How do you identify an exceptional company with a durable competitive advantage from the INCOME STATEMENT?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.


INCOME STATEMENT

Gross Profit

Gross Profit is a key number that helps determine whether or not the company has a long term competitive advantage.

Companies that have excellent long term economics working in their favour tend to have consistently higher gross profit margins than those that don't.

What creates a high gross profit margin is the company's durable competitive advantage, which allows it the freedom to price the products and services it sells well in excess of its cost of goods sold.

As a general rule (and there are exceptions):
Companies with gross profit margins of 40% or better tend to be companies with some sort of durable competitive advantage.

Companies with gross profit margins below 40% tend to be companies in highly competitive industries, where competition is hurting overall profit margins (there are exceptions here, too).

Any gross profit margin of 20% and below is usually a good indicator of a fiercely competitive industry, where no one company can create a sustainable competitive advantage over the competition.

The gross profit margin test is not fail-safe, it is one of the early indicators that the company in question has some kind of consistent durable competitive advantage.

You should track the annual gross profit margins for the last ten years to ensure that the consistency is there.


Operating Expenses

Selling, General and Administrative (SGA) expenses

In the search for a company with a durable competitive advantage the lower the company's Sales, General and Administrative (SGA) expenses, the better.

If they can stay consistently low, all the better.

Anything under 30% of Gross Profit is considered fantastic.

However, there are a number of companies with a durable competitive advantage that have SGA expenses  in the 30% to 80%range.

If you see a company that is repetitively showing SGA expenses close to, or in excess of 100%, the company is likely in a highly competitive industry where no one entity has a sustainable competitive advantage.

There are also companies with low to medium SGA expenses that destroy great long term business economics with high research and development costs, capital expenditures and/or interest expense on their debt load.

Steer clear of companies with consistently high SGA expenses.

The economics of companies with low SGA expenses can be destroyed by expensive research and development costs, high capital expenditures, and/or lots of debt because the inherent long-term economics are so poor that even a low asking price for the stock will not save investors from a lifetime of mediocre results.

Research &Development expenses

Companies that have to spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long term economics at risk, which means they are not a sure thing.


Depreciation

Depreciation is a very real expense and should always be included in any calculation of earnings.  It is a cost that cannot be ignored.

The companies that have a durable competitive advantage tend to have lower depreciation costs as a percentage of gross profit than companies that have to suffer the woes of intense competition.

Less depreciation always means more when it comes to increasing the bottom line.


Interest Expense

Interest expense is a financial cost, not an operating cost and it is isolated out on its own in the income statement because it is not tied to any production or sales process.

Interest is reflective of the total debt that the company is carrying on its books.

Companies with high interest payments relative to operating income (EBIT) tend to be in a fiercely competitive industry, where large capital expenditures are required for it to stay competitive, or a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.

The companies with a durable competitive advantage often carry little or no interest expense.

Even in highly competitive businesses like the airline industry, the amount of the operating income paid out in interest can be used to identify companies with a competitive advantage.

Warren's favourite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income.

The percentage of interest payments to operating income varies greatly from industry to industry.

The investment banking business, the average interest payments are in the neighbourhood of 70% of its operating income.

The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in.

A simple rule:  In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have a competitive advantage.

Investing in the company with a durable competitive advantage is the only way to ensure that we are going to to get rich over the long term.

Gain (or Loss) on Sale of Assets and Other

Non-recurring, non-operating, unusual and infrequent income and expense events (e.g. sale of assets) can significantly affect a company's bottom line.

Since these are nonrecurring events, they should be removed from any calculation of the company's net earnings in determining whether or not the company has a durable competitive advantage.


Income before tax (Pretax earnings)

Income before tax is also the number that Warren uses when he is calculating the return that he is getting when he buys a whole business or when he buys a partial interest in a company through the open-market purchase of its shares.

[With the exception of tax-free investments, all investment returns are marketed on a pre-tax basis.  And since all investments compete with each other, it is easier to think about them if they are thought about in equal terms.]

Warren has always discussed the earnings of a company in pre-tax terms.  This enables him to think about a business or investment in term relative to other investments.

It is also one of the cornerstones of his revelation that a company with a durable competitive advantage is actually a kind of "equity bond" with an expanding coupon or interest rate.

Income Tax paid

One of the ways to see if the company is telling the truth is to look at the documents they file and see what it is paying in income tax.  If this doesn't equal the amount according to the tax rate, better start asking some questions.

Companies that are busy misleading the IRS are usually hard at work misleading their shareholders as well.

The beauty of a company with a long-term competitive advantage is that it makes so much money it doesn't have to mislead anyone to look good.


Net Earnings

Net earnings that are consistent and showing a historical long term upward trend can be equated to durability of the competitive advantage.

The ride doesn't have to be smooth but it should be a historical upward trend.

A company's historical net earnings trend may be different from its historical per share earnings trend due to changes in the number of shares outstanding (e.g. share buyback programs will increase per share earnings even though actual net earnings haven't increased.)

Look at the business's net earnings to see what is actually going on.

Companies with a durable competitive advantage will report a higher percentage of net earnings to total revenues than their competitors will.

Net profit margins tell us a lot about the economics of the business compared with other businesses.

High net profit margins reflect the companies' superior underlying business economics.

Low net profit margins reflect the highly competitive nature of the business.

A simple rule (and there are exceptions) is that if a company is showing a net earnings history of more than 20% on total revenues, there is a real good chance that it is benefiting from some kind of long term competitive advantage.

If a company is consistently showing net earnings under 10% on total revenues it is - more likely than not - in a highly competitive business in which no one company holds a durable competitive advantage.

Those companies that earn between 10% to 20% on total revenue may also have companies with long term competitive advantage yet to be discovered.

One of the exceptions to this rule is banks and financial companies, where an abnormally high ratio of net earnings to total revenues usually means a slacking off in the risk management department.    In the game of lending money, this is usually a recipe for making quick money at the cost of long term disaster.


Per-Share Earnings

The more a company earns per share the higher its stock price is.

A per share earnings figure for a ten year period can give us a very clear picture of whether the company has a long term competitive advantage working in its favour.

Look for a per share earning picture over a ten year period that shows consistency and an upward trend - an excellent sign that the company in question has some kind of long term competitive advantage working in its favour.

Consistent earnings are usually a sign that the company is selling a product or mix of products that don't need to go through the expensive process of change.

The upward trend in earnings means that the company's economics are strong enough to allow it either to make the expenditures to increase market share through advertising or expansion, or to use financial engineering like stock buybacks.

Erratic earnings picture that shows a downward trend, punctuated by losses tells that this company is in a fiercely competitive industry prone to booms and busts.

There are thousands of companies like this and the wild price swings in shares, caused by each company's erratic earnings, create the illusion of buying opportunities for traditional value investors.  But what they are really buying is a long, slow boat ride to investor nowhere.

Prem Watsa 2011 (Good Video)

Published on 7 Dec 2015

In addition to acting as a guest speaker on February 16, Mr. Prem Watsa, Chairman and CEO, Fairfax Financial Holdings Ltd. has invited Dr. Athanassakos and a group of his Value Investing MBA and HBA students to attend the Fairfax annual meeting of shareholders on Wednesday, April 20, 2011 at 9:30 a.m. in Toronto, Ontario, Canada. After the annual meeting, students will have an opportunity to meet Mr. Watsa and his team.

Mr. Watsa is the Chairman and Chief Executive Officer of Fairfax Financial Holdings Ltd., a financial services holding company, which he took over in 1985. The company, through its subsidiaries, is engaged in property and casualty insurance and reinsurance, as well as investment management. Mr. Watsa is a Chartered Financial Analyst, a graduate of the prestigious Indian Institute of Technology with a degree in Chemical Engineering and a holder of an MBA from the Ivey Business School at Western University. He is a member of the Board of Trustees of the Hospital for Sick Children, a member of the Advisory Board for the Ivey Business School and a member of the Board of Directors of the Royal Ontario Museum Foundation, as well as Chairman of the Investment Committee of St. Paul’s Anglican Church.

Fairfax has been one of the few companies to escape the ravages of the great recession of 2008 as Mr. Watsa and his team had anticipated the credit crisis and had taken the necessary steps to protect Fairfax . Mr. Watsa, also known as the Buffett of the North, had discussed his fears about the markets in a key note speech he gave to The Ben Graham Center of Value Investing First Annual Symposium on Value Investing on May 25, 2007. His key note speech can be viewed here.

For more on Fairfax Financial Holdings Ltd., see www.fairfax.ca

Charlie Munger on Thinking errors and Misjudgements (Summary)

Summary:

Do we behave to environmental stimuli like ants?

1.  Reward and Punishment Super-response Tendency 

(Incentive and disincentive-caused bias.  It is imperative to understand the role of incentives and disincentives in changing cognition and behavior. The power of incentives can be used to produce desirable behavioural changes.  An incentive-caused bias can tempt people into immoral behaviour.  If you rip apart any system and look at its core design, you will find mainly two things: incentives and disincentives. Communism has failed due to the absence of exactly those incentives. The US financial crisis was an outcome of wrong incentives and absence of disincentives.   It is quite clear that man responds more often and more easily to incentives than to reason and conscience. )

2.  Liking and Loving Tendency 

(This tendency to love has its own set of side effects.  Don't fall in love with your stocks.  Fall in love and protect your capital.  Be a disciplined value investor!)

3. Doubt-avoidance Tendency

(Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity.  When neither under pressure nor threatened, a person should ideally not be prompted to remove doubt through rushing to some decision.)

4.  Inconsistency-avoidance Tendency 

(We tend to filter away any piece of information which may be inconsistent with our ideas and beliefs.  Be disciplined with your approach:  play the devil's advocate or have processes and procedures in place that tend to minimize hasty and biased decision making.  Adjourn your stock purchases till you are sure.  Stock markets will always keep swinging higher and lower.  Investing opportunities will be there.)

5.  Envy and Jealousy Tendency  

(Greed is fuelled by envy.  Everyone is here not just to make money, but to make more money than what the next person is making.  Comparison and competition are intense, creating a perfect recipe for jealousy tendency.  The important point to take home is to not let such negative emotions affect your investment decisions. Avoid discussions that would trigger feelings of jealousy.  Keep extremely low profile and keep discussions to stock ideas and business fundamentals.)

6.  Over-optimism tendency  

(Excess of optimism is the normal human condition.  "What a man wishes, that also will he believe."  The best way is to acknowledge that this bias exists in the first place.  Challenge your views by asking yourself as many questions as possible to see if your views can stand the attack of reason.)

7.  Social proof tendency

( It is an automatic tendency to think and act the way people around you are thinking and acting.  The evil of corruption continues to persist because of the Serpico Syndrome, which is created by the social proof tendency and the power of incentives.  It dominates how investors behave in stock markets, how company managements (institutional imperative) do business and so on.  Have the management act as if they were the owners.  Buffett says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.)

8.  Contrast Misreaction Tendency 

(We perceive everything in relative terms.  It influences how we think about economic news and information, corporate performance, stock prices and so on.  Contrast misreaction cause people to make wrong judgements based on misleading contrasts between two or more things and situations.  For example, a person shifting to another city and looking for a new house and his estate agent using this trick on him.  For the investor, why he did not buy the stock at 140 (because it rose from 90) and then he bought the same stock at 300 (because it fell from 450)?  A stock with P/E of 50 in past and is now at P/E of 30 does not mean it is a lucrative buying opportunity.  Look at the company's business fundamentals and its past financial track record.  Valuing the company based on such important parameters will help you avoid false comparisons.)

9.  Availability-misweighing Tendency  

(Due to the relentless flow of news and information, the human mind has a tendency to focus on what's easily available.  In doing so, often tend to give undue importance to it.  In the absence of relevant information, investors often end up giving undue importance to such insignificant matters.  Adopt Charles Darwin's approach.  He would try to gather evidence to disconfirm it.  Challenge the merit of the idea.  Look for potential risks and concerns that could adversely affect the company.  The ultimate investing decision should be based solely on your understanding and insght and not from borrowed optimism.  Be discipline.  To avoid falling prey to this tendency is to prepare an investment check list and adhere to the process in a disciplined manner.)

10.  Use-it-or-lose-it Tendency  

(The importance of regular practice is especially very vital in skills of a very higher order.  Many people take investing as a side business which can be done without putting in too much time and effort.  And that is one of the biggest fallacies.  Legendary investors such as Warren Buffett, Charlie Munger and Peter Lynch did not create great fortunes out of thin air. They are known to be rigorous practitioners of their art.  They all read extensively and spend a huge amount of their daily routine analysing companies.  By using their mental skills meticulously, they have become successful pilots of the investing world.)

11.  Senescence-misinfluence Tendency  

(At an age when you may not be in the best physical frame to travel distances and perform demanding tasks, what could you do for an alternative source of income?  The answer is investing.  The real risk of significant losses lies in speculative short-term trading.  If you choose the path of long term value investing, you will not only live with minimal risk, but the chances of immense profits will be significantly high.  Remember, in the long run, equities tend to outperform all major asset classes.  If you develop useful skills early in your life and practice them rigorously over the years, you could manage to retain those skills for a much longer period, despite the aging process.)

12.  Authority-misinfluence Tendency  

(Uncertainty and risk have a big influence on how independently people take their decisions.  This makes the stock market a place that is incurably afflicted by the authority-misinfluence tendency.  Just spare a moment and ponder about how exactly you decide when to buy or sell a stock.  What makes you follow these experts?  It is important that you exercise your own independent judgement to the opinions of others.  "Mr. Market is there to serve you, not to guide you."  The greatest investors in the world are those who do not give in to the moods of Mr. Market.  (Mr. Market is a parable told and popularised by Benjamin Graham, teacher of Warren Buffett.)

13.  Twaddle Tendency  

(Man often indulges in petty small talks and chatter.  They only become a nuisance when they come in the way of some serious work that is in progress.  This twaddle tendency, like the twaddle dance of the honey bees, can lead to unproductive results.  And this is what we need to keep a check on.   Better to stay in a quiet corner meantime rather than doing something silly, irrelevant or unproductive.)

Sustainable Growth Rate = Return on Equity X Retention Ratio

Tips, Tricks, & Techniques

SustainableGrowth Rate.

You may forecast an earnings growth rate for the future.

There are a number of guidelines for this forecast.

One is called the Sustainable Growth Rate.

Sustainable growth rate is that rate at which the company can continue to grow, without having to borrow money or without having to issue new common stock.

This rate is a function of both Return on Equity [ROE] and the dividend payout ratio.

ROE is a measure of how well management is using stockholders money to build the company.

It compares the gains in EPS to gains in book value per share.

Dividend payout ratio is that percentage of profits paid out to stockholders. Keep in mind that every dollar paid out in dividends is one dollar less to grow the company with.

Formula: Sustainable Growth Rate = ROE * [1 - dividend payout ratio]


Example:

Company’s ROE is 20%.

Dividend payout ratio is 10%.

What is the Sustainable Growth Rate?

0.20 * [1.0 — 0.10] = 0.20 * 0.90 = 0.18 = 18%

Good guideline to determine forecast EPS: Keep forecast EPS estimate lower than Sustainable Growth Rate.

The ROE value used is the average for the last 5 years where ROE is calculated as the EPS for the given year divided by the prior year’s Book Value per Share.

The rational for calculating ROE in this manner is that this year’s EPS is the result of last year’s Book Value.


Addendum to Sustainable Growth Rate comments by Ellis Traub 

As happens so often, we can get carried away with the formulae and the numbers and lose sight of the concepts.

A company begins the year with $100 million in equity.

And, during the course of that year, it earns $15 million for a return on that equity of 15 percent.

If it retains all of what it earned, the equity will have grown 15 percent.

And, since the company was able to make 15 percent on its equity, those retained earnings should also be able to earn 15 percent in the next year.

Similar to compounding, this shows that the sustainable growth, just the growth produced by those retained earnings, be 15 percent.

Companies aren't restricted from growth above that rate. They use a variety of resources to increase or perpetuate a higher rate.

They include leverage (using other people's money) to acquire the assets that generate more revenue, or they sell more shares.

While those shares might dilute the EPS, they were sold not given away, so they do add to the equity of the company.

Acquiring productive assets, acquiring operating companies, etc. are only a few of the things that managements, or directors, commonly do to exceed the sustainable growth rate.

So, of what interest is it to us?

 It's just a simple metric that tells us that, without doing these other things, the company can still grow at that rate. 

The only thing that might keep the ROE, sustainable growth, and earnings growth from being the same is the prospect of not using all of those earnings to produce more but, instead, to pay out some of those earnings in dividends. 

This, of course, would reduce the amount of money that is available to earn more; and it will, therefore, cut down the sustainable or implied growth rate. 

Otherwise, if dividends are not paid, the ROE and earnings growth rate will be the same, as will Implied growth.

If earnings growth falls, so will the ROE.

This formula (Implied growth = ROE * RR) [RR=Retention ratio, the percent of earnings NOT distributed to shareholders] will not work if you use ending or average equity.



http://naicspace.org/pdf/sustainablegrowthrate.pdf


STOCK FUNDAMENTALS By Ellis Traub USING ROE TO ANALYZE STOCKS: WHAT YOU NEED TO KNOW ABOUT
http://www.aaii.com/journal/article/using-roe-to-analyze-stocks-what-you-need-to-know-about

Charlie Munger on Thinking errors and Misjudgements

Charlie Munger developed his own system of psychology.  These have very powerful implications for investors.

Do we behave like ants?

The ant merely responds to stimuli (e.g. pheromone) with a few simple responses programmed into its nervous system by its genes.

Under complex circumstances, don’t we also find ourselves behaving counterproductively just like ants?

Aren’t the stock markets a perfect playground for this kind of behavior?

1.  Reward and Punishment Super-response Tendency

All creatures seek their own self-interest.

Our innate drive is to maximize pleasure while at the same time avoiding or reducing pain.

It is imperative to understand the role of incentives and disincentives in changing cognition and behavior.

The power of incentives can be used to produce desirable behavioural changes.

An incentive-caused bias can tempt people into immoral behaviour.

Human nature, bedeviled by incentive-caused bias, causes a lot of ghastly abuse.

It is important to understand the motives and incentives of people and organizations you are dealing and investing with.

Widespread incentive-caused bias requires that one should often distrust or take with a grain of salt, the advice of one’s professional advisor.

If you rip apart any system and look at its core design, you will find mainly two things: incentives and disincentives.

The success or failure of any economic system depends on how incentives and disincentives are designed.

The success of the free-market system as an economic system comes from its inherent reward-punishment mechanism.

Communism has failed due to the absence of exactly those incentives. 

The US financial crisis was an outcome of wrong incentives and absence of disincentives.  

The crisis was a failure of the entire system. 

 “Incentives were horribly skewed in the financial sector, with the workers reaping rich rewards for making money but being only lightly penalized for losses.”

It is quite clear that man responds more often and more easily to incentives than to reason and conscience. 

2.   Liking and Loving Tendency

Love is one of the most basic of emotions.

It extends not only towards people but also towards things, ideas and concepts.

This tendency to love has its own set of side effects.

Now ask yourself these questions:

·                     Do you tend to ignore their faults? Do you readily comply with their wishes?

·                     Do you favour people, products, and actions merely associated with them?

·                     Do you distort any unpleasant facts about them?

We dislike challenging and reasoning with things and ideas that we love.

Do fall in love, but not with your stocks.  

Love your capital and do the best you can to protect it and to help it grow. 

Be a disciplined value investor!

3.   Doubt-avoidance tendency

Doesn't our mind often display a tendency to steer clear of doubts to quickly reach a decision or conclusion?

But the problem with any kind of psychological tendency or mental programming is that it doesn't work well in all situations. 

A person who is neither under pressure nor threatened should ideally not be prompted to remove doubt through rushing to some decision.

Yet, more often than not we find ourselves doing exactly the opposite.

When a person comes to the stock markets with a bag full of money to invest, he is usually inclined to fall in love with any stock that seems promising. 

The boredom and pain that is usually part of a thorough scrutiny and analysis of a stock is often avoided.

Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity. 

If you learn how to reign over the doubt-avoidance tendency while you conduct your business in the stock markets, there is little that can stop you from becoming a successful investor. 

4.  Inconsistency-avoidance tendency

While habits can be good, and good habits doubly so, there are several disadvantages as well. 

Habits often come in the way of any kind of change or transformation. 

As Charlie Munger puts it very aptly, "People tend to accumulate large mental holdings of fixed conclusions and attitudes that are not often reexamined or changed, even though there is plenty of good evidence that they are wrong." 

The inconsistency-avoidance tendency is very rampant amongst human beings. In simple words, we filter away any piece of information which may be inconsistent to our ideas and beliefs.

Stock markets are largely driven by sentiment. So you must do your best to be as objective as you can and guard yourself from the lures of greed and fear. 

Getting back to inconsistency-avoidance tendency, can you remember instances when you have used this tendency to your own peril?

Have you lost money on your favourite stock that had once been an outperformer? 

The company's prospects may have changed, it may no longer be worth putting your money into, but you still couldn't let go of it. Why?

Because letting go of it would be inconsistent with your original beliefs about it.

So you did everything to console and convince yourself that nothing was wrong.

But your portfolio losses have a different story to say, don't they? 

How exactly do you get rid of this tendency?   You need to be very disciplined with your approach. 

·                     One great way is to play the devil's advocate. If you find a prospective company very compelling, first start with rejecting the hypothesis. In other words, try to gather facts and arguments that will prove that the stock is a bad investment. After all your analysis, if you arrive at the conclusion that the stock is still good, then it has passed the bar. 

·                     You can also take a good lesson from the court of law. Law courts have processes and procedures in place that tend to minimise hasty and biased decision-making, which can cost someone's life. 

As investors, you must learn not to be hasty. Adjourn your stock purchases till you're not clear in your mind. 

Always remember, stock markets will always keep swinging higher and lower. Investing opportunities will be there. 

If you can tackle with your inconsistency-avoidance tendency, money will consistently keep pouring into your bank accounts. 

5.   Envy and Jealousy Tendency

These emotions are so innate to human nature that it is almost impossible to get rid of them.

Given the crucial role that these emotions play in the human world, you could risk ignoring them at your own peril. 

It is often said that stock markets are driven by greed and fear.

But legendary investor and Charlie Munger's 'Siamese twin,' Warren Buffett, has an important interruption to make here. He very wisely points out, "It is not greed that drives the world, but envy."

While 'greed' refers to an excessive desire to possess something, 'envy' is a desire to possess what the other person is possessing. 

And more often than not, greed is fuelled by envy.

Everyone is here not just to make money, but to make more money than what the next person is making. 

Comparison and competition is intense, creating a perfect recipe for jealousy tendency.

The important point to take home is to not let such negative emotions affect your investment decisions. 

But isn't it a little too difficult to not feel bad if your friends and colleagues make a lot more money than you do? It is indeed difficult. 

So the best antidote in such a case is to avoid discussions that would trigger feelings of jealousy.

In fact, some of the best investors in the world keep extremely low profile and keep their discussions limited to stock ideas and business fundamentals. 

In the absence of such external disturbances, they are able to make more rational investment decisions. 

6.   Over-optimism tendency 

Charlie Munger opines that an excess of optimism is the normal human condition. 

And this tendency to be over-optimistic not only manifests when man is in pain, but also when he is doing well and there is no threat of pain whatsoever.

"What a man wishes, that also will he believe." 

Over-optimism tendency drives not just stock markets but the entire world of finance and economics. 

Why otherwise would we have booms and bubbles with such amazing regularity?

Why do people continue to flock to the financial markets despite the regular crises and busts that torment the markets?

In fact, all the malaise troubling the global economy today, from the debt crises in the developed economies to the high inflation and slowing growth in emerging economies, do have roots in excessive optimism. 

The problem is that when things are good, we expect them to get better and better in a linear fashion. 

And even when things are bad and getting worse, we often expect that the situation will turn good again sometime in the future. 

This tendency is so often displayed by company managements. 

·                     During good times, they tend to get over-optimistic and take up massive debt-funded expansion plans by way of capacity additions or wasteful mergers and acquisitions. When the cycle turns and things turn sour, you see red ink all over their financial statements. 

·                     What is surprising is that even in bad times, a lot of companies are extremely shy to admit that things are not going too well. They tend to project and hope only what they wish to see and not what there is really. 

As investors, the best way to deal with this bias is to acknowledge that it exists in the first place. 

That is half solution done because most of the times we are not aware of our own biases. 

Then a very effective antidote to over-optimism is to challenge your views by asking yourself as many questions as possible. 

If your views cannot stand the attack of reason, you know which tendency is to be blamed. 

 7.  Social proof tendency

 What is social proof tendency? It is an automatic tendency to think and act the way people around you are thinking and acting. 

The social proof tendency works in both positive and negative situations.

Be it riots and terrorists. Or be it the massive support that came in for a certain good cause

This tendency most readily occurs in the presence of puzzlement or stress, or both. 

Charlie Munger points out one interesting aspect of the social proof tendency which very well explains why in certain societies, corruption is so deeply rooted. 

The "Serpico Syndrome" is named in the memory of Frank Serpico who once entered a highly corrupt New York police division. 

Unlike others, he resisted to be consumed by the contagion of corruption. And for that resistance, he was almost about to lose his life.

As it is evident, the evil of corruption continues to persist in our country because of this very Serpico Syndrome, which is created by the social proof tendency and the power of incentives. 

Akin to the other spheres of life, social proof tendency is present in overwhelming proportions in the world of business and finance.

It dominates how investors behave in stock markets, how company managements do business and so on.

Many of us may think of corporate leaders and managers as highly qualified, intelligent and experienced people who would be making rational business decisions.

A deadly force which Buffett calls the 'institutional imperative' often hinders rational decision making and at times, even destroys businesses. 

What does institutional imperative mean?  The Oracle of Omaha explains the institutional imperative as that need for managers to act and do like their peers no matter how irrational it may seem. 

A simpler term that comes to mind is peer pressure.

However surprising it may seem even CEOs are subject to this pressure which forces them to make stupid mistakes. 

'Everybody was doing that'. 

From his own mistakes, Buffett realised how important it was to not fall victim to this force. 

Have the management act as if they were the owners. What happens when managers start thinking like owners? They think very differently. They think twice if their own money is at stake. 

The tendency to fall prey to the social proof tendency is also seen among investors. 

Stock market booms, bubbles and eventual crashes clearly show how investors succumb to peer pressure and end up burning their fingers. 

What should investors do to avoid such mistakes? 

Buffett has a solution for this as well. He says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." 

It may sound simple but it's indeed a very powerful way to guard yourself against the social proof tendency. 

8.  Contrast Misreaction Tendency

How do we really perceive things? 

For instance, how does our brain figure that an elephant is a big fat creature? Or, how do we know that a tortoise is very slow? 

The answer to both these questions is relative comparison. 

We perceive everything in relative terms. 

This mode of perception extends to all things in life, and very evidently in investments and stock markets. 

It influences how we think about economic news and information, corporate performance, stock prices, and so on. 

The reason why we tend to perceive things in relative terms is that it is impossible for the human nervous system to measure everything in absolute scientific units. 

So we use our senses to identify things by comparing them with other things. 

It is the relative contrast that gives things their specific characteristics.

What is contrast misreaction tendency?  Contrast misreaction causes people to make wrong judgments based on misleading contrasts between two or more things and situations.

Charlie Munger cites an interesting example where this tendency is often misused-

A person is shifting to another city and looking for a new house for his family. 

To get some quick help, he goes to a real estate broker.

First, the salesman takes him around and shows him some really terrible homes for insanely high prices.

Then, he takes the person to a merely bad house at a slightly lower price. Need we mention what happens next!

What exactly went amiss in this case? How did the home buyer fall into the saleman's psychological trap? 

Blame it on the contrast misreaction tendency. 

When the person was shown the last property, he compared the house and its price to the horrible ones he saw before.

Because of this comparison, he was ready to buy the not-so-good-house at a pretty high price. 

Do investors in the stock markets also make wrong investment decisions because of the contrast misreaction tendency? The answer is yes, very often.

The following instance will explain how investors enter this psychological trap.

“Expensive at 140, attractive at 300!”

Mr C  was an active investor.

He was suggested by a friend to buy shares of XYZ Ltd when the stock price was 90 per share.

Instead of buying immediately, he decided to wait for some time.

But in just a matter of few weeks the stock price mounted to 140 per share. That was a whopping rise of nearly 56%.

Obviously, Mr C was very distressed. He cursed himself for not buying when the stock was trading at 90.

But now, he couldn't get himself to invest in the stock. It's way too expensive, he thought.

In the meanwhile, the stock continued to rally. In just a few months, the stock price was hovering around 400.

Mr C had never felt so miserable. 

He had missed such a big opportunity. 

But then the stock price faced some selling pressure and corrected by about 25%. 

At 300, what do you think Mr C must have done?  He invested heavily into the stock. 

Why did he not buy the stock at 140? What forced him to buy the same stock at 300? 

The answer in both cases is contrast misreaction tendency.

140 seemed very expensive in contrast to 90, the price at which his friend had suggested.

However, 300 seemed cheaper relative to the high of 400 that the stock had witnessed.

A similar mistake also occurs with valuation multiples. 

For instance, if a stock has commanded a price to earnings (P/E) multiple of 50 times in the past, it doesn't mean that a P/E of 30 times is a lucrative buying opportunity. 

How can investors avoid such thinking errors? 

The principles of value investing are a perfect antidote for the contrast misreaction tendency. 

Never judge the value of a company based on its past stock price performance or P/E multiples. 

Look at the company's business fundamentals and its past financial track record. 

How are the future growth prospects? 

What are the risks and opportunities to the business? 

Do the company's managers behave like owners? 

Valuing the company based on such important parameters will help you avoid false comparisons.

9.  Availability-misweighing tendency

What appears more often and more prominently around us assumes a lot more importance than it may deserve.

On the other hand, issues that may not be discussed could be disregarded as trivial. 

What does it mean? 

Charlie Munger explains it very aptly quoting a song: "When I'm not near the girl I love, I love the girl I'm near."

The human mind has a tendency to focus on what's easily available. And in doing so, often tends to give undue importance to it.

On the other hand, the significance of things and events that are not easily accessible could be undermined.

Business fundamentals and earnings drive stock prices over the long term. 

However, on a day-to-day basis, it is the relentless flow of news and information that sends markets up and down. 

Owing to this intricate relationship with news, the stock market is one place that most easily falls prey to the availability-misweighing tendency.

Isn't it often observed that news items that are prominently projected in the media elicit substantial response from the stock markets?

In other words, the markets are ready to react to any information that is made available to them. 

This also means that important matters that are not covered by the news media may be ignored by the stock markets. 

The case of individual investors is also very similar. 

Stocks that are most widely talked about in the media often make an easy entry into the stock portfolio.

Many companies tend to use this tendency to prop up their share prices. 

Using their PR machinery, companies bombard the media with press releases, interviews and news reports about every trivial development and achievement, many of which may not have any major impact on earnings. 

But in the absence of other relevant information, investors often end up giving undue importance to such insignificant matters. 

Charlie Munger suggests that taking Darwin's approach could be an effective antidote for availability-misweighing tendency. 

What did Darwin do to eliminate biases? 

It is said that Darwin was a very strong proponent of objectivity. He was known for playing the devil's advocate to his own ideas and hypotheses. 

So much so that as soon as he would have an idea, he would try to gather evidence to disconfirm it.

In fact, he tended to be even more rigorous in his approach with ideas that were particularly compelling.

Let's try and apply this approach to investing in stock markets. 

Say for instance, there is a certain stock that your friend has strongly recommended you to consider buying.

Suddenly, the stock price goes up following a positive piece of news. What would be your reaction? 

Your friend is optimistic about the stock. The news is positive. The markets too have cheered the news. Isn't there enough reason to run and call your broker to buy the shares?

If you would have done that, you would have quite likely fallen prey to the availability-misweighing tendency. 

A wiser response would have been to do what Darwin always did: Challenge the merit of the idea. 

Look for potential risks and concerns that could adversely affect the company.

Arrive at your independent view only after thoroughly evaluating the potential of the stock. 

The ultimate investing decision should be based solely on your understanding and insight and not from borrowed optimism. 

In short, if you come across a stock that appears to be the market's darling with a lot of media attention on it, play the devil's advocate and consider all possible risks and concerns that can derail the investment.

If the idea still holds, it is certainly worth investing.

It is observed that a vital quality that is common amongst all great investors is discipline. 

It is this discipline that helps them overcome the various thinking errors and biases, availability-misweighing tendency being one of them. 

A practical way to ensure discipline and to avoid falling prey to this tendency is to prepare an investment check list and adhere to the process in a disciplined manner. 

10.  Use-it-or-lose-it tendency

 If you don't use a certain skill, you tend to lose it gradually.

The same holds true for the various mental and physical skills that we possess. 

What can one do to avoid such loss of useful skills? The only way to keep such skills alive is to use them regularly.

The importance of regular practice is especially very vital in skills of a very higher order.

Charlie Munger suggests using something that is a functional equivalent of the aircraft simulator employed in pilot training. 

While investing is not a rocket science, there is no reason to take it too casually.

Many people take investing as a side business which can be done without putting in too much time and effort.   And that is one of the biggest fallacies. 

Legendary investors such as Warren Buffett, Charlie Munger and Peter Lynch did not create great fortunes out of thin air.

They are known to be rigorous practitioners of their art. 

They all read extensively and spend a huge amount of their daily routine analysing companies.

In other words, by using their mental skills meticulously, they have become successful pilots of the investing world. 

11.  Senescence-misinfluence tendency

Senescence-misinfluence refers to the cognitive decay and mental limitations on account of biological aging.

The aging process may differ from person to person in terms of the time it commences and the pace at which it progresses. 

But, by and large, old people have difficulty acquiring new skills. 

As such, the probability of learning complex new skills is practically zilch. 

Though acquiring new skills may be challenging,the good news is that some people very well manage to retain old skills that they have practiced intensely over the years.

What does senescence-misinfluence tendency have to do with investing?

Our financial needs change with the various phases of our life. 

Given that the topic under discussion concerns old age, let us focus on a person's financial needs post retirement. 

At this age, you may not have the burden of educating and marrying your kids.

You may also not have to worry about buying a home.

With all major investments and expenses behind you, you may be relatively relieved.

But you may have several other expenses. 

For instance, your healthcare expenses could be significantly higher.

You may also want to fulfil all the dreams that you may have sacrificed in your youth.  And so on. 

The point is that you are going to need a good deal of money irrespective of your age.

  

But would your pension income be enough to take care of your post-retirement needs? 

And wouldn't you want to avoid depending on your kids for money? 

At an age when you may not be in the best physical frame to travel distances and perform demanding tasks, what could you do for an alternative source of income? 

The answer is investing. 

Some may counter with the usual argument that investing in stocks is risky. 

Of course, there is no denying that there is an inherent risk. 

But the real risk of significant losses lies in speculative short-term trading.

If you choose the path of long term value investing, you will not only live with minimal risk, but the chances of immense profits will be significantly high.

Remember, in the long run, equities tend to outperform all major asset classes. 

But it would be a big mistake if you wait until retirement to start investing actively. The preparation has to start much earlier. 

When you are relatively young, invest time regularly to educate yourself about value investing.

Let this be a life-long process of learning and investing. 

In this way, you will be very well-equipped to deal with your investments in your latter years.

But wouldn't old age hinder your thinking abilities and decision making? 

Your greatest inspirations could be Warren Buffett (82 years) and his so-called Siamese twin Charlie Munger (89 years). 

What is the secret behind their outstanding thinking prowess and investing acumen even at this age? The answer is simple.

If you develop useful skills early in your life and practice them rigorously over the years, you could manage to retain those skills for a much longer period, despite the aging process. 

12.  Authority-misinfluence tendency

Why? Simply because it came from an authority! 

Errors owing to the misinfluence of authority are found across all spheres of human life. 

In some cases, the results tend to be very tragic.

A classic case that shows the powerful influence of an authority figure is the Holocaust. What else do you think could have motivated Nazis to ruthlessly slaughter millions of innocent Jews?

Why is man innately wired to follow authority?

What causes man to submissively bow down to authority even if it may seem wrong and unreasonable? 

The answer probably lies in the way we have evolved over the ages. All our ancestors lived in dominance hierarchies. 

Dominance hierarchy is a social living group with a ranking system based on power. 

Owing to competition over limited resources and mating opportunities, relative  relationships are developed between members of the same gender. 

This results in the creation of a social order. 

The social order undergoes changes only when a dominant animal is overpowered by a subordinate one.

Human societies have followed a similar path. 

History has been largely shaped by few men at the helm, while the majority of humanity has simply followed orders. 

This explains why following authority is a very automatic tendency of man. 

Following authority is not a flaw in itself. In several cases, it is quite crucial. 

For instance, think about the fate of a military operation where each member refuses to take orders without questioning. 

On the other hand, follow-the-leader tendency can be very dangerous at times as the examples above suggest.

Authority-Misinfluence tendency in stock markets

Uncertainty and risk have a big influence on how independently people take their decisions.

The greater the risk and uncertainty, the greater is the tendency to seek guidance and conformation from an authority figure. 

This makes the stock market a place that is incurably afflicted by the authority-misinfluence tendency.

Just spare a moment and ponder about how exactly you decide when to buy or sell a stock. 

Do you invest based on 'hot tips' shared by 'influential' friends?

Do you avidly track the portfolio of successful investors/ fund managers and try to mimic them?

Do you invest based on the advice given by stock experts who appear on television?

Do you blindly follow the advice of your broker or any other advisor?

If your answer is a 'yes' to any one of these, then here are some more questions. 

What makes you follow these experts? 

Do you ever question or challenge their opinions?

Do you trust them simply because they are in a position of authority?

Is it convenient for you to follow them blindly so that you can escape the blame in case things go wrong? 

If you honestly reflect over these questions you will see that your decisions are seldom your own.

In fact, it is not just small investors who fall prey to the wrong influence of authority.  Even experts do, a lot of times.

Listening to views and opinions from experts is quite valuable.

But there is difference between listening to experts with discretion and blindly following them. 

It is important that you exercise your own independent judgment to the opinions of others.


'Mr Market' is there to serve you, not to guide you

In an abstract sense, 'Mr Market' (as referred to the stock market by value investing genius Benjamin Graham) is a representation of an authority figure.

People pay excessive attention to where the markets are going.

But you must remember that 'Mr Market' is a fickle leader and often deviates away from the rational path.

The greatest investors in the world are those who do not give in to the moods of 'Mr Market'.

In fact, in his Letter to Shareholders in 1987, legendary investor Warren Buffett put down some very important lessons that he had learned from his Columbia Business School professor. 

Ben Graham had taught him to look at the market quotations as if they were coming from an emotionally troubled fellow called 'Mr Market'. 

The poor guy often goes through periods of euphoria followed by periods of gloom.

But the good thing is that 'Mr Market' does not mind if you ignore him.

His only job is to come up with a new quote every day, every few seconds.

So if you learn to command this peculiar gentleman, you can take advantage when he is gloomy and rack up great businesses at depressed prices. 

On the other hand, when 'Mr Market' is euphoric, you can simply ignore him. 

The most important thing to remember is to let the 'Mr Market' serve you, not to influence your investing decisions. 

13.  Twaddle tendency

All creatures survive in groups and the one factor that connects creatures of a species is communication.

One of the things that differentiate human beings from other animals is our ability to think. 

The relatively larger size of our cerebral cortex is the reason for our creativity, language and logical deduction.

As such, we have a highly advanced and complex language at our disposal.

But do we always make the most rational and productive use of words? The answer seems to be no.

And this is where the 'twaddle tendency' fits in. An online dictionary defines 'twaddle' as silly, trivial or pretentious talk or writing. 

Being a social animal, man often indulges in petty small talks and chatter. 

Twaddle or nonsense talks are not such a bad thing by themselves.

They only become a nuisance when they come in the way of some serious work that is in progress.  And this is what we need to keep a check on. 

Charlie Munger relates an interesting experiment on honeybees which can be used as an analogy to show how the twaddle tendency can lead to unproductive results.

After returning to the honey comb with pollen or nectar, the worker bee performs a dance with particular movements. 

The other worker bees then follow the directions suggested and set out to gather pollen and nectar.

A certain scientist was curious to know how the honeybees would respond if the nectar was placed in an unusual position.

So he placed the nectar in a straight-up position at a significant height.

As you would have guessed, no nectar exists in such a position in a natural setting.

So, this baffles the honeybee. It does not have a genetic program that is capable of communicating this new position. 

According to you, what should the honeybee ideally do in such a situation? 

It should just go back to the hive and pick a quiet corner, shouldn't it?   But the honeybee does not do that.

Instead, it comes back and attempts a dance.

But the dance turns out to be incoherent. Just like twaddle! 

Can this behavioural tendency of the honeybee also apply to human beings? 

Summary:

Do we behave to enviromental stimuli like ants?

1.  Reward and Punishment Super-response Tendency (Incentive and disincentive-caused bias)

2.  Liking and Loving Tendency (Fall in love and protect your capital, not with your stocks)

3. Doubt-avoidance Tendency (Quick conclusions and quick decisions are often preferred instead of the burden of doubts and ambiguity.  When neither under pressure nor threatened, a person should ideally not be prompted to remove doubt through rushing to some decision.)

4.  Inconsistency-avoidance Tendency (We tend to filter away any piece of information which may be inconsistent to our ideas and beliefs.  Be disciplined with your approach:  play the devil's advocate or have processes and procedures in place that tend to minimize hasty and biased decision making.  Adjourn your stock purchases till you are sure.  Stock markets will always keep swinging higher and lower.)

5.  Envy and Jealousy Tendency  (Greed is fuelled by envy.  Avoid discussions that would trigger feelings of jealousy.  Keep extremely low profile and keep discussions to stock ideas and business fundamentals.)

6.  Over-optimism tendency  (Excess of optimism is the normal human condition.  "What a man wishes, that also will he believe."  The best way is to acknowledge that this bias exists in the first place.  Challenge your views by asking yourself as many questions as possible to see if your views can stand the attack of reason.)

7.  Social proof tendency ( It is an automatic tendency to think and act the way people around you are thinking and acting.  The evil of corruption continues to persist because of the Serpico Syndrome, which is created by the social proof tendency and the power of incentives.  It dominates how investors behave in stock markets, how company managemetns (institutional imperative) do business and so on.  Have the management act as if they were the owners.  Buffett says, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.)

8.  Contrast Misreaction Tendency  (We perceive everything in relative terms.  It influences how we think about economic news and information, corporate performance, stock prices and so on.  Contrast misreaction cause people to make wrong judgements based on misleading contrasts between two or more things and situations.  For example, a person shifting to another city and looking for a new house and his estate agent using this trick on him.  For the investor, why he did not buy the stock at 140 (because it rose from 90) and then he bought the same stock at 300 (because it fell from 450)?  A stock with P/E of 50 in past and is now at P/E of 30 does not mean it is a lucrative buying opportunity.  Look at the company's business fundamentals and its past financial track record.  Valuing the company based on such important parameters will help you avoid false comparisons.)

9.  Availability-misweighing Tendency  (Due to the relentless flow of news and information, the human mind has a tendency to focus on what's easily available.  In doing so, often tend to give undue importance to it.  In the absence of relevant information, investors often end up giving undue importance to such insignificant matters.  Adopt Charles Darwin's approach.  He would try to gather evidence to disconfirm it.  Challenge the merit of the idea.  Look for potential risks and concerns that could adversely affect the company.  The ultimate investing decision should be based solely on your understanding and insght and not from borrowed optimism.  Be discipline.  To avoid falling prey to this tendency is to prepare an investment check list and adhere to the process in a disciplined manner.)

10.  Use-it-or-lose-it Tendency  (The importance of regular practice is especially very vital in skills of a very higher order.  Many people take investing as a side business which can be done without putting in too much time and effort.  And that is one of the biggest fallacies.  Legendary investors such as Warren Buffett, Charlie Munger and Peter Lynch did not create great fortunes out of thin air. They are known to be rigorous practitioners of their art.  They all read extensively and spend a huge amount of their daily routine analysing companies.  By using their mental skills meticulously, they have become successful pilots of the investing world.)

11.  Senescence-misinfluence Tendency  (At an age when you may not be in the best physical frame to travel distances and perform demanding tasks, what could you do for an alternative source of income?  The answer is investing.  The real risk of significant losses lies in speculative short-term trading.  If you choose the path of long term value investing, you will not only live with minimal risk, but the chances of immense profits will be significantly high.  Remember, in the long run, equities tend to outperform all major asset classes.  If you develop useful skills early in your life and practice them rigorously over the years, you could manage to retain those skills for a much longer period, despite the aging process.)

12.  Authority-misinfluence Tendency  (Uncertainty and risk have a big influence on how independently people take their decisions.  This makes the stock market a place that is incurably afflicted by the authority-misinfluence tendency.  Just spare a moment and ponder about how exactly you decide when to buy or sell a stock.  What makes you follow these experts?  It is important that you exercise your own independent judgement to the opinions of others.  "Mr. Market is there to serve you, not to guide you."  The greatest investors in the world are those who do not give in to the moods of Mr. Market.  (Mr. Market is a parable told and popularised by Benjamin Graham, teacher of Warren Buffett.)

13.  Twaddle Tendency  (Man often indulges in petty small talks and chatter.  They only become a nuisance when they come in the way of some serious work that is in progress.  This twaddle tendency, like the twaddle dance of the honey bees, can lead to unproductive results.  And this is what we need to keep a check on.   Better to stay in a quiet corner meantime.)