to changes in perceived rates of growth.

Investors tend to confuse incremental ROIC with ROCE (return on capital employed) or ROIC. ROIIC less cost of capital drives value creation. Even though legacy moat businesses with established franchises and low or no growth opportunities may have high return on invested capital, if you purchase their stock today and own it for ten years, it is unlikely that you will achieve exceptional returns. In this case, the company’s high ROIC reflects returns on prior invested capital rather than on incremental invested capital. In other words, a 20 percent reported ROIC today is not worth as much to an investor if no more 20 percent ROIC opportunities are available to reinvest the profits. Mature legacy moat businesses with good dividend yields may preserve one’s capital, but they are not great at compounding wealth.

I prefer businesses that grow intrinsic value over time. This type of growth provides us with a margin of safety not just in the valuation but also in the gap between price and intrinsic value, which widens over time as the business value continues to grow. If two businesses (Company A and Company B) have the same current ROIC of 20 percent, but Company A can invest twice as much as Company B at that 20 percent rate of return, then Company A will create much more value over time for its owners than Company B. Both of these companies will show up as businesses that produce 20 percent ROIC, but one is clearly superior to the other. Company A can reinvest a higher portion of its earnings, and thus it will create a lot more intrinsic value over time. The longer you own Company A, the wider the gap grows between Company A’s and Company B’s investment result.

I cannot emphasize this critical fact enough: although valuation is more important over shorter time periods, quality along with growth is much more important over long time periods (seven to ten years and longer). The longer you hold a stock, the more the quality of that company matters. Your long-term returns will almost always approximate the company’s internal compounding results over time. It is far more important to invest in the right business than it is to worry about whether to pay 10× or 20× or even 30× for current-year earnings. Many mediocre businesses are available at less than 10× earnings that lead to mediocre results over time for long-term owners. The intrinsic value of quality business increases over time, thus increasing the margin of safety in the event of a stagnant stock price. This is a pleasant situation because it creates antifragility for an investor. In contrast, if a business is shrinking its intrinsic value, time is your enemy. You must sell it as soon as you can, because the longer you hold it, the less it is worth.

“Time is the friend of the wonderful company, the enemy of the mediocre.” — Warren Buffett

“The bitterness of poor quality remains long after the sweetness of low price is forgotten.” — Benjamin Franklin

“The best stocks will always seem overpriced to a majority of investors.” — Gerald Loeb

An astonishing anomaly is that these superlative reinvestment moat opportunities often hide in plain sight. Most investors shun them at first glance, citing expensive current valuations, and end up overlooking the long-term power of internal compounding. The math behind choosing the right business is compelling.

Let’s consider two investments and observe which yields better results over a ten-year horizon (table 22.1). The first business, Reinvestment Corporation, has the ability to deploy all of its retained earnings at a high rate because of its strong reinvestment moat. Of course, the market acknowledges this likelihood, and the entry price is fairly high, at 20× earnings, leading most deep value investors to scoff. Conversely, Undervalued Corporation is a typical Graham cigar butt—that is, a steady business with a good dividend yield selling for only 10× earnings. Assume that, over time, both companies will be valued in line with the market, at 15×. [Note: Reinvestment Corp IRR of 21.5% compares to 13.6% for Undervalued Corp. The value of the more expensive stock 10 years out is multiples higher.]

TABLE 22.1 Comparison of investment results

“This is the most nuanced and misunderstood aspect of investing: a fair price may be a lot more than you would think if profitable reinvestment really can take place.” — Tom Gayner

“What is most important…is that stocks are not bought in companies where the dividend pay-out is so emphasized that it restricts realizable growth.” — Phil Fisher

Investing is part art, part science, but over the long term, investing in businesses that earn high returns on incremental invested capital significantly improves the probability of achieving above-average returns. Finding a great business that does all of the heavy lifting for you while you passively let value compound is about as good as it gets. These businesses give long-term investors the joys of averaging upward on improved prospects and superior execution, which is akin to giving a bonus to your best-performing employees for exceeding expectations. After all, the promoters of our investee companies are working around the clock to create wealth for us.

You might ask: How does one determine whether the attractive returns of the past will continue in the future? In his 1987 letter, Buffett shared his insights on businesses that are built to last: “The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest-paying capacity. Really good businesses usually don’t need to borrow. Second, except for one company that is “high-tech” and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane. Most sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.”

In terms of percentages, the high-quality compounder category likely will have fewer errors—that is, fewer permanent capital losses—than the “statistically cheap” securities category. This doesn’t mean one will do better than the other, as a higher winning percentage doesn’t necessarily mean higher returns. But if you want to reduce “unforced errors,” or losing investments, it is more beneficial to focus on high-quality businesses. As an investor, life feels so pleasant when you are invested in high-quality compounders. Buffett advises: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards—so when you see one that qualifies, you should buy a meaningful amount of stock…. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” – Buffett

A few years back, I randomly came across a sample table of stock returns while browsing the Internet (table 22.2). This was the moment of awakening that made me finally realize the true power of Buffett’s insight. It sparked an illumination, an enlightenment, an oceanic feeling. Something akin to the one that sent Archimedes jumping out of the tub shouting, “Eureka!”

TABLE 22.2 Comparison of stock returns, 2008 and 2013

Consider that $20,000 invested in the great businesses (Hawkins, ITC, Titan, and HDFC Bank) appreciated almost five times, to $100,000, in five years, while the same money in the gruesome businesses (Reliance Communications, Reliance Capital, DLF, HDIL, and GMR Infra) experienced brutal destruction and would have been worth only $3,000. … This led me to one of the biggest findings in my investing journey: great businesses created a lot of wealth even when measured from the top of the previous bull market to close to the end of the subsequent bear market. To achieve big wealth creation, an investor had only to hold on to them in a disciplined manner during the turbulent times in the stock market and stay the course. Liquidity and sentiment drive the market index in the short term, whereas individual company earnings drive stock prices in the long term. Great businesses create enormous wealth over long holding periods across market cycles, even in the midst of negative macro headlines about high inflation, rising interest rates, geopolitical tensions, weak macroeconomic data points, and political uncertainty. Gruesome businesses eventually destroy wealth, irrespective of whether the news is positive or negative.

Sample this. The Dow Jones Industrial Average was 874.12 on December 31, 1964, and 875.00 on December 31, 1981. Nearly zero change in seventeen long years. Yet Buffett compounded his capital at more than 20 percent compound annual growth rate during this period. Investing is about identifying great businesses with high-quality earnings growth and capital allocation and firmly holding on to them as long as they exhibit these characteristics. The stock markets do not really matter over the long run when you invest in such businesses and, most important, stay the course.

Tying It Together: ROIC with Competitive Advantage and Capital Allocation

Critically evaluating the durability of competitive advantage and how capital allocation affects shareholder value can create a variant perception when selecting equities for long holding periods. —Pat Dorsey

Combining the key insights from this chapter, we arrive at investing nirvana: long-term ownership of competitively advantaged businesses with significant reinvestment potential, managed by excellent capital allocators and shareholder-friendly management teams.

Competitive Advantage

Capitalism is brutal. Excess returns attract competition. Only a few rare businesses enjoy excess returns for many years by creating structural competitive advantages or economic moats. … An extended period of excess returns increases business value. Competitive advantages stem from various sources, including intangible assets, such as brands, patents, and licenses; switching costs; network effects; or low-cost advantages.

Intangible Assets

Some companies (such as Apple) simply offer a product or service that is far superior to their competitors’ products, and other companies offer a product or service of quality similar to their competitors’ products but simply are better at telling a story about that product (such as Tiffany & Co.). Businesses that primarily depend on marketing a story are much more vulnerable to shifting consumer behavior. (The most devastating substitutes cost less and have at least one feature that is superior.) Branding has historically served a few key purposes: to guarantee minimum assured product quality and to allow people to express their identity in a social context. Brands prospered in an environment of information scarcity, in which an asymmetrical relationship developed between customers and companies. Signs are clear, however, that this trend is coming to an end. Brands must be authentic, because very few veils remain between a business and the public. Everything is on the record all the time in today’s information age. In a highly connected and well-informed world, value to the customer is the most important thing to consider when analyzing a company.

Another intangible asset is patents. Patents confer legal monopolies (in the case of innovator companies), and a basket of patents is preferable to an overdependence on a single patent. Some regional or national monopolies have a product that customers have difficulty avoiding, something like a toll road. (Buffett often has talked about his love for toll roads in a figurative manner, such as newspapers in one-newspaper towns.) Likewise, licenses and regulatory approvals confer legal oligopoly status through regulatory fiat (as is the case with ratings agencies).

Switching Costs

Switching costs come in many forms and may be explicit (in the form of money and time) or psychological (resulting from deep-rooted loss aversion or status quo bias). These costs tend to be associated with critical products (such as Oracle’s SAP software) that are so tightly integrated with the customer’s business processes that it would be too disruptive and costly to switch vendors, or with products that have high benefit-to-cost ratios (such as Moody’s).

Network Effects

The network effect advantage comes from providing a product or service that increases in value as the number of users expands, as with Airbnb, Visa, Uber, or the National Stock Exchange of India. This functions as a strong moat as long as pricing power is not abused and the user experience does not degrade. Creating a two-sided network such as an auction or marketplace business requires both buyers and sellers, and each group is going to show up only if they believe the other side will be present as well. Once this network is established, it becomes stronger as more participants from either side engage. As more buyers show up, more sellers are attracted, which in turn attracts more buyers. Once this powerful positive feedback loop is in place, it becomes nearly impossible to convince either the buyer or the seller to leave and join a new platform. This kind of business actually becomes stronger as it grows and displays accelerating fundamental momentum. Look at Airbnb’s strong two-sided network as an example of a business model that greatly benefits from positive feedback loops (figure 22.1). FIGURE 22.1 The strong network effect enjoyed by Airbnb. Source: “Airbnb TWOS: Network Effects,” SlideShare, March 7, 2016, https://www.slideshare.net/a16z/network-effects-59206938/34-AirbnbT_W_O_S_I.

Low-Cost Advantages

Low-cost advantages stem from various sources, including process, scale, niche, and interrelatedness.

Process. Advantage accrues when a company creates a cheaper way to deliver a product, which cannot be replicated easily, as with Inditex, GEICO, or Southwest Airlines. [Fundsmith?]

Scale Advantage accrues when a company spreads fixed costs over a large base, as do Costco and Nebraska Furniture Mart. Relative size in a market matters more than absolute size in isolation.

Niche Advantage accrues when a company dominates an industry with high minimum efficient scale relative to total addressable market, as with Wabtec Corporation or Spirax-Sarco Engineering.

Interrelatedness of new initiatives with existing lines of business. Companies gain an advantage when their product lines or business segments are interrelated and reinforce each other (as with Hester Biosciences). Saurabh Madaan of Markel Corporation refers to this as the “octopus model.” Phil Fisher has talked about this source of competitive advantage in the past: “The investor usually obtains the best results in companies whose engineering or research is to a considerable extent devoted to products having some business relationship to those already within the scope of company activities.”

Low-cost producers can sell their product or service at a lower margin than competitors and still operate profitably, because of the large volume of customers. A good example of a low-cost producer is GEICO, the direct seller of automobile insurance to Americans. GEICO has the lowest operating costs in its industry, primarily because it sells directly to its customers instead of hiring insurance agents. Buffett has often talked about GEICO’s cost advantage over its competitors as a strong moat: “Others may copy our model, but they will be unable to replicate our economics.” The more customers that buy from a low-cost producer, the more its cost advantage moat widens over time, creating a “flywheel” that accelerates as the business grows.

Culture as a Moat

We have discussed the traditional sources of competitive advantages, but a much-underappreciated source of a sustainable and difficult-to-replicate competitive advantage is culture. Culture is best epitomized by such companies as Berkshire Hathaway, Amazon, Costco, Kiewit Corporation, Constellation Software, and Markel Corporation, to name a few.

To illustrate the critical significance of an organization’s culture, consider this: from 1957 to 1969, Buffett did not mention the word “culture” even once in his letters; from 1970 to 2017, he has mentioned the word more than thirty times. Businesses with a strong culture focus on delivering a great customer value proposition and communicating about the same more effectively than their competitors do. To create strong value propositions, firms should ask customers what they want to achieve and how they measure success and failure. (Instead, too many firms still ask customers what they want. Customers are not experts on the solution.)

As investors, we look for those companies that are fanatically obsessed with the well-being of their customers and that empathize with them more than their competitors do. Culture matters to long-term investors because it empowers the company’s employees to do their day-to-day tasks slightly better than the company’s competitors do theirs. Over time, these little advantages compound into much larger advantages, which can persist far longer than conventional wisdom expects.

When investing in businesses that are widening the moat, with the passage of time, these businesses invariably turn out to be much cheaper than what would have resulted from our initial valuation work.

High absolute market share (think General Motors) is not a moat. Great technology products (think GoPro), absent customer lock-in, is not a moat, as commoditization and disruption are inevitable. Hot products (like Crocs) can generate high returns for a short period of time, but sustainable excess returns make a moat. When assessing the moat of any business, simply ask yourself how quickly a smart competitor with unlimited financial resources could replicate it. If your competitors know your success secret and still can’t copy it, you have a strong moat.

“One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it.” —Warren Buffett

Capital Allocation

Capital allocation is the bridge between intrinsic business value and shareholder value. If a company has high-return investment opportunities internally, it should reinvest heavily. Maturing companies, however, often continue to invest despite declining or low returns on capital. (Aging is tough for companies as well as for people.) These companies should instead return capital via dividends or share buybacks. Dividends are important not only for the obvious reason of the use of idle cash but also because they act as a discipline—for a company to pay a dividend, the profits have to be real. Remember, dividends are not necessarily good if they are funded poorly (sometimes management takes on debt just because shareholders expect dividends) or if they are paid out in lieu of investing in high-net-present-value projects and represent a large opportunity cost.

The time to evaluate quality is before the price action starts and not after it.

Making the correct qualitative judgment about a business, including the long-term sustainability of its success attributes, is more important than the entry valuation over a long-term holding period. Within reason, you can survive overpaying for a growing high-quality franchise. If you have to go wrong, go wrong on valuation but not on quality.

It seems fitting to end this chapter with Buffett’s views on the topic of quantitative versus qualitative investing: “Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess — I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a high-probability insight. This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.”

Chapter 23: The Market is Efficient Most, but Not All, of the Time

The stock market is a giant distraction to the business of investing. —John Bogle

Napoleon’s definition of a military genius: “The man who can do the average thing when all those around him are going crazy.” Your lifetime achievement as an investor will be determined primarily by how you conduct yourself during the occasional periods of extreme market behavior.

This advice is what Buffett was referring to when he shared the secret to becoming rich in the stock market: “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”

Peter Lynch calls these companies “stalwarts.” They are the big companies without a lot of high growth potential. Occasionally, however, you can buy them at a discount and sell them after a 30 percent to 50 percent rise, which largely comes from the valuation multiple reverting back to the mean, as opposed to the business value increasing. Always remember: stock prices randomly fluctuate every day, sometimes wildly on either side, but business value changes very slowly. Therein lies the big opportunity. Focusing on what is moving is part of our evolutionary instincts. This explains why market participants focus more on stock prices, which keep bobbing around, than on business values, which change quite slowly.

The major thing we look at is liquidity, meaning as a combination of an economic overview. Contrary to what a lot of the financial press has stated, looking at the great bull markets of this century, the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going [emphasis added].

Investors usually step up their efforts during a bear market, because of the tense environment, and they tend to become complacent during a bull market. Instead, dream big, manage risk, and intensify your efforts during a bull market to achieve financial independence early in life. When you are lucky to experience a bull market, ensure that it makes a big difference to your life. Make the most of a bull market to earn. Make the most of a bear market to learn.

Andy Grove’s words, “Bad companies are destroyed by crisis, good companies survive them, great companies are improved by them.”

“The real key to making money in stocks is not to get scared out of them.” -Peter Lynch

Buffett’s advice: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” He continues, “During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy.”

Just because a company’s future is highly uncertain or unknown at present, this does not mean an investment in it is risky. In fact, some of the best investment opportunities are highly uncertain but have minimal risk of permanent capital loss.

When I read James Surowiecki’s book The Wisdom of Crowds, I finally learned to recognize the significance and deeper meaning of trading volumes. When in doubt about a stock after a sudden sharp move on either side, look at the volumes. The collective wisdom of the market will guide you in the right direction most of the time.

Chapter 24: The Dynamic Art of Portfolio Management and Individual Position Sizing

“The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results.” —Charlie Munger

“The appeal of a concentrated portfolio is that it is the only chance an investor has to beat the averages by a noteworthy margin.” —Frank Martin

“The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obviously good idea. But ninety-eight percent of the investment world doesn’t think this way.” —Charlie Munger

“Phil Fisher believed in concentrating in about ten good investments and was happy with a limited number. That is very much in our playbook. And he believed in knowing a lot about the things he did invest in. And that’s in our playbook, too. And the reason why it’s in our playbook is that to some extent we learned it from him.” —Charlie Munger

“As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” —John Maynard Keynes

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” – George Soros

“I size individual allocations in my portfolio according to my evaluation of potential risk, with the largest holdings having the lowest likelihood of permanent capital loss coupled with above-average return potential. I initiate new positions with a minimum weighting of 5 percent and subsequently average upward if the management executes above my expectations. Individual position sizing is important not only for its impact on overall portfolio performance but also for mental peace of mind. I sell down to my “sleeping point” if an individual position becomes a discomfortingly large percentage of my portfolio value. Always have bigger weights in businesses with high longevity, solid growth prospects, and disciplined capital allocators. As Mae West said: Too much of a good thing can be wonderful.”

Every bust in one area of the market establishes the foundations for a boom in another. Every company’s rising cost is another company’s rising revenue; every company’s declining revenue is another company’s declining cost. The best part is that the stock market usually does an excellent job of recognizing the beneficiaries in each situation by sending their stocks to the fifty-two-week-high list. Money has a metaphysical-like attraction to places of its best possible use. This is one of the powerful correcting forces of capitalism. Take advantage of it.

As Humphrey Neill said, “Don’t confuse brains with a bull market.”

Chapter 25: To Finish First You Must First Finish

“You just have to be prepared to be wrong and understand that your ego had better not depend on being proven right. Being wrong is part of the process. Survival is the only road to riches.” – Peter Bernstein

How much you are able to retain after the recovery from a bear market is far more important than how much paper profit you make during a bull market. And quality of business matters the most in retaining long-term wealth.

Market turbulence tends to cluster. This is no surprise to an experienced trader…. They also know that is in those wildest moments—the rare but recurring crisis of the financial world—where the biggest fortunes of Wall Street are made and lost. …Periods of big price changes groups together, interspersed by intervals of more sedate variation—the tell-tale marks of long memory and persistence. It shows scaling. …Large price changes tend to be followed by more large price changes, positive or negative. Small changes tend to be followed by more small changes. Volatility clusters [emphasis added].

We all contemplate and understand the things that happen within three standard deviations, but everything important in financial history takes place outside those three standard deviations.

Failure often comes from a failure to imagine failure.

Investors should study what happened to RS Software India, which used to get about 85 percent of its revenues from Visa. [AA NOTE: It went from 20 to 420 then back to 20].

Source: Bloomberg

“More money has been lost reaching for yield than at the point of a gun.” – Raymond DeVoe Jr.

Businesses with staying power have stable product characteristics, a strong competitive advantage, a fragmented customer and supplier base, prudent capital allocation, a growth mind-set with a razor-sharp focus on long-term profitability and sustainability, a corporate culture of intelligent and measured risk taking, a cash-rich promoter family or parent company that can infuse capital during periods of high stress, a highly liquid balance sheet, and both the willingness and the capacity to suffer by investing for the long term at the expense of short-term earnings. These companies thus have higher longevity, higher duration of cash flows, and thus higher intrinsic value.

From an investor’s point of view, staying power comes from a strong passion for the investing discipline; a constant learning mind-set; a long remaining investing life span; low or no personal debt; frugality; discipline; a sound understanding of human behavior, market history, and cognitive biases; a patient, long-term mind-set; and a supportive family whose importance is appreciated in a big way during the periodic rough times in the market. It seems fitting to end this chapter with Buffett’s profound words on avoiding the risk of ruin: “It takes twenty years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

Chapter 26: Read More History and Fewer Forecasts

“Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you have invested.” —Peter Lynch

Jason Zweig explains the constant human urge to predict, in his book Your Money and Your Brain: “Just as nature abhors a vacuum, people hate randomness. The human compulsion to make predictions about the unpredictable originates in the dopamine centers of the reflexive brain. I call this human tendency ‘the prediction addiction’ [emphasis added].”2

“Progress happens too slowly to notice; setbacks happen too quickly to ignore.” —Morgan Housel

“Whatever methods you use to pick stocks, your success will depend on your ability to ignore the worries of the world long enough to allow your stocks to succeed. No matter how intelligent you are, it isn’t the head but the stomach that will determine your fate.” —Peter Lynch

With rare exceptions, most of the miracles of humankind are long-term, constructed events. Progress comes bit by bit.

“More money has been lost trying to anticipate and protect from corrections than actually in them.” —Peter Lynch

Emotions cannot be back-tested

The market moves first. The accompanying sense-making narrative follows later. Always.

As the saying goes, “No force on earth can stop an idea whose time has come.” And India’s time has arrived. It took India nearly sixty years to reach its first trillion dollars in GDP but only seven years to reach its second trillion. The next consecutive trillions are expected to be reached in faster succession. Even if market cap to GDP remains around parity in the long run, one can envision the kind of wealth creation that lies in store for investors in great Indian businesses. Trillions of dollars. This, in turn, will have a positive multiplier effect on the prosperity of the nation.

“In times like these, it helps to recall that there have always been times like these.” – Paul Harvey

French polymath Gustave Le Bon wrote one of the most influential works on social psychology, The Crowd, as a rant on French politics, but his observations also describe how stock market manias take place. The book, widely considered to be the definitive work on mass psychology, despite its 1895 publishing date, explains how a crowd goes from controlled logic to uncontrolled emotion, resulting in conscious personalities vanishing into a collective mind.

Bear markets bring the fundamental truths of investing to the fore.

“There are 60,000 economists in the U.S., many of them employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they’d all be millionaires by now…. But as far as I know, most of them are still gainfully employed, which ought to tell us something.”

Chapter 27: Updating Our Beliefs in Light of New Evidence

“If you do not change direction, you may end up where you are heading.” —Lao Tzu

“Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate. Something interesting is happening.” —Tom Goodwin

“The big picture is that software is eating the world—that is, many of the products and services developed over the past 150 years are transforming into, or being disrupted by software…. The implications are enormous; software is infinitely replicable and, through the internet, can be delivered at zero marginal cost. When a major input to business—distribution cost—goes to zero, entire industries get disrupted. When one can build a business model from the ground up with entirely new assumptions, one can attack incumbents in a way that is very difficult to defend.” —Marcelo Lima

In psychology, this is referred to as cognitive flexibility. Psychologists consider this flexibility to be one of the key mental skills required to succeed along with other skills, such as creativity, critical thinking, and problem solving.

…there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.

Munger’s warning usually comes true: “When you mix raisins with turds, you’ve still got turds.”

What matters far more to the superforecasters than Bayes’ theorem is Bayes’ core insight of gradually getting closer to the truth by constantly updating in proportion to the weight of the evidence.

“When information is cheap, attention becomes expensive.” – James Gleick

Bayesian thinking helps us overcome our biases and personal prejudices. Many investors in the Indian markets have a prejudice against Hyderabad-based companies, microcap stocks, turnaround situations, conglomerates, highly leveraged companies, commodity stocks, and holding companies. That prejudice (baseline information) is reflected in the cheaper valuations. “At the same time, however,” writes Bakshi, “you should recognize the possibility that this particular business which you are evaluating could be different from the statistical class to which it belongs.” (For instance, I usually begin studying select leveraged distress situations after the borrowers have entered into a formal debt-restructuring arrangement.)

In his book Winning on Wall Street, Martin Zweig talks about how bearish he was during a sell-off in February and March 1980: “I was sitting there looking at conditions and being as bearish as I could be—but the market had reversed. Things began to change as the Fed reduced interest rates and eased credit controls. Even though I had preconceived ideas that we were heading toward some type of calamity, I responded to changing conditions.” He concludes, “The problem with most people who play the market is that they are not flexible…. To succeed in the market you must have discipline, flexibility, and patience.”

The art of timely selling is gradually developed through real-life experience in the markets and increasing familiarity with the finer nuances of various industries and their evolving valuation dynamics over time.

One big lesson I have learned over the years is to be reluctant to sell a great business that is trading at expensive valuations, especially when cash is the alternative. A better approach is to wait to sell until a far superior opportunity comes along, or until the stock has become absurdly overvalued.

“How can anyone say with even moderate precision just what is overpriced for an outstanding company with an unusually rapid growth rate? Suppose that instead of selling at twenty-five times earnings, as usually happens, the stock is now at thirty-five times earnings. Perhaps there are new products in the immediate future, the real economic importance of which the financial community has not yet grasped. Perhaps there are not any such products. If the growth rate is so good that in another ten years the company might well have quadrupled, is it really of such great concern whether at the moment the stock might or might not be 35 percent overpriced? That which really matters is not to disturb a position that is going to be worth a great deal more later. …If the job has been correctly done when a common stock is purchased, the time to sell it is—almost never.” – Phil Fisher

The best time to invest is when you have money. This is because history suggests it is not timing which matters, but time.” – John Templeton

“My dad never worried about quarterly comparisons. He slept well.” – Walther Schloss’ son Edwin.

“There’s no shame in losing money on a stock. Everybody does it. What is shameful is to hold on to a stock, or worse, to buy more of it when the fundamentals are deteriorating.”

I am happy to have learned Confucius’s teaching well: “A man who has committed a mistake and doesn’t correct it is committing another mistake.”

Chapter 28: Life is a Series of Opportunity Costs

It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it. —W. Somerset Maugham

An effective way to counter this bias is to mentally liquidate your portfolio before the start of every trading day and ask yourself a simple question: “Given all the current and updated information I now have about this business, would I buy it at the current price?” If you conclude that you would not buy the shares today but find that you cannot push the sell button, be aware that this is because of endowment bias and not because of a logical hold thesis. Sell. … In most cases, you will find that your smallest-weight holdings will be the ones that get sold, because you had less conviction in them to start with (as indicated by their low weights).

When we are truly disciplined and highly demanding in the required hurdle rate for incoming ideas, then the best stock to buy at any given time is usually among the ones we already own in our portfolio. Don’t diversify just for the sake of it. Avoid adding anything to your life, your investment portfolio, or your business unless it makes them better.

Chapter 29: Pattern Recognition

“People Calculate Too Much and Think Too Little”

Investors who primarily rely on screening tools to generate ideas end up missing such opportunities.

Receiving voluntary praise from a competitor is always a positive sign for a firm. But these softer aspects cannot be captured by quants, Excel spreadsheets, or screeners.

…if the leading stocks of a sector are falling sharply even after reporting strong earnings or are going up even after bad earnings, the market is trying to tell you something important.

Many business-to-business companies (though not all) face much slower changes in customer preferences, making financial modeling easier.

In his second quarter 2018 letter to Heller House fund clients, Marcelo Lima wrote: “Cheap” is a poor proxy for value: the new business models…—SaaS [software as a service] in particular—are not well suited to traditional GAAP [generally accepted accounting principles] accounting. Here’s why: if distribution costs are zero, the optimal strategy is to gain as many customers for your software product, as quickly as possible. In digital businesses, there are increasing advantages to scale, and many of these companies operate in winner-take-all or winner-take-most markets. The name of the game is thus to build, grow, then monetize. Frequently, this means spending a lot of money in sales and marketing, which depresses reported earnings. Thus, SaaS companies spend to acquire customers upfront, and recognize revenue from those customers over many years. This mismatch burdens the income statement. Some of the most successful—and highest performing stocks—in the SaaS world have spent many years growing despite producing no meaningful accounting profits. They are very profitable in terms of unit economics, and once they stop reinvesting every dollar generated into further growth. The traditional method of screening for low P/E stocks doesn’t work in this scenario. For these SaaS companies, study the incremental unit economics—that is, how much it costs to acquire each customer and how much value they deliver over a span of time—and then analyze what the business margins and cash flows look like at a steady state once the investment phase slows down. Then discount those cash flows back to the present.

Second, some types of unknowable situations have been associated with highly profitable outcomes, and we can think about these situations systematically. People overwhelmingly prefer to take on (measurable and quantifiable) risk in situations in which they know specific odds rather than an alternative risk scenario in which the odds are completely ambiguous. They tend to choose a known probability of winning over an unknown probability of winning, even if the known probability is low and the unknown probability could be a guarantee of winning. (This paradox in decision theory in which people’s choices violate the postulates of subjective expected utility is known as the Ellsberg paradox.) Fear of the unknown is one of the most potent kinds of fear, and the natural reaction is to get as far away as possible from what is feared. Unknown unknowns make most of us withdraw from the game. These, however, are also the circumstances in which extraordinary returns are possible.

“One of the lessons your management has learned—and, unfortunately, sometimes re-learned—is the importance of being in businesses where tailwinds prevail rather than headwinds.” —Warren Buffett

Based on my personal investing experiences over the years, I have found that it is better to buy a good company in a great sector than a great company in a bad sector.

There’s no course in business school called ‘Getting on the Right Train,’ but it’s really important. You can be an average passenger but if you get on the right train it will carry you a long way.”… In other words, invest in companies with tailwinds, not headwinds.

Chapter 30: Acknowledging the Role of Luck, Chance, Serendipity, and Randomness

“The first step toward improving your luck is to acknowledge that it exists.”

“Whenever I meet anyone at the peak of success who insists luck isn’t a huge factor, I make a mental note to check back on him* five years later. Five years later, none of these people have still been at the peak.” – Jason Zweig Twitter, March 9, 2018, https://twitter.com/jasonzweigwsj/status/972131380460163074.

Just as I had no personal conviction or good understanding of my choices when buying these stocks, I did not have any better insight when selling them. Yes, this is true. This was my pitiful state as an investor at the time, even after being present in the markets since 2007. I had initiated my self-education on value investing in 2013, and the power of compounding knowledge had not yet kicked in.

The best way to approach learning is with childlike curiosity. All of us came into this world with abundant curiosity. As children, we were inherently curious and constantly engaging in joyful discoveries. Exploration preceded explanation. As we grew up, however, a fear of looking stupid dampened this curiosity. Snap out of it. Adopt the motto “ABC: Always Be Curious.” (As Charlie Munger often says, if we want to become smarter, the question we need to keep asking is “Why, why, why?”)

Albert Einstein once wrote to a friend, “I have no special talents. I am only passionately curious.”

Don’t think about why you question, simply don’t stop questioning. Don’t worry about what you can’t answer, and don’t try to explain what you can’t know. Curiosity is its own reason. Aren’t you in awe when you contemplate the mysteries of eternity, of life, of the marvelous structure behind reality? And this is the miracle of the human mind—to use its constructions, concepts, and formulas as tools to explain what man sees, feels and touches. Try to comprehend a little more each day. Have holy curiosity. —Albert Einstein

In fact, luck is the sole reason that I am alive today and able to share my story. I have survived three potentially fatal accidents in my personal life—once, I fell down the stairs of my building during my childhood years and underwent a surgery; once, I toppled over while riding an all-terrain vehicle in Thailand and miraculously incurred only minor bruises; and, on a third occasion, I was badly injured in a bike accident during my MBA college days in Ahmedabad, India. As a survivor, I remain ever grateful for the smallest of things in my life. Every new day is God’s gift to me. I am truly blessed.

The lucky approach is to say to yourself, “Okay I’m going to get into this risky situation—this roulette game, this mutual fund investment. But I am not operating under the delusion that planning will make it turn out my way. I see luck looming large in it, so I will be careful not to let myself grow too confident and relaxed. I will expect rapid change. I won’t make large, irrevocable commitments. I’ll stay poised to bail out the minute I see a change I don’t like.”… To be lucky in this game you must discard bad hands when you get them. … Much more often what starts to go wrong stays wrong—or goes wronger. In a souring situation, with no compelling reason to think things will get better, you are always right to cut your loss and go. You are right even when, in retrospect, you turn out to have been wrong.

“Obvious responses to opportunities and circumstances, rather than studied decisions, have put me on the particular roads I have followed.” —Herbert Simon

If you want to feel rich, just count all the gifts you have that money can’t buy.

Economists, market advisers, political oracles, and clairvoyants all know the basic rule by heart: If you can’t forecast right, forecast often…. Not all oracles have been able to organize the annual forecast-revising dance of the economists, but all are followers of the basic rule. They all forecast often and hope nobody scrutinizes the results too carefully….

Stock market investing is an activity in which luck plays a significant role. Consider the typical process that many retail investors follow. They look at a fund manager’s most recent few years of performance and invest their money in his or her mutual fund if it has been a recent outperformer. And then their chosen fund starts underperforming the benchmark for the next few years. Frustrated, these investors pull out the money and find another fund manager based on the same criteria—the manager with the most recent few years’ outperformance. A similar episode is repeated. The investors are completely baffled as to why their chosen fund’s performance deteriorates immediately after they put their money into it. Mean reversion, my friend.

“Most fund buyers look at past performance first, then at the manager’s reputation, then at the riskiness of the fund, and finally (if ever) at the fund’s expenses. The intelligent investor looks at those same things—but in the opposite order.” —Jason Zweig

This is the big lesson for all investors. Focus on the “karma”—the process and action—and not on the outcome. Numerous research studies have identified a common trait among successful professionals in fields of probabilistic activity: they all emphasize process over outcome.

“Whatever the future holds, we will stick to our process. We are not guaranteed of getting what we want all the time—far from it—but we believe it is the best foundation for getting what we want over time. —Chuck Akre

Chapter 31: The Education of a Value Investor

During 2016, I bought a stock solely on the basis of the rationale of a peer who I admired and looked up to for his investing skills. A few weeks later, the stock fell sharply, post weak quarterly earnings, and I exited my position at a 14 percent loss because I lacked the personal conviction to hold. To rub salt into the wounds, the stock then doubled in less than ten months. Ouch.

We live in a world in process, and it changes continuously, every single minute. Nothing stays the same. Thomas Russo likes to give the analogy of a seven-hundred-year-old temple in Japan. The temple is made of wood, and none of the wood is seven hundred years old, as the pieces have been replaced numerous times over the years. But we still talk about the temple as if it is seven hundred years old. In the stock markets, we see the effect of change in similar ways. Consider the S&P 500, one of the most frequently cited market indexes. On average, over the past fifty years, more than twenty companies are swapped out each year. Yet investors cite and treat the S&P 500 as if it were a monolithic, unchanging object. It clearly isn’t. The constituents of the S&P 500 of 2020 are completely different from the S&P 500 of 2000, even though our language infers otherwise when we say things like, “The S&P 500 is trading at a premium/discount to its ten-year average.”

“For the great majority of transactions, being stubborn about a tiny fractional difference in the price can prove extremely costly.” —Philip Fisher

If the story has gone wrong, simply book your losses and move on to a better opportunity. Continuity of compounding is the key to success in this long-term game. After buying a stock, forget what you paid, or this knowledge will forever affect your judgment.

Another faulty anchor is the past price of a stock—that is, the point at which an investor originally contemplated buying it but failed to pull the trigger, after which point the stock has appreciated significantly. Missing out on an early opportunity creates regret. That regret often is unwarranted because, for a truly outstanding business, multiple opportunities to buy the stock exist. By definition, a hundred-bagger is a ten-bagger twice over. Even if someone bought it after it became 10×, it still went up another 10×. This shows the importance of actively keeping up with a company’s story even after you have exited it. Think of investments not as disconnected events but as continuing sagas that need to be reevaluated periodically for new twists and turns in the plot. Unless a company goes bankrupt, the story is never over.

This applies to selling as well. Selling a big winner from our portfolio is never easy, because we tend to get emotionally attached to it over the years. After all, it has been responsible for our wealth creation. But a stock does not know that we own it. Just as we cling to outdated beliefs, we hang on to these stocks because we remain fixated on meaningless anchors like our lower original cost price. But the investor of today does not benefit from yesterday’s growth.

Ernest Hemingway’s words: “There is nothing noble in being superior to your fellow man; true nobility is being superior to your former self.”

As Munger says, “You don’t have to pee on an electric fence to learn not to do it.”

When we have a negative opinion about the person delivering the message, we close our minds to what they are saying and miss a lot of learning opportunities because of it. Likewise, when we have a positive opinion of the messenger, we tend to accept the message without much vetting. Both are bad. —Annie Duke

In investing, always consciously separate the stock from the personality of the individual at the helm of the company. Concentrate on the merits and economics of the underlying business. Look at the facts and assess the situation objectively.

Conversely, I once displayed disliking bias by delaying my decision to buy the stock in a great business just because I did not like the rude verbal tone of its promoter on television. This was completely irrational behavior. The business had good economics and the promoter had a clean corporate governance track record. A highly capable CEO may be arrogant, loud, flamboyant, and smoke cigars, whereas another CEO might be humble, introverted, and a self-disciplined individual of high moral character. We tend to be biased toward people who display qualities we admire or who are similar to us, but the people we like are not necessarily the people who have the capabilities to execute and deliver results.

“The degree of one’s emotion varies inversely with one’s knowledge of the facts—the less you know, the hotter you get.” —Bertrand Russell

(If something is too much in the news, it is already discounted in the price.)

Chapter 32: Conclusion

You only get one mind and one body. And it’s got to last a lifetime. Now, it’s very easy to let them ride for many years. But if you don’t take care of that mind and that body, they’ll be a wreck forty years later…. It’s what you do right now, today, that determines how your mind and body will operate ten, twenty, and thirty years from now.

Money without health is pointless.

“Take care of your body. It’s the only place you have to live.” —Jim Rohn

Your mind is like an empty glass; it’ll hold anything you put into it. You put in sensational news, negative headlines, talk-show rants, and you’re pouring dirty water into your glass. If you’ve got dark, dismal, worrisome water in your glass, everything you create in your mind will be filtered through that muddy mess, because that’s what you’ll be thinking about. Be conscious of your information diet.

I can’t emphasize this enough: learn to meditate. When you train your mind to focus on something as simple as the breath, it also gives you the discipline to focus on much bigger things and to tell the difference between what’s really important and everything else.

The difference between interest and commitment is the will to not give up. When you truly commit to something, you have no alternative but success. Getting interested will get you started, but commitment gets you to the finish line.

It’s not getting to the wall that counts; it’s what you do after you get there.

“Nothing in the world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent.” —Calvin Coolidge

In his blog, Joshua Kennon wrote about Munger’s excruciatingly painful experiences with multiple adversities during his lifetime: In 1953, Charlie was 29 years old when he and his wife divorced. He had been married since he was 21. Charlie lost everything in the divorce, his wife keeping the family home in South Pasadena. Munger moved into “dreadful” conditions at the University Club and drove a terrible yellow Pontiac…. Shortly after the divorce, Charlie learned that his son, Teddy, had leukemia. In those days, there was no health insurance, you just paid everything out of pocket and the death rate was near 100 percent since there was nothing doctors could do. Rick Guerin, Charlie’s friend, said Munger would go into the hospital, hold his young son, and then walk the streets of Pasadena crying. One year after the diagnosis, in 1955, Teddy Munger died. Charlie was 31 years old, divorced, broke, and burying his 9-year-old son. Later in life, he faced a horrific operation that left him blind in one eye with pain so terrible that he eventually had his eye removed. It’s a fair bet that your present troubles pale in comparison. Whatever it is, get over it. Start over. He did it. You can, too. … You never know how strong you are until being strong is the only choice you have.

In his memoir Man’s Search for Meaning, Viktor Frankl wrote about this intrinsic virtue in all of us: “Everything can be taken from a man but one thing: the last of the human freedoms—to choose one’s attitude in any given set of circumstances, to choose one’s own way.” … Montaigne, the great French philosopher, adopted these seventeen words as the motto of his life: “A man is not hurt so much by what happens, as by his opinion of what happens.”

Our view of the world can be completely transformed when we embrace the belief that people are inherently good. … When you change the way you look at things, the things you look at change.

It’s not dying you should worry about; it’s chronic disease. What you can expect from not making the right health decisions isn’t an early death—in fact, that’s the least of your worries. Instead, you should be concerned about years, possibly decades, of suffering from chronic disease in your old age. As the pendulum has swung away from deaths caused by acute illness, it has gravitated toward chronic illness. Today, a great number of working professionals die from heart problems, strokes, diabetes, and lung disease. Our cars, Internet connections, and lives have become faster, but our physical activities have become slower.

As James Clear aptly puts it, “The costs of your good habits are in the present. The costs of your bad habits are in the future.”

young will catch up with you when you get old. As James Clear aptly puts it, “The costs of your good habits are in the present. The costs of your bad habits are in the future.”

The World Health Organization makes it clear that chronic disease is primarily caused by common, modifiable risk factors, with the big three being unhealthy diet, physical inactivity, and tobacco use.

That’s why it’s critical to break out of the vicious cycle of being unfit. Poor health triggers negative feelings, thoughts, and emotions, which hinder your performance and prevent you from reaching your potential. If you don’t approach your limits (which is a prerequisite for deliberate practice), you won’t improve. With enough dedication and discipline, what was once your stretch goal will become your warm-up routine. Those who have undergone major healthy changes realize how the state of their body correlates with the clarity of their mind and the stability of their emotions. These, in turn, influence the quality of social interactions.

High performance often hides behind boring solutions and underused basic insights. The fundamentals aren’t cool or sexy. They just work. One of the best health habits is to exercise for one hour three to four times every week and to avoid prolonged sedentary periods. The second habit is to get eight hours of sleep every night. The third is to drink more water and consume less sugar and junk food. All three are obvious, but they are often overlooked. They have a more meaningful and immediate impact on the quality of your mental and physical health than 99 percent of all productivity tips. Systems are better than goals because once you reach a goal (e.g., to lose twenty pounds), you tend to stop doing the very thing that made achieving that goal possible, and you revert back to your old ways.

A person who puts in continuous effort for ten years may achieve more in one week than someone who, having started six months ago, will achieve in an entire year.

Do less than you’re capable of, but do it consistently. That is the key to compounding. You have to build a program that you can do for decades, not weeks or months. It’s far easier and requires a lot less energy to take off once and maintain a regular speed (even if it is slower than everyone else) all along the way. Start with the easiest things so you gain momentum and confidence to tackle the more difficult things later. Pursue small, incremental victories. A small, concrete win creates momentum and affirms our faith in our further success. Confidence is like a muscle. The more you use it, the stronger it gets.