Book: Non-Consensus Investing

Rupal Bhansali is chief investment officer and portfolio manager of Ariel's international and global equity strategies. In this capacity, she oversees global research effort and manages multi-billion dollar portfolios. She also co-manages the global concentrated strategy at Arial Investments.

In Non-Consensus Investing: Being Right When Everyone Else Is Wrong, Rupal makes a case for active investing when the world is favouring more of passive investing. In the book, she shares her perspective and her learnings. It is definitely a book worth reading at least once. For new investors, it is a must-read book.

Below are some of the sections and the most interesting statements, observations, learnings, and views of Rupal Bhansali. The words in Italics are my words to give additional clarity where required.

How My Passion Became My Profession

• This experience of thinking about both the long and short sides of the trade has become the signature element of my upside-down investment process: it focuses on what can go wrong (and how much the stock can go down), not just what can go right (and how much the stock can go up).
• Non-consensus investing is not simply doing the opposite of what everyone else is doing. It is deeper and broader and requires its practitioners to develop skills to recognize when widely held investment views are likely to be wrong.
• Non-consensus thinkers are not simply contrarians in a psychological or behavioural sense. They are analytical and independent thinkers who try to figure out what is misunderstood about the business and mispriced in the stock.
• Instead of trying to select companies, I look for reasons to reject them. By first and foremost looking for things to dislike and identifying what can go wrong, I proactively try to reduce the risk of being blindsided if adversity arises.
• The worst thing is being poor after you have been rich.
• Few people realize that investing is a paradox: to enhance returns one must reduce risks.
• Chapters 4 through 11 dissect the core principles of non-consensus investing, ranging from the need to stand alone to stand apart, to how misunderstanding quality can be the mother of all mistakes but also the mother lode of all opportunities.
• The concluding chapter 12 summarizes the core facets and tenets of non-consensus investing. Think of these principles as a north star, pointing you toward success.
• Keeping with the spirit of the contrarian theme that permeates this book, I often discuss what not to do and how not to do it.

“And” Not “Or” -- highlighting the different kinds of risk associated in investing.

• Who will buy the expensive stocks owned by passive investors when they want to sell? A wide divergence between what active investors are willing to pay (based on fundamentals) versus the price (bid up by flows) at which passives have valued their portfolios could set the stage for big markdowns, aka losses.
• Redemption risk. If everyone rushes to exit at the same time, how will passive easily liquidate its underlying assets into cash? Who will take the other side of the trade? Will a liquid asset class turn illiquid, causing passive managers to curtail redemptions?
• Liquidity risk. To avoid restricting redemptions, passive managers may have no choice but to dump stocks in a disorderly fashion, causing them to gap down, which I describe as the cost to exit positions.
• Front- running risk. In bull markets, nobody notices or complains about front running because it pushes prices up, creating the illusion of making money. On the way down, it can turn into a house of cards, as selling begets more selling by the front runners, paving the way for larger losses.
• Permanent- impairment- of- capital risk. Cheap beta (which is the promise of passive) is only desirable in bull markets. Passive cannot protect you against capital loss.
• Behavioural risk. Passive is not the negation of human neuroses or biases, but the aggregation of all neuroses and biases that exist in a market.
• Momentum risk. Lacking self- correcting mechanisms, indices can swing wildly from greed to fear as momentum cuts both ways. On the way up, it turbocharges returns; on the way down, it turns into a vicious downward spiral. Such roller coasters can be nerve-wracking, and investors may feel compelled to redeem instead of riding it out, exposing them to many of the risks described previously.
• Reflexivity risk. If you think that passive is unemotional, objective, and rational, think again. Going passive is itself an active decision. It is humans who make the decision to choose or quit passive, and they can be every bit as emotional and biased (which are accusations typically levelled against active managers).
• Market-inefficiency risk. Because passive does not care whether a market price reflects fair value or not (and therefore the efficiency of the market itself), all of society suffers.

Stocks or Bonds?

• You win or lose by chance, not a choice. In investing, you have the power to alter the odds, if you are willing to do the work. This means you win or lose by choice, not chance. This is a crucial distinction. If you play an active role in investing, you can influence the outcomes through skill. In speculating, you are reduced to a passive position where luck prevails, and skill does not matter.
• What exactly do those two words, “risk” and “reward,” mean? I think of risk as to the potential for permanent loss of money, and reward as the compounded rate of return over a full market cycle, typically ten years or more.
• This leads me to address a big question that should be on everyone’s mind: Should I invest in stocks or bonds? Which give better returns? Which have lower risk?
• Just as a brief illness builds your immune system, learn to think of volatility as a healthy interlude on the road to a stronger market eventually.
• If the fundamentals of the business have not materially changed and its intrinsic value— what the business is worth— is not impaired, a sinking stock price is an opportunity to gain even higher returns at a lower risk.
• Note, too, that the greater the discount to intrinsic value, the larger the margin of safety and the greater the reward. As the price falls, there is a bigger reward and lower risk.
• Conviction (aka confidence or hubris) will lead people to make a decision about a certain stock based on some sort of gut feeling— a whim, a hunch. But investing is not a confidence game; it is about being more correct, not being more confident.
• Free cash flows represent the surplus cash flows a company generates after: 1. Paying all expenses of the business 2. Reinvesting in the business to support ongoing operations or growth 3. Setting aside money to pay back long- term liabilities
• This is exactly what my investment approach strives to do. It tries to take advantage of both the volatility and the value- creation potential of equities and helps me choose well, to make higher returns without taking a higher risk.
• Then, as interest rates go up and risk appetite goes down, many borrowers may have difficulty repaying their debt. This is called a default risk.
• For sixty years, interest rates were range-bound between 2 and 5 per cent; then, in just over twenty years, they shot up to 15 per cent (see figure 3.2). The UK never regained its former glory.
• Most bonds, especially corporate bonds, are far less liquid than equities. If you need to sell them, you may not find a buyer right away, and you may have to offer significant discounts to their fair value to entice bids.
• You will only know their true value when you sell them. This takes us right back to the illiquidity risk. If you cannot liquidate, you cannot establish real value. Illiquidity risk exacerbates valuation risk.
• In November 2016, rating agency Fitch warned that a mismatch within open-ended bond funds offering daily liquidity while holding less liquid securities had increased to a record high. Fitch analyst Manuel Arrive cautioned, “Drawdowns resulting from fire sales in illiquid markets increasingly put fund capital at risk, as bond carry returns have become insufficient to offset volatility.” 2
• There’s one more type of risk, and it is a big one: Bonds can expose you to large losses but cannot offer large gains (unless you buy them in the secondary market at a huge discount to their face value).
• That is because a bond’s upside is capped at par. 3 Let’s say you hold a bond with a par value of $ 100. At any point before its maturation date, that same bond can fall in price to $ 70 or $ 60 or even lower.
• Bottom line: It is naive to think that bonds do not come with any risk. They just come with a different risk.
• Think of owning stocks of quality businesses akin to raising a child whose best days are still ahead of her. Sure, she may act up now and then, but you do not give up on a child just because of a few stumbles. Children, like stocks, may not offer joy every day, and on some days, they may bring pure nuisance and annoyance, but you would not decide not to have kids because some bad comes with the overwhelming good.

To Stand Apart, You Must Stand Alone

• That is, you must be right and prove others wrong. To achieve exceptional results, you must do something that makes you stand apart from the rest.
• To succeed, not only must you be right, you must prove everyone else wrong. That kind of asymmetry can be tough to understand, let alone accept, so let us take a deeper look.
• If research does not uncover anything original or differentiated, it is not value-added research but simply regurgitation, the investment equivalent of reinventing the wheel.
• Active investors who are unskilled in their research efforts are rightly facing an existential wake- up call: differentiate or die.
• This is what makes investing not simply different but asymmetric. You may not make any money for being correct if your correct views are consensus, but you will lose money for being incorrect. Figure 4.1 depicts this asymmetry:
• What I learned was that to find a treasure instead of a trap, an investor must first be a business analyst and then a financial analyst.
• Note that nobody in this gravy train questions whether their activity results in price discovery or price distortion. Is the stock trading above, at, or below its intrinsic value? Everyone blithely skips that part. Quant doesn’t calculate it (“ algorithms compute relative value not intrinsic value”), trend followers don’t care about it (“ don’t let facts get in the way of a good momentum story”), growth investors rationalize it (“ the high growth assumptions justify it”), and passive ignores it (“ theirs not to question why theirs but to do or die”).
• As the years rolled by and active managers continued to underperform in a strong upmarket, investors did what they often do— top ticked a trend (bought at the highs). In 1999– 2000, many clients withdrew money from their active managers and ploughed it into passive by investing in vehicles such as the QQQs (an ETF which mimicked the movements of the Nasdaq 100), which had doubled.
• A paper published in the Financial Analysts Journal in 2017 concludes that there is no evidence of underperformance among a group of funds with a high active share (those whose holdings differ substantially from their benchmark). Indeed, those who are also patient (withholding duration of more than two years) have outperformed, on average, by more than 2 per cent per year. Earlier studies showed similar results.
• The underperformers fell into two categories: closet indexers (benchmark huggers who called themselves active but were not) and pseudo active (those with a low active share between 60 and 80 per cent who pretended to be active but were not).
• When you look underneath the covers, there is a very compelling difference and argument in favour of truly active and against pseudo or closet active, not all active.

Score Upset Victories

• However, I want to make it clear that investing is not about gambling or betting or playing games, but about conducting serious, differentiated research which uncovers information that proves both correct and non-consensus.
• Investing is a pari-mutuel endeavour, where you are betting against other people since every share you buy is being sold to you by someone else. Unlike gambling, where the odds of winning and losing are preset by the casino and no gambler’s bets can alter those predetermined odds, in investing, each investor’s decision alters the preexisting odds. And as the odds change, the payoffs change. Of course, investing is not a zero-sum game, but one in which everyone can win something. However, those who score upset victories win way more, and that makes all the difference because the goal of an active investor is to beat the market, not just match it.
• If the companies did not generate free cash flows, we were told to look at earnings. • If they did not make any earnings, we were redirected to revenues; earnings would come later. • If there wasn’t much in the way of revenues, we were told to look at eyeballs; it was all about user engagement. • If there weren’t enough eyeballs, we were redirected to the founder’s vision; the eyeballs would follow.
• The arguments boiled down to buying concepts instead of companies. It felt surreal because it was. Eventually, investors began to realize that the emperor had no clothes, and the Nasdaq (which was heavily weighted in TMT stocks) crashed, losing 78 per cent of its peak value. What took five years to make took less than three years to lose (most of it anyway). What is worse, many of the concept stocks in the Nasdaq went out of business, causing permanent losses. In investing, it is not what you make but what you keep that matters. Your checks will bounce if you write them based on what your portfolio used to be valued at its peak but is no longer worth that high- watermark.
• Incidentally, this speaks to the power of global research: when you cover fifty countries around the world, as I do, you see fifty times as much. So even when pundits such as Alan Greenspan and Ben Bernanke debunked the notion of a nationwide housing crisis, I took the opposite path, selling many of my financial stocks in 2006. Two years later, the financial crisis of 2008 sent markets into unprecedented turmoil. Many financial institutions went under or had to be rescued at taxpayer expense.
• They say you can tell the experts are wrong when they unanimously agree on something. In all the preceding examples, the crowds believed their investment theses to be foolproof bets resting on solid ground— until they were not. In my experience, at best, crowded trades won’t make you much money, but at worst you could end up losing a lot of it (if not initially then eventually). On the other hand, at its best, the lonely trade can often help you score big, but if it doesn’t work out, you won’t lose much money either. This asymmetric risk/ reward tips the scales in favour of lonely trades and against crowded trades. This is where correct fundamental research comes into the picture. If the correct research is also non-consensus, you have all the makings of an upset victory.
• The bottom line is that betting on the underdog can improve the odds of making a lot of money while betting on everyone’s favourite increases the odds of losing it. (A prerequisite is that your research on the underdog must be correct.)

Do No Harm

• You always lose money from a higher number but gain money from a lower number, which is why incurring heavy losses proves more damaging than missing some gains. Investors are better off researching potential for failure and avoiding losers than chasing success stories and picking the winners. The main reason to invest in equities is to compound capital, and losing money is the albatross.
• For one thing, risk comes in many forms: financial-leverage risk, corporate-governance risk, currency-devaluation risk, regulatory risks, low-barriers-to-entry risk, and on and on. For another, the risk is often hidden from plain sight or comes in a disguise, not revealing its true character or intensity until it is too late.
• There is ample statistical data on default rates to help you handicap future expected losses. You would be benefiting from underwriting experiences of the past. However, there is another, more sinister type of risk you should be on the lookout for, and it can be vastly different from risk experience. I’m talking about risk exposure.
• In bull markets, where the focus is on returns, there is a greater tendency to become complacent about risk. This is dangerous. At precisely the time when investors should be paying more attention to risk, they pay less.
• This feeds a self- fulfilling cycle of ignoring risks which multiply unabated and finally blow up in our faces (as we all confronted in 2008).
• It is not that regulators, central bankers, management teams, rating agencies, and money managers were not looking at risk reports on the banking sector. The problem is that they were looking at misleading metrics such as value at risk, or VAR. 2 The formula for calculating VAR relies on measuring volatility experienced, which was of little help in 2008 because the securities were often new and had limited trading history (data). Therefore, to understand risk exposure, investors needed to use judgment, not statistics. If they had, they would have realized that the facts, taken out of context, were misleading. They would have seen that during a persistent bull market with an upward trending bias, volatility was likely to be understated, and thus would give a skewed sense of risk exposure.
• I researched a whole range of risk factors and exposures in the banking sector and foresaw the high-risk exposures such as asset/ liability mismatch risk, maturity-mismatch risk, wholesale-funding risk, counterparty-risk, and so on, that had eluded many.
• For instance, I examined the corporate-governance incentives of CEOs and found that their compensation packages often incentivized them to expand their banks and maximize short- term returns rather than walk away from risky assets.
• Think of stock- price volatility as the minor heart- rate fluctuations that we routinely experience when we move from resting to walking to running. They are not significant, and you can usually ignore them. On the other hand, chronically high blood pressure, for which you may see no obvious outward signs of fluctuation, is a huge risk. You would find it absurd if your doctor measured your heart rate all day long and completely ignored measuring your blood pressure. But this is exactly the absurdity we indulge in when we focus on beta or volatility instead of risk. Unfortunately, because we cannot easily measure or visualize risk before it happens, while measures such as historical beta, volatility, or tracking error are precise and tangible, people fall into the trap of measuring something that does not matter because they can, not because they should. Measuring risk is right but not easy; measuring beta and volatility is easy but not right.
• Just as not all cholesterol is bad for you, not all deviations from the benchmark are bad.
• A well-meaning but equally damaging form of swapping risk comes from the recent obsession with owning stability at any cost and avoiding volatility at any cost.
• What is more worrisome is that instead of focusing on fundamental improvements in corporate strategy or execution, many activists now overwhelmingly focus on what they call “maximizing capital structure.” It’s nothing but a euphemism for leveraging up the balance sheet to fund share buybacks.
• Expensive share buybacks funded with “cheap” debt are nothing but a form of doubling down on risk.
• Many investors encourage companies to buy back their shares in bull markets only to cut those programs in bear markets when they should be doing the opposite.
• Long- term stock- price performance arises from value creation in the underlying business, not from tinkering with the capital structure via financial engineering.
• To add insult to injury, the companies and money managers who have the guts and grit to stay out of this fray find themselves in the unfortunate predicament of having to apologize for their conservative risk management. Cash has become a four-letter word, while debt is not. It has become fashionable to ridicule companies holding cash (which is nothing but a form of risk management) while taking on debt is encouraged.
• I am not for management teams hoarding excessive cash, and obviously deciding what level is excessive is a judgment call. But I would rather the board and long- term shareholders make that decision than short-term traders or fly-by-night activists.
• Debt is a double-edged sword; it can amp up your returns in the good times but wipe you out during the tough times. Such binary outcomes make a highly indebted company very speculative. My advice: avoid it.
• Acquisition risk is a special form of denial in which inferior risk management is indulged in the name of superior return management. Invariably, management teams and investors justify their expensive forays with arguments of faster growth and immediate profit accretion. The downside emerges much later, when accounting regulations force them to confess to their mistakes by impairing the value of the asset. Once again, focusing on short- term gain and ignoring long- term pain proves to be a losing investment strategy in the fullness of time. Overpaying for an asset in the name of the strategy is simply obfuscating the valuation risk.
• Another form of doubling up on risks comes when a company with operating leverage takes on financial leverage. That is a deadly cocktail in times of adversity. Many financially leveraged energy companies went bankrupt when oil prices crashed unexpectedly in 2014 because their bonds and shares plunged simultaneously as investors priced in both bond default and equity- dilution risk. At exactly the time that the company needed to raise money to get through the downturn, both equity and debt markets closed their doors because of this layering of risk upon risk.
• Risk is absolute, not just relative. A lot of small risks with low probabilities can add up to a gigantic fat- tail risk. Layering risk upon risk ensures multiple ways to lose, instead of multiple ways to win. Doubling up on risk means that a humdrum downturn can explode into a full-blown crisis. Do not put yourself in such a vulnerable position in the first place.
• Risk is omnipresent. There is no denying it or avoiding it. Your only choice is to find it and deal with it. Equity investors need to be especially vigilant about risks because they are the risk- bearers of first resort. Risk management is not an attempt to eliminate all risks (that is impossible) but to distinguish between those risks that are minor— in which case the equity is worth buying at a good price— or major, meaning you should steer clear at any price.
• If the risks in the business are outsize, unquantifiable, or of a binary/ speculative nature, stay away. Do not own the stock at any time or any price. This is an absolute standard, not mitigated by a low or falling price. Warren Buffett put it best in his 1996 annual letter to shareholders: “If you wouldn’t own the business for ten years, don’t even think of owning it for ten minutes.”
• In other words, when markets pay you to assume the risks of a high- quality business, you should bear them. When markets do not pay you, you can sit back and wait for a setback in the business or pullback in the share price. Let the opportunity come to you, and only engage when the risk/ reward balance becomes attractive. Thus, risk management is not only about risk reduction but also about return enhancement. You can take advantage of risk to generate returns if a stock is mispriced.
• Investors can reduce the risk of large losses by insisting on a large value spread between the price of a stock and its intrinsic value.
• Part of astute risk management is to not be afraid because excessive fear can cause you to miss out on opportunities. I call this risk an error of omission, and I too have fallen into this trap.
• In life, we don’t give up striving for success because some struggles or sacrifices come with it. We figure out how to manage and overcome them, so they do not overwhelm us. Similarly, in investing, you must not give up the pursuit of any return just because it comes with some risk. Instead, you learn to identify risk, manage it proactively and prudently, and insist on getting paid for it.
• They are just not in plain view or have not materialized yet. I refer to this out-of-sight-out-of-mind risk as a blind spot.
• Risk is a virus that can mutate unpredictably, not a bacterial cell that multiplies predictably. Your doctor would not confuse a bacterial infection with a viral one, and neither should you. Like a potentially deadly virus that keeps morphing, risk requires you to be constantly vigilant and stay a step ahead. This requires judgment, foresight, and multidimensional approaches, not reliance on rote checklists or static metrics. Managing risk is an ongoing process, not a one- and- done task.
• Remember that being risk aware does not mean you should be risk-averse.
• In his 1921 book, Risk, Uncertainty, and Profit, Frank Knight, an economist, formalized a distinction between the two. He understood that an ever-changing world brings new opportunities for businesses to make profits, but also means we have imperfect knowledge of future events. Risk, according to Knight, applies to situations in which we do not know the outcome but can accurately measure the odds. Uncertainty, on the other hand, applies to situations in which we cannot know all the necessary information to set accurate odds in the first place.
• If you do not know how to tune into risk, or do not want to, that’s fine. Outsource it. You do this in many aspects of your life, by finding the best doctor to avoid the risk of dying from some disease or the best lawyer to avoid the risk of losing a lawsuit. Apply the same logic in investing. Find the money managers or financial advisers who know how to manage the risks of your investment portfolio, not just its returns. As Peter Bernstein, the guru on risk management, rightly noted: “Risk is a choice, not a fate.”

False Positives and Negatives

• Porter’s Five Forces: industry rivalry, threat of new entrants, threat of substitutes, bargaining power of suppliers, and the power of customers.
• its moat became irrelevant, and the company became marginalized in the marketplace.
• The question is not “What is their market share?” but “Why do they have that market share?” Not “What is the profit margin?” but “Why do they have that profit margin?” “Why” provides the missing link that goes past the symptom to the source.
• Business model is understanding the change in trend or technology that can impact the business.
• They repeated this mistake when they bought bank stocks as they were falling in 2008, using the same circular logic of cheapness. Historical financial numbers or naïve valuation metrics such as low price- to- book or price-to-earnings ratios will not tell you that the quality of the underlying business is about to deteriorate. Non-consensus investing is about buying quality when it goes on sale, not buying junk at clearance prices.
• Non-consensus investing is about buying quality when it goes on sale, not buying junk at clearance prices.
• Knowing how to correctly distinguish quality from junk is a prerequisite to generating higher returns with lower risk— which is a central aspiration of non-consensus investing.
• Familiar but flawed Real and reliable Indicators of low-quality Indicators of high-quality Competitive advantage Darwinian1 advantage Leading market share Growing market share Pricing power Price disrupter Captive customers Loyal customers Brand Value proposition Results Process Buzz model Business model Luck Skill Patents Know-how High tech Proprietary tech
• It is those who are most capable of adapting to their environments over time who gain the upper hand.
• While expanding market share is better than not, it is a means to an end, not an end in itself. The pursuit of market share should not come at the expense of developing a strategic advantage and pursuing long-run profits. Markets are dynamic, and winners and losers are continuously shifting.
• They mistook captive customers, who had nowhere else to go, for loyal customers. The moment those customers got a choice, they shifted their business en masse, exposing the business model for the low quality that it was. Captivity is not loyalty. High- quality businesses are those where customers willingly do business even if they could go elsewhere, because they are getting real value for their money.
• The worst offenders are those that rely excessively on their brands to do the heavy lifting of increasing revenues.
• Another red herring that keeps investors going in circles is looking at the quality of outcomes when they should be looking at the quality of the underlying decisions a company makes.
• Leverage in any form— operating or financial— is a source of risk to equity shareholders, and therefore highly leveraged companies fall squarely in the low- quality camp.
• The lesson here is that winning by default (being in the right place at the right time) is not the same as winning by design (strategically positioning yourself to win against the odds). Luck, in the form of tailwinds and externalities, may confer a fleeting victory to a company or industry but it will not stand the test of time.
• Did you know that some of the worst-performing stocks over the past several years, such as Xerox, IBM, and Canon, are some of the largest patent owners? In my experience, patents are overrated, know-how is underrated.
• Know-how is accumulated knowledge about a process or technique that is hard to decipher or reverse engineer. That means it can yield a competitive advantage for a long period of time.
• I was right about the facts but wrong about the conclusion. A petrochemical- manufacturing plant is indeed very sophisticated and complex. However, the technology and expertise to build and install the process- automation equipment in the manufacturing plant is owned by their suppliers, such as ABB, Siemens, and Emerson Electric, and they sell it to anyone who wants to buy it. There is nothing exclusive or proprietary about it. This explains why, despite being high- tech, petrochemical plants do not generate good returns on capital invested, which makes them low- quality businesses with poor value- creation prospects.
• This underscores the importance of distinguishing high tech from proprietary tech. They are not the same.
• In assessing quality, you must be vigilant about circular logic, in which you confuse cause and effect or conflate numbers with the narrative.
• A genuinely high- quality business is one that offers exclusive and enduring value propositions to consumers and generates a fair return to justify both the costs and risks of lawfully engaging and reinvesting in that business.

Ditch the Database, Embrace the Search Engine

• Research is not merely about knowing a lot; it is about understanding a lot and, more importantly, applying what you know. Unfortunately, from kindergarten through college, most people are spoon-fed questions that lead them to “right” answers. We need to rewire these bad forms of learning, because they give us a knack for accumulating knowledge, not applying it.
• Where has apathy or pessimism degenerated into neglect?
• Where is failure priced in, but success is not?
• You are better off researching failure. Two benefits: it will sharpen your antennae for what can go wrong; but also, if it has already gone wrong and your research tells you a reversal is at hand, you can score an upset victory.
• My unconventional view is that for the companies rooted in science and skilled in doing R& D, the industry’s challenges are also their opportunities.
• Where is the future better than the past?
• Where is secular growth hiding behind cyclical volatility?
• Disruptive business models or technologies can be fertile sources of upset victories, provided one knows how to conduct such research. It often takes deep domain expertise about the industry and years of training and practice to parse the reality from the hype, so be sure to stay within your circle of competence.
• Where are the setbacks that are due for a comeback?
• if a turnaround company belongs to a bad industry, its problems are likely to be more chronic than transient.
• Where are the second-order impacts being ignored?
• This instant payoff may feel gratifying, but it is chump change compared to the big payoffs that come from figuring out second-order impacts, where one change results in another change, like a domino effect. Focusing on second-order effects is like watching a stone thrown into a still pond; take your eyes off the stone and instead note where the ripples go. Let’s look at an example.
  Where are the “and” propositions?
  The leader will be working and exploring various aspects of the customer needs.
  Companies that deliver products with “and” propositions tend to succeed for a long time because what they do is exceedingly difficult to replicate.
  Two attributes— high quality and low cost.
• Non-consensus investors are always on the lookout for companies that make or deliver a product, service, or solution in such a compelling way that customers don’t even think of trying an alternative because none exists. Such companies epitomize high quality and exude the “and” proposition on a multitude of vectors:
• They possess exclusive and enduring Darwinian advantages.• They offer higher quality and lower cost, delivering unbeatable value propositions.• They generate surplus cash to reinvest in the business and distribute regular dividends to shareholders.• They succeed in the present and build momentum for the future.• They play good offence and defence.• They perform well in good times and hold up better in tough times.• They offer upside potential and provide downside protection.

From Victim to Victor

• Flaw #1. Jumping to False Conclusions: The Availability Bias.
  Academic papers, interviews with key division heads in speciality trade publications, books written by former employees of companies I was researching, memoirs of former CEOs, case studies of analogous challenges faced in other industries, and so on.
• Flaw #2. Falling Victim to Vividness: The Recency Effect
• Flaw #3. Monday- Morning Quarterbacking: Hindsight Bias
  To give yourself a much- needed reality check down the road, take time to investigate before you invest, write down your investment theses and quantify your qualitative expectations in a spreadsheet. Then track how things are going in the business versus how you modelled it. This will enable you to separate out the luck from the skill. Most professional investors do this.
• Banking on Best-Case Scenarios: The Planning Fallacy
  We all know that when the stakes are high, we should not count on the best-case scenarios, but instead plan for the worst. Yet most of us hope for the best and tune out the rest.
  I had fallen for the planning fallacy. I had not considered the possibility that they would satisfy their growth envy through acquisitions, no matter how expensive or risky. I had assumed that because the management was also the largest shareholder, they would be excellent stewards of capital. But simply being aligned with shareholders is not enough for the best outcomes. Even well-intentioned, well-incentivized management teams can make mistakes in allocating capital. It was clear that I should have considered worst-case scenarios, not just planned on the best case.
• Overvaluing What You Possess, or Denial on Steroids: The Endowment Effect
  Complacency is not a good reason to continue owning overrated stocks well past their prime.
  “If I didn’t own the stock already, would I buy it today?” 1 This is known as zero-base thinking.
  Many hedge- fund managers guard against the endowment effect by forcing preset stop-loss limits on trades. They automatically sell the stock when the limit hits. The manager can then reassess whether to reinstate that position by buying it back. Some would regard this as suboptimal from the standpoint of transaction cost: it costs money to liquidate and reinstate a position. But the smart money considers it a small price to pay to guard against the larger cost of suffering from the endowment effect. In fact, because the benefits can outweigh the costs, in many hedge funds this is a standard risk-management policy.
  Cutting your losses ensures two salutary outcomes: you learn from your mistakes, and you spare your portfolio further damage from an investment that is headed south. The best way to figure out if one is wrong, rather than simply ahead of others in an investment call, is to compare how the underlying business is performing (as opposed to how the stock is performing) versus one’s expectations in the original investment thesis. If the business (not the stock) is tracking my expectations, I hold onto or even average down on my investment. However, if it is performing worse than my expectations, I force myself to rethink my thesis and apply the fix.
• Clinging to the Past and Being Slow to React to Change: Anchoring Bias
  Many companies generate high profits when times are good, not necessarily because the company itself is good. When the tailwinds turn to headwinds, the company flounders. The mind takes time to process this changed reality. Academics call this anchoring— the tendency to adjust prior estimates insufficiently when presented with new information. In simpler terms, it means human beings are slow to react to change and prefer to cling to a point of view even though it is no longer valid.
  To overcome this bias, it is best to appoint someone else to do clean- slate research so that original or contradictory points of view emerge. That person needs to be ruthless and relentless in looking for information that invalidates, refutes, upends, or discredits any or all beliefs about company X.
  This Emperor Has No Clothes: Relying on Intuition Over Data
  Listening to your gut instead of checking the facts is what academics describe as intuition bias: relying on intuition over data.
• Knowing Less Than You Think You Know: Overconfidence Bias
  In fact, you might call overconfidence the original sin of investing. Thinking we know more than we do, certain that we are right, works against having the humility— or the common sense— to know when our judgment is off.
  Human beings are prone to overestimating what they know and underestimating what they do not know. Confucius put it best when he described knowledge as knowing the extent of one’s ignorance. The worst part of this behavioural flaw is we do not know what we do not know. So we underestimate the uncertainties of the future and invest as if we knew all there is to know. Such blind faith leads us to bet the farm on investments that appear to have great promise because we ignore what can go wrong.
  The lesson learned is that investing comes with uncertainty. No matter how much you to try to handicap all outcomes, unexpected things happen. No amount of research would have uncovered this accident. Sometimes all you can do is reassess the risk/ reward of an investment as new facts emerge and then take appropriate action.
• Believing What You Believe Instead of Questioning It: Confirmation Bias
  However, in investing, we need to do the opposite. Figure out what does not add up, instead of what does. Actively look to invalidate rather than validate.
  Too many investors inadvertently set themselves up for confirmation bias by favouring companies that score well on a checklist of desired attributes.
  When you seek out information that does nothing more than confirm what you already “know” to be true, you have swapped confidence bias for confirmation bias.
  Here is a summary of the top five mental states a non-consensus investor would do well to cultivate: 1. Scepticism (poke holes, insist on triangulated validation) 2. Optimism (consider what can go right) 3. Pessimism (stress- test what can go wrong) 4. Pragmatism (don’t bet the farm on some hunch or belief) 5. Stoicism (be equanimous amid adversity or euphoria)
• Flaws Fixes 1. Availability bias Go outside the sandbox 2. Recency effect Think long term. 3. Hindsight bias Parse luck from skill. 4. Planning fallacy Play devil’s advocate. 5. Endowment effect Practice zero- base thinking. 6. Loss aversion Acknowledge reality and cut bait 7. Anchoring bias Adopt clean- slate thinking. 8. Intuition bias Collect and connect information. 9. Overconfidence bias Accept what you do not or cannot know. 10. Confirmation bias Look to invalidate, not validate.

Value Investing = Margin of Safety

• The first negotiation ploy (someone offered $ 125 in the past) appeals to “reversion- to- mean” investors who believe that if the stock traded at a higher price or multiple in the past, it will do so in the future.
• The second negotiation ploy (someone else was willing to pay $ 100) is designed to deceive you with the “greater fool theory,” or what I call “optical value.” Just because someone else was willing to pay a higher price does not mean you should.
• The third negotiation ploy (compared to $ 100, you can have it for $ 80) appeals to “relative value” investors. In relation to something else, it can be made to look cheap, so it appears to be a bargain even if it is not. You have seen plenty of “relative” value traps even if you didn’t know the name.
• The fourth negotiation ploy (if you want this, you must buy it right now) is to trick you into making a hasty decision without having all the necessary information. Investing before investigating is risky; you are playing the game blind and relying on luck rather than skill. Do not fall for this ruse.
• The fifth negotiation ploy (offering you more for less) appeals to “distressed value” investors.
• Value is driven by what you are getting, not just by what you are paying.
• In good times, people focus unduly on what can go right and ignore what can go wrong. In troubled times, people dwell unduly on what has gone wrong and overlook what can go right.
• Investors who were betting on Sony’s continued dominance paid the price. Over a decade, Sony went from being a growth stock to a “reversion to mean” value trap to succumbing to the “greater fool theory” to being perceived as “relative value” to finally being regarded as “distressed value.” Frankly, it never represented value but a value trap, as all these value frameworks are false ways to assess value.

Sizzle Fizzles, Patience Prospers

• Confusing luck with skill is endemic in investing because the short term and the long term often diverge and investors tend to confuse frequency and severity.
• “What Matters May Not Be Measured and What Is Measured May Not Matter.” (Albert Einstein)
• Worse still, frequent measurement of performance is not only futile, it actually proves counterproductive.
• The ideal scenario is a money manager who has built an investor base with common investment philosophy, time horizon, resolve, and tolerance for underperformance. Only then can a manager maintain the stable capital base required to see his contrarian philosophy through to a successful conclusion.
• This is about managing expectations rather than managing money.
• In his book Active Portfolio Management, published in 1995, Ronald Kahn demonstrated through a series of equations that it takes sixteen years’ worth of performance data to prove skill over luck with a high degree (95 per cent) of statistical confidence.
• I would also seek managers who have been baptized in the school of hard knocks and not given in or given up. It takes character and fortitude, not just calibre and intellect, to succeed in this profession.
• Often, strategies appear compelling because they are easy to explain and understand, not because they are sound or effective in practice. When launching a new product, it has become easy to impress investors with backtesting statistics that predict high-performance potential. That kind of statistical evidence can seem very convincing but be careful. It may be none other than fanciful data mining that fails in practice because implementation costs are too high, or the targeted inefficiency is so small that it is unlikely to produce any meaningful returns. Evaluating skills and capability has predictive power; looking at historical performance does not.
• Leverage turbocharges performance in a bull market but decimates it in a bear market.
• However, exactly when the opportunity to make money is highest, investor interest is lowest. An out-of-favour asset class, sector, geography, or stock offers rich pickings for those who are willing to be contrarian. 

North Star

• Conducting differentiated research to identify what is misunderstood and therefore mispriced by the consensus. 2. Taking advantage of excessive pessimism that focuses unduly on negative developments in the near term while ignoring what can go right in the long term. 3. Investing countercyclically to other people’s investment appetite when the sentiment swings from greed to fear or reverence to repulsion. 4. Looking at pockets of the market suffering from sheer neglect. 5. Arbitraging differing time horizons, taking advantage of people’s inability or unwillingness to think long term.
• Whenever investors pursue a fad or a fetish, there is usually money to be made by looking at the opposite end of the spectrum.

A Special Message from Me to You

• Everywhere, I encountered people, practices, and cultures that seemed vastly different from one another. But on reflection, what my travels really revealed is not how different we are, but how similar: the same aspirations, if not the same ideals; the same values, even if not the same religion; the same basic human needs, wants, emotions, and vulnerabilities, even if expressed in different forms.
• However, in most situations, in-depth analysis or painstaking rigour is simply overkilled.