Saturday, December 06, 2008

Managing the Schrodinger's cat

I think there's a fundamental shift in my research techniques. After immersing myself in investing and all the literature on investments, I came to the realisation that numbers and ratios are not everything. What is? Management!

Imagine out of your classmates in secondary school, you're supposed to pick one whom you think will have the greatest potential to be the most successful. Who do you pick? Do you pick the ones that perennially top the cohort? Do you select those who always play truant and disrupt the class? Do you pick the most talkative ones, or the most quiet ones? The ones with the most activities outside of school work?

I'll pick the ones with the character that I admire. Honesty, integrity, steadfastness, leadership, charisma are some of the characteristics one may look out for. They might not necessary be the smartest in exams nor the least playful. You literally have to bet for the ones that have the most qualities that you admire.

Now, how different is that from an investing point of view?

Investing is not just analysing the statements, the business and the economics. It's not just calculating the PE, liquidity ratios, free cash flow. It's not just forecasting and projecting the earnings forward. You're literally betting on the management to bring the company through in good times and bad times, to trust them to place your monies in worthy projects that gives adequate and safe returns, and to believe in them when they do not distribute dividends not out of their lack of a sense of security but because they can use the retained earnings to give you a better return. You're betting on the management to make decisions for you to run the company you've entrusted them in the best of their abilities, to be honest when they made mistakes and to have the foresight and leadership to propel the company forward. There's no numbers or ratios to determine that. There are no stock screens to determine that.

There's only the intangible human assets (or liabilities) that cannot be put in the balance sheet of the company. If you can't trust the management, you can't trust the statements, you can't trust the business.

It's not easy to see something that cannot be seen. It's both frustrating and futile to think that after analysing the companies quantitatively and it passes your criteria and viola! you have your company to invest in. In every investment, we are betting on the future, not in the past. How to determine the future? Project a straight line from the past records and extrapolate to the future (CAGR)? Using a linear model to predict a non-linear world is an exercise in futility. Rely on earnings model? We can't even predict tomorrow's weather accurately using the most sophisticated models, why talk about complex adaptive reflexive system in a particular company's earnings. future lies in how the management handles the company in every road bumps that lie ahead. The future of any company is shaped by unknown decisions made by the management. They are the ones who come out with new products. They come up with plans to counteract competition and to consolidate their grounds. Management is everything.

In the face of such insurmountable and unknown uncertainties, what is an investor to do? We'll do a Pascal's wager on each company that we're going to do an investment in. We're going to focus on what we know and hope for the best. How about this as an action plan?

1. Value each company to the best of your abilities, in the most conservative manner and apply an adequate margin of safety in case your 'conservative' turns out to be not too conservative. How about a margin of safety for the margin of safety?

2. Think not of the growth, nor the earnings, but rather the downside. Think what happens if you're wrong. Think about what can make the company fail in the next 10 years, not what can make the company become the next triple-bagger in the next 10 weeks.

3. Can you trust the management to handle the company you're going to invest in? Are they shady? Do they have a sense of idea how to handle the company in crisis, and how to avoid joining the herd in bullish times? Do they blame others when they made a mistake? Do they think about the employees and cut them off like weeds when times are bad?

I cannot overemphasize this: Do your due diligence and hope for the best. In an uncertain world, we cannot hope to know everything. So the best plan is to make sure you're not overexposed to the downside. Being an investor would necessary mean that you have to handle uncertainty as naturally as breathing - to invest when you do not have all the information and to invest when times are uncertain.

Take care of the downside, the upside will take care of itself :P


PanzerGrenadier said...


Unfortunately, as the case of the bank failures in the US have shown, management's interest may not be aligned to shareholders' interest in that CEOs get paid millions taking inordinate risks of shareholder capital to bet on instruments they hardly even understand (well).

So who can you trust?

In the case of sovereign wealth fund, it is ever scarier to contemplate if management interest is aligned to shareholders (i.e. common citizen).

Be well and prosper.

la papillion said...

Hi PG,

Yes, that's right. To find a good management is to find one whose interests are aligned with that of the shareholders. Hard to quantify really.

Brendan Lee said...

You said "Imagine out of your classmates in secondary school, you're supposed to pick one whom you think will have the greatest potential to be the most successful. Who do you pick?"

This is a question that I have always been searching and observing.

My conclusion is those who are hardworking, passion in what they are doing, outspoken, and had achieved excellence academics.

What is your observation?

PanzerGrenadier said...

Hi Brendan

Hardwork and passion are both important ingredients for success in any effort. But I have come to realise, people and their potentials become unleashed sometimes by accident.

One of my secondary school classmates is now a successful business owner. But when he was in school, he was an average student and was very quiet. Quite the opposite to being outspoken.

Even for myself, I wasn't known to be an extrovert or popular guy but my exposure to toastmasters (long after I started working) opened up the world of public speaking and speaking off-the-cuff to me.

I was fortunate enough to win a Division title in table-topics a few years back.

Would any of my teachers/peers have thought that was possible? Even my parents thought I was by nature a quiet boy in front of strangers although I was a terror at home...hahha.

Bottom line, we sometimes don't know what we're capable of until we try it out!

Be well and prosper.

la papillion said...

Hi Brendan and PG,

For my case, I'm the 'class nerd' sort who did very well in academic studies. I'm very very quiet in school, so never expected myself to be a private tutor as well. I shake when I talk to strangers because of my introvert character.

Well, same as PG, I think my teachers would never expect me to be the person I am today.

I think luck plays an important criteria. If you have the mental preparation to seize opportunities, and luck throws one in front of you, you'll be ahead in others. A sec friend of mine is also a successful business owner now (much to my surprise, to be frank).

Oh well, it's hard to pinpoint what makes a successful person huh?