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Notes on Tanjm Meeting with MIIF managment

July 10, 2006 by Kyith Leave a Comment

He wants us to keep this info private so i shall post this private.

Introduction
I met for an hour with MIIF management recently. Gregory Osborne and Robert Thorpe were present. Gavin Kerr (the incoming CEO) was also present as an observer. One of the motivations of the meeting may have been a desire to improve investor relations (and indirectly the share price – which influences their fees).

I am currently an investor in MIIF. I am relatively indifferent to the state of the short term share price of MIIF as I would regard lower prices as an opportunity to buy. Please do not regard this note as an inducement to buy or sell – I’m not trying to do anything in this direction. In my view, at the current prices, MIIF has a potential long term total return of about 12% with relative safety.

The following notes are prepared by me based on my own notes and memory. Any errors, misunderstanding of what was said, or miscommunication are definitely due to me. Please do not treat this as an official communication from or about MIIF. I do not guarantee anything – please take this note as is and do your own homework if necessary. Take what I say at YOUR OWN RISK.

Any additional comments by me or notes outside of what was discussed in the meeting are enclosed in [].

Please do not reproduce this text anywhere. If you must, please link to it from elsewhere. In particular, I would strongly object to your only reproducing a partial quote.

Macquarie Bank (MBL) and MIIF management
[In this section, please note that MBL and its infrastructure business has operated for 15 and 10 years respectively. So take the “history” part withthe necessary pinch of salt].

MBL and MIIF have to comply with the various regulators for the protection of investors. [In particular, MBL has multiple regulators (US, Aus, SG) todeal with, who may take an interest in MBL related activities even if the regulator is not directly involved].

Most importantly, MBL has been in business for some time. They certainly want their word to be important to and trusted by investors. In that sense, every time they do something they have to bear the larger business in mind. Many of the underlying funds of MIIF themselves have external shareholders and other regulators.

[I would treat this as an essentially self-regulatory mechanism for MBL and MIIF not to play too fast and loose with investors.]

Historically speaking, performance fees have been taken in script (shares) for all their funds. Certainly, any impact of performance fees on distributable income is an important input they have to consider if they ever want to take performance fees in cash.

They have taken the suggestion to be more clear, and accessible about management/performance fees and their calculations, including deficit calculations etc. I think this will be forthcoming.

Control over new acquisitions. Besides the need for investors to approve all new acquisitions, another control is the fact that there are 3 independent directors on the team who, with the assistance of a 3rd party advisor, get to evaluate any acquisition without any interference from MBL related parties or directors.

Transaction costs. One example brought up was the recent Tanquid transaction in which the transaction cost was >10% of the deal size. It was explained that over 50% of the cost was paid to independent 3rd parties for due diligence purposes (i.e. lawyers, valuers etc). They acknowledge that they could be clearer in differentiating the transaction costs. The independent directors mentioned above are also a point of control in managing transaction costs.

Use of derivatives or synthetic instruments to manage cash flow. Other than normal hedging to cover physical cash flow, they do not do anything to “manage” their cash flow.

Nature of Assets
Generally, before any acquisition is undertaken, they typically do a 20-30 year model of the business, including all possible expenses. Their valuation of the business to be purchased is based on this model. In other words, their model (at least within the 20-30 year period) takes into account any reasonably expected expenses [and interest rates, growth rates etc]. This has a bearing on the sustainability of the yield they project.[this portion was part of an answer to a question from me regarding interruptions to cash flow from capital expenses or other sources].

[They have released the analyst model spreadsheet to me. In that spreadsheet, they have projections up to as far as 2025 for leisureworld and 2031 forBrussels Airport for example]

Accounting rules generally require them to depreciate book value to zero within a certain period of time (e.g. 20 years) even though these assets may have useful life way beyond the time when their book value is reduced to zero. Many of their assets only need maintenance to carry on useful cash generating activity beyond their remaining book life. One example to use is the Leisureworld business. More on that below.

[I get the impression overall that they do not regard book value as important. Cash flow is more important.]

They generally acquire assets in which they expect the cash flow to gradually increase – barring any unexpected happenings. Even for risk to cash flow from debt, they are hedged to within several years against interest rate risks. As for renewal of debt, they do not anticipate other risks (such as decrease of credit standing) due to the nature of the businesses – i.e. they do not expect problems renewing debt other than those due to external market conditions over which they have no control.

[in other words, according to them, they generally expect cash flow earnings to be relatively stable and consistent and even to grow a little]

Accrual accounting and cash flows
Generally, I get the impression they think accrual accounting is not very appropriate for appreciating this type of business, though it is a regulatory requirement. i.e. the earnings statement may confuse people. They acknowledge they need to do better to communicate to help investors understand.

[They operate under rules which allow them to distribute available cash in excess of accounting earnings – which is similar to the way REITs andBusiness Trusts in SGX are regulated.]

See also the mention on depreciation in the previous section.

One suggestion given was that they publish a simple table or excel spreadsheet, showing the expected cash flows during the year (including from whom, when it is expected, worse and best cases). I think this was taken positively.*

One specific question raised was one that was first brought to my attention by tankie on the wallstraits forum (see this link). When raising funds for new equity, an “Offer Information Statement” dated 15th Nov 2005 was circulated. In it, the unconsolidated profit (ex. Non-recurring expenses, performance fees, and transaction costs) was published as 39.8 million. But the guidance was about 46 million dollars. It was explained that 39.8 million is based on accruals – income which has been declared by their assets. 46 million is based on their expectation of what they would receive. They can only include “declared” income in the profit forecast. A simple, illustrative example was given:

• Business owns 8 assets. 7 assets have declared their income.
• Business reports forecasted profits based on the 7 assets. But the expected cash flows would include the 8th asset.

Note that the suggestion given in the * paragraph of this section would help to resolve such issues.

Leisureworld Case Study
This was taken as a case study in order to look at in a little bit more detail. There is another thread in wallstraits forum which talks about leisureworld (see this link) in more detail. You may want to read it to understand this section better.

Book Value – why so small
A large part of their book value was under “intangibles” – CAN$37 million in net assets if you don’t include CAN$112 million in intangibles (bed licences, resident relationships, support contracts). The reported value of the 55% investment for MIIF is SGD165 million (i.e. the entire business is valued at about CAN$207 million).

2 relevant responses.

The intangibles represent long term contracts by the Canadian government to pay the business based on the occupied beds and activities on behalf of residents, of the business. While, in theory, these payments could vary, in practice (given aging population, unwillingness of government to increase beds unnecessarily) they are regarded as “practically guaranteed” [my words. The actual word used was “perpetual”. In other words, they do not regardthese contracts as being truly “intangible”]

Many of the physical assets are quite old, and their book value has already been largely written down by accounting treatment. However, in their view, these assets are still quite usable [see remarks earlier about depreciation] and represent value in excess of their reported book value [though inpractice, they can’t really easily realize these assets].

Cash Flow – why last years 2.5 mths was low
A significant part of the infrastructure of the business has been involved in upgrading works (no specific percentage was given at the meeting). Hence, the financial statements that were issued from mid Oct 2005 to end Dec 2005 may not reflect expected cash flows from the business going forward. [MIIF projects cash flow ex. fees from LW to be >11% of the invested value of SGD165million.]

Others
It was suggested that MIIF organize their web page to include links to all the financial statements and other reports of their assets. This was taken positively.

It was suggested that MIIF include on their web page, the market prices of their listed assets. It was noted by me in passing that MIC and a couple of other assets (all listed in the US) they own actually had trading yields of 6-7% – well below MIIF’s current trading yield.

Filed Under: Portfolio, Uncategorized

Richard Russell’s Wisdom: Rich Man Poor Man

July 9, 2006 by Kyith 7 Comments

Richard Russell has been writing and publishing the Dow Theory Letters since 1958, and never has he missed an issue! It is the longest newsletter service continuously published by one person in the investment business. Richard is now 80 years old, and writes an extremely popular daily e-letter, full of commentary on the markets and whatever interests him that day. He gets up at 3 am or so and starts his daily (massive) reading and finishes the letter just after the markets close. He is my business hero.

He was the first writer to recommend gold stocks in 1960. He called the top of the 1949-66 bull market, and called the bottom of the bear market in 1974 almost to the day, predicting a new bull market. (Think how tough it was to call for a bull market in late 1974, when things looked really miserable!) He was a bombardier in WWII, lived through the Depression, wars, and bull and bear markets. I would say that Russell is one of those true innate market geniuses that have simply forgotten more than most of us will ever know, except I am not certain he has forgotten anything. His daily letter is loaded with references and wisdom from the past and gives us a guide to the future. (You can learn more – and subscribe! – at www.dowtheoryletters.com.)


By Richard Russell

For the average investor, you and me, we’re not geniuses so we have to have a financial plan. In view of this, I offer below a few rules and a few thoughts on investing that we must be aware of if we are serious about making money.

I. The Power of Compounding

Rule 1: Compounding. One of the most important lessons for living in the modern world is that to survive you’ve got to have money. But to live (survive) happily, you must have love, health (mental and physical), freedom, intellectual stimulation — and money. When I taught my kids about money, the first thing I taught them was the use of the “money bible.” What’s the money bible? Simple, it’s a volume of the compounding interest tables.

Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately anybody can do it. To compound successfully you need the following: perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. You need knowledge of the mathematical tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road. And, of course, you need time, time to allow the power of compounding to work for you. Remember, compounding only works through time.

But there are two catches in the compounding process. The first is obvious — compounding may involve sacrifice (you can’t spend it and still save it). Second, compounding is boring — b-o-r-i-n-g. Or I should say it’s boring until (after seven or eight years) the money starts to pour in. Then, believe me, compounding becomes very interesting. In fact, it becomes downright fascinating!

In order to emphasize the power of compounding, I am including the following extraordinary study, courtesy of Market Logic, of Ft. Lauderdale, FL 33306.

In this study we assume that investor B opens an IRA at age 19. For seven consecutive periods he puts $2,000 into his IRA at an average growth rate of 10% (7% interest plus growth). After seven years this fellow makes NO MORE contributions — he’s finished.

A second investor, A, makes no contributions until age 26 (this is the age when investor B was finished with his contributions). Then A continues faithfully to contribute $2,000 every year until he’s 65 (at the same theoretical 10% rate).

Now study the incredible results. B, who made his contributions earlier and who made only seven contributions, ends up with MORE money than A, who made 40 contributions but at a LATER TIME. The difference in the two is that B had seven more early years of compounding than A. Those seven early years were worth more than all of A’s 33 additional contributions.

This is a study that I suggest you show to your kids. It’s a study I’ve lived by, and I can tell you, “It works.” You can work your compounding with muni-bonds, with a good money market fund, with T-bills, or say with five-year T-notes.

RULE 2: Don’t Lose Money.This may sound naive, but believe me it isn’t. If you want to be wealthy, you must not lose money; or I should say, you must not lose BIG money. Absurd rule, silly rule? Maybe, but MOST PEOPLE LOSE MONEY in disastrous investments, gambling, rotten business deals, greed, poor timing. Yes, after almost five decades of investing and talking to investors, I can tell you that most people definitely DO lose money, lose big-time — in the stock market, in options and futures, in real estate, in bad loans, in mindless gambling, and in their own businesses.

Rule 3: Rich Man, Poor Man.In the investment world the wealthy investor has one major advantage over the little guy, the stock market amateur, and the neophyte trader. The advantage that the wealthy investor enjoys is that HE DOESN’T NEED THE MARKETS. I can’t begin to tell you what a difference that makes, both in one’s mental attitude and in the way one actually handles one’s money.

The wealthy investor doesn’t need the markets, because he already has all the income he needs. He has money coming in via bonds, T-bills, money-market funds, stocks, and real estate. In other words, the wealthy investor never feels pressured to “make money” in the market.

The wealthy investor tends to be an expert on values. When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry or gold is on the “giveaway” table, he buys art or diamonds or gold. In other words, the wealthy investor puts his money where the great values are.

And if no outstanding values are available, the wealthy investors waits. He can afford to wait. He has money coming in daily, weekly, monthly. The wealthy investor knows what he is looking for, and he doesn’t mind waiting months or even years for his next investment (they call that patience).

But what about the little guy? This fellow always feels pressured to “make money.” And in return he’s always pressuring the market to “do something” for him. But sadly, the market isn’t interested. When the little guy isn’t buying stocks offering 1% or 2% yields, he’s off to Las Vegas or Atlantic City trying to beat the house at roulette. Or he’s spending 20 bucks a week on lottery tickets, or he’s “investing” in some crackpot scheme that his neighbor told him about (in strictest confidence, of course).

And because the little guy is trying to force the market to do something for him, he’s a guaranteed loser. The little guy doesn’t understand values, so he constantly overpays. He doesn’t comprehend the power of compounding, and he doesn’t understand money. He’s never heard the adage, “He who understands interest, earns it. He who doesn’t understand interest, pays it.” The little guy is the typical American, and he’s deeply in debt.

The little guy is in hock up to his ears. As a result, he’s always sweating — sweating to make payments on his house, his refrigerator, his car, or his lawn mower. He’s impatient, and he feels perpetually put upon. He tells himself that he has to make money — fast. And he dreams of those “big, juicy mega-bucks.” In the end, the little guy wastes his money in the market, or he loses his money gambling, or he dribbles it away on senseless schemes. In short, this “money-nerd” spends his life dashing up the financial down escalator.

But here’s the ironic part of it. If, from the beginning, the little guy had adopted a strict policy of never spending more than he made, if he had taken his extra savings and compounded it in intelligent, income-producing securities, then in due time he’d have money coming in daily, weekly, monthly, just like the rich man. The little guy would have become a financial winner, instead of a pathetic loser.

Rule 4: Values. The only time the average investor should stray outside the basic compounding system is when a given market offers outstanding value. I judge an investment to be a great value when it offers (a) safety, (b) an attractive return, and (c) a good chance of appreciating in price. At all other times, the compounding route is safer and probably a lot more profitable, at least in the long run.

II. Time

TIME: Here’s something they won’t tell you at your local brokerage office or in the “How to Beat the Market” books. All investing and speculation is basically an exercise in attempting to beat time.

“Russell, what are you talking about?”

Just what I said — when you try to pick the winning stock or when you try to sell out near the top of a bull market or when you try in-and-out trading, you may not realize it but what you’re doing is trying to beat time.

Time is the single most valuable asset you can ever have in your investment arsenal. The problem is that none of us has enough of it.

But let’s indulge in a bit of fantasy. Let’s say you have 200 years to live, 200 years in which to invest. Here’s what you could do. You could buy $20,000 worth of municipal bonds yielding, say, 5.5%.

At 5.5% money doubles in 13 years. So here’s your plan: each time your money doubles you add another $10,000. So at the end of 13 years you have $40,000 plus the $10,000 you’ve added, meaning that at the end of 13 years you have $50,000.

At the end of the next 13 years you have $100,000, you add $10,000, and then you have $110,000. You reinvest it all in 5.5% munis, and at the end of the next 13 years you have $220,000 and you add $10,000, making it $230,000.

At the end of the next 13 years you have $460,000 and you add $10,000, making it $470,000.

In 200 years there are 15.3 doubles. You do the math. By the end of the 200th year you wouldn’t know what to do with all your money. It would be coming out of your ears. And all with minimum risk.

So with enough time, you would be rich — guaranteed. You wouldn’t have to waste any time picking the right stock or the right group or the right mutual fund. You would just compound your way to riches, using your greatest asset: time.

There’s only one problem: in the real world you’re not going to live 200 years. But if you start young enough or if you start your kids early, you or they might have anywhere from 30 to 60 years of time ahead of you.

Because most people have run out of time, they spend endless hours and nervous energy trying to beat time, which, by the way, is really what investing is all about. Pick a stock that advances from 3 to 100, and if you’ve put enough money in that stock you’ll have beaten time. Or join a company that gives you a million options, and your option moves up from 3 to 25 and again you’ve beaten time.

How about this real example of beating time. John Walter joined AT&T, but after nine short months he was out of a job. The complaint was that Walter “lacked intellectual leadership.” Walter got $26 million for that little stint in a severance package. That’s what you call really beating time. Of course, a few of us might have another word for it — and for AT&T.

III. Hope

HOPE: It’s human nature to be optimistic. It’s human nature to hope. Furthermore, hope is a component of a healthy state of mind. Hope is the opposite of negativity. Negativity in life can lead to anger, disappointment, and depression. After all, if the world is a negative place, what’s the point of living in it? To be negative is to be anti-life.

Ironically, it doesn’t work that way in the stock market. In the stock market hope is a hindrence, not a help. Once you take a position in a stock, you obviously want that stock to advance. But if the stock you bought is a real value, and you bought it right, you should be content to sit with that stock in the knowledge that over time its value will out without your help, without your hoping.

So in the case of this stock, you have value on your side — and all you need is patience. In the end, your patience will pay off with a higher price for your stock. Hope shouldn’t play any part in this process. You don’t need hope, because you bought the stock when it was a great value, and you bought it at the right time.

Any time you find yourself hoping in this business, the odds are that you are on the wrong path — or that you did something stupid that should be corrected.

Unfortunately, hope is a money-loser in the investment business. This is counterintuitive but true. Hope will keep you riding a stock that is headed down. Hope will keep you from taking a small loss and, instead, allow that small loss to develop into a large loss.

In the stock market hope gets in the way of reality, hope gets in the way of common sense. One of the first rules in investing is “don’t take the big loss.” In order to do that, you’ve got to be willing to take a small loss.

If the stock market turns bearish, and you’re staying put with your whole position, and you’re HOPING that what you see is not really happening — then welcome to poverty city. In this situation, all your hoping isn’t going to save you or make you a penny. In fact, in this situation hope is the devil that bids you to sit — while your portfolio of stocks goes down the drain.

In the investing business my suggestion is that you avoid hope. Forget the siren, hope; instead, embrace cold, clear reality.

IV. Acting

ACTING: A few days ago a young subscriber asked me, “Russell, you’ve been dealing with the markets since the late 1940s. This is a strange question, but what is the most important lesson you’ve learned in all that time?”

I didn’t have to think too long. I told him, “The most important lesson I’ve learned comes from something Freud said. He said, ‘Thinking is rehearsing.’ What Freud meant was that thinking is no substitute for acting. In this world, in investing, in any field, there is no substitute for taking action.”

This brings up another story which illustrates the same theme. J.P. Morgan was “Master of the Universe” back in the 1920s. One day a young man came up to Morgan and said, “Mr. Morgan, I’m sorry to bother you, but I own some stocks that have been acting poorly, and I’m very anxious about these stocks. In fact worrying about those stocks is starting to ruin my health. Yet, I still like the stocks. It’s a terrible dilemma. What do you think I should do, sir?”

Without hesitating Morgan said, “Young man, sell to the sleeping point.”

The lesson is the same. There’s no substitute for acting. In the business of investing or the business of life, thinking is not going to do it for you. Thinking is just rehearsing. You must learn to act.

That’s the single most important lesson that I’ve learned in this business.

Again, and I’ve written about this episode before, a very wealthy and successful investor once said to me, “Russell, do you know why stockbrokers never become rich in this business?”

I confessed that I didn’t know. He explained, “They don’t get rich because they never believe their own bullshit.”

Again, it’s the same lesson. If you want to make money (or get rich) in a bull market, thinking and talking isn’t going to do it. You’ve got to buy stocks. Brokers never do that. Do you know one broker who has?

A painful lesson: Back in 1991 when we had a perfect opportunity, we could have ended Saddam Hussein’s career, and we could have done it with ease. But those in command, for political reasons, didn’t want to face the adverse publicity of taking additional US casualties. So we stopped short, and Saddam was home free. We were afraid to act. And now we’re dealing with that failure to act with another and messier war.

In my own life many of the mistakes I’ve made have come because I forgot or ignored the “acting lesson.” Thinking is rehearsing, and I was rehearsing instead of acting. Bad marriages, bad investments, lost opportunities, bad business decisions — all made worse because we fail for any number of reasons to act.

The reasons to act are almost always better than the reasons you can think up not to act. If you, my dear readers, can understand the meaning of what is expressed in this one sentence, then believe me, you’ve learned a most valuable lesson. It’s a lesson that has saved my life many times. And I mean literally, it’s a lesson that has saved my life.

Filed Under: Investment Advice, Money Management, Richard Russell Tagged With: bear market, bear markets, bible, bombardier, bull and bear, Compounding, compounding interest, depression, dow theory letters, geniuses, gold stocks, hero, intellectual stimulation, investment business, investor, kids money, make money, newsletter service, physical freedom, Rich Man Poor Man, Richard Russell, rule 1, wisdom

The Limits To Learning

July 9, 2006 by Kyith Leave a Comment

By James Montier

Everybody thinks they are experts at learning. After all, most of us have gone through years of university education and emerged on the other side with a piece of paper ‘proving’ our ability to assimilate information. However, I’m not concerned with book learning; I am far more interested in learning from our own errors and mistakes or, somewhat more accurately, why we often fail to learn from our own past failures.

But first I ought to present just a couple of examples of the evidence we have of people not learning from past mistakes. The first comes form the work of Max Bazerman of Harvard. He regularly asks people the following question:

You will represent Company A (the potential acquirer), which is currently considering acquiring Company T (the target) by means of a tender offer. The main complication is this: the value of Company T depends directly on the outcome of a major oil exploration project that it is current undertaking. If the project fails, the company under current management will be worth nothing ($0). But if the project succeeds, the value of the company under current management could be as high as $100 per share. All share values between $0 and $100 are considered equally likely.

By all estimates, Company T will be worth considerably more in the hands of Company A than under current management. In fact, the company will be worth 50 percent more under the management of A than under the management of Company T. If the project fails, the company will be worth zero under either management. If the exploration generates a $50 per share value, the value under Company A will be $75. Similarly, a $100 per share under Company T implies a $150 value under Company A, and so on.

It should be noted that the only possible option to be considered is paying in cash for acquiring 100 percent of Company T’s shares. This means that if you acquire Company T, its current management will no longer have any shares in the company, and therefore will not benefit in any way from the increase in its value under your management.

The board of directors of Company A has asked you to determine whether or not to submit an offer for acquiring company T’s shares, and if so, what price they should offer for these shares.

This offer must be made now, before the outcome of the drilling project is known. Company T will accept any offer from Company A, provided it is at a profitable price for them. It is also clear that Company T will delay its decision to accept or reject your bid until the results of the drilling project are in. Thus you (Company A) will not know the results of the exploration project when submitting your price offer, but Company T will know the results when deciding on your offer. As already explained, Company T is expected to accept any offer by Company A that is greater than the (per share) value of the company under current management, and to reject any offers that are below or equal to this value. Thus, if you offer $60 per share, for example, Company T will accept if the value under current management is anything less than $60. You are now requested to give advice to the representative of Company A who is deliberating over whether or not to submit an offer for acquiring Company T’s shares, and if so, what price he/she should offer for these shares. If your advice is that he/she should not to acquire Company T’s shares, advise him/her to offer $0 per share. If you think that he/she should try to acquire Company T’s shares, advise him/her to offer anything between $1 to $150 per share. What is the offer that he/she should make? In other words, what is the optimal offer?

The correct answer is zero. The reasoning is as follows: Suppose the acquirer offers $60. From the above we know that all points are equally likely, so by offering $60, Company T is assumed on average to be worth $30. Given that the company is worth 50% more to the acquirer, the acquirer’s expected value is 1.5*$30 = $45. So a bid of $60 has a negative expected value. Any positive offer has a negative expected value, so the acquirer is better off making no offer.

In contrast to this rational logic, the overwhelming majority of responses fall in the range $50-$75. The ‘logic’ behind this is that on average the company must be worth $50, thus be worth $75 to the acquirer, so any price in this range is mutually beneficial. However, this ignores the rules of the game. Most obviously, the target can await the result of the exploration before accepting or rejecting, and the target will only accept offers that provide a profit.

The first chart below shows 20 rounds of the game. Across twenty rounds, there is no obvious trend indicating that participants learned the correct response. In fact, Ball et al find that only five of the seventy-two participants (MBA students from a top university) learned over the course of the game.

The second chart shows the results over a 1000 rounds of the game from a study by Grosskopf and Bereby-Meyer. Players didn’t learn from hundreds and hundreds of rounds!

The second example of a failure to learn comes from a simple investment game devised by Bechara et al. Each player was given $20. They had to make a decision on each round of the game: invest $1 or not invest. If the decision was not to invest, the task advanced to the next round. If the decision was to invest, players would hand over one dollar to the experimenter. The experimenter would then toss a coin in view of the players. If the outcome was heads, the player lost the dollar. If the outcome landed tails up then $2.50 was added to the player’s account. The task would then move to the next round. Overall, 20 rounds were played.

The chart below shows there was no evidence of learning as the game went on. If players learnt over time, they would have worked out that it was optimal to invest in all rounds. However, as the game went on, so, fewer and fewer players continued: they were actually becoming worse as time went on!
I’m sure you can think back and remember many mistakes that you should have learnt from, but didn’t (or perhaps I shouldn’t judge everybody by my standards). The above is merely setting the scene for our discussion over why people fail to learn. It is the impediments to learning that we now turn our attention towards.

The major reason we don’t learn from our mistakes (or the mistakes of others) is that we simply don’t recognise them as such. We have a gamut of mental devices all set up to protect us from the terrible truth that we regularly make mistakes.

Self attribution bias: heads is skill, tails is bad luck

We have a relatively fragile sense of self-esteem; one of the key mechanisms for protecting this self image is self-attribution bias. This is the tendency for good outcomes to be attributed to skill and bad outcomes to be attributed to sheer bad luck. This is one of the key limits to learning that investors are likely to encounter. This mechanism prevents us from recognizing mistakes as mistakes, and hence often prevents us from learning from those past errors.

You can’t have helped but notice that the football world cup is under way at the moment. Personally I can’t stand the sport, but it might just be worth listening to the post match analysis to see how many examples of self attribution one can find.

Lau and Russell examined some 33 major sporting events during the autumn of 1977. Explanations of performance were gathered from eight daily newspapers, giving a total of 594 explanations. Each explanation was measured in terms whether it referred to an internal (something related to the team’s abilities) or external factor (such as a bad referee).

Unsurprisingly, self attribution was prevalent. 75% of the time following a win, an internal attribution was made (i.e. the result of skill); whereas only 55% of the time following a loss was an internal attribution made.

The bias was even more evident when the explanations were further categorized as coming from either a player/coach or a sportswriter. Players and coaches attributed their success to an internal factor over 80% of the time. However, internal factors were blamed only 53% of the time following losses. Sportswriters attributed wins to internal factors 70% of the time when it was their home team, and 57% of the time when their home team lost.

The expected outcome of the game had no impact on the post match explanations that were offered. Even when one team was widely expected to thrash the other, the attributions of the winners referred to internal factors around 80% of the time, and the attributions of the losers referred to an internal factor 63% of the time.

To combat the pervasive problem of self attribution we really need to keep a written record of the decisions we take and the reasons behind those decisions. We then need to map those into a quadrant diagram like the one shown below. That is, was I right for the right reason? (I can claim some skill, it could still be luck, but at least I can claim skill), or was I right for some spurious reason? (In which case I will keep the result because it makes the portfolios look good, but I shouldn’t fool myself into thinking that I really knew what I was doing). Was I wrong for the wrong reason? (I made a mistake and I need to learn from it), or was I wrong for the right reason? (After all, bad luck does occur). Only by cross-referencing our decisions and the reasons for those decisions with the outcomes, can we hope to understand when we are lucky and when we have used genuine skill.

Hindsight bias: I knew it all along

One of the reasons I suggest that people keep a written record of their decisions and the reasons behind their decisions, is that if they don’t, they run the risk of suffering from the insidious hindsight bias. This simply refers to the idea that once we know the outcome we tend to think we knew it was so all along.

The best example of this from the investment world is probably the bubble in TMT in the late 1990s. Those who were going around telling people it was a bubble were treated as cretins. However, today there seems to have been an Orwellian re-writing of history, so everyone now thinks they knew it was a bubble (even though they were fully invested at the time).

Barach Fischhoff first noted this strong tendency in 1975. He gave students descriptions of the British occupation of India and problems of the Gurkas of Nepal. In 1814, Hastings (the governor-general) decided that he had to deal with the Gurkas once and for all. The campaign was far from glorious. The troops suffered in the extreme conditions, and the Gurkas were skilled at guerrilla style warfare and few in number, offering little chance for full-scale engagements. The British learned caution only after several defeats.

Having read a much longer version of the above, Fischhoff asked one group to assign probabilities to each of the four outcomes: (i) British victory, (ii) Gurka victory, (iii) military stalemate without a peace settlement, (iv) military stalemate with a peace settlement.

With the other four groups, Fischhoff provided the ‘true’ outcome, except that three of the four groups received a false ‘true’ outcome. Again these groups were asked to assign probabilities to each of the outcomes.

The results are shown in the chart below. The hindsight bias is clear from even a cursory glance at the chart. All the groups who were told their outcome was true assigned it a much higher probability than the group without the outcome information. In fact, there was a 17 percentage point increase in the probability assigned once the outcome was known! That is to say, none of the groups were capable of ignoring the ex post outcome in their decision making.

Hindsight is yet another bias that prevents us from recognising our mistakes. It has been repeatedly found that simply telling people about hindsight and extolling them to avoid it has very little impact on our susceptibility. Rather Slovic and Fischhoff found that the best mechanism for fighting hindsight bias was to get people to explicitly think about the counterfactuals: what didn’t occur and what could have lead to an alternative outcome? In experiments, Slovic and Fischhoff found that hindsight was still present when this was done, but it was much reduced.

Skinner’s pigeons

An additional problem stems from the fact that our world is probabilistic. That is to say, we live in an uncertain world where cause and effect are not always transparent. However, we often fail to accept this fundamental aspect of our existence. Way back in 1947, B.F. Skinner was exploring the behaviour of pigeons. Skinner was the leader of a school of psychology known as behaviouralism, which held that psychologists should study only observable behaviour, not concern themselves with the imponderables of the mind.

Skinner’s theory was based around operant conditioning. As Skinner wrote, “The behavior is followed by a consequence, and the nature of the consequence modifies the organism’s tendency to repeat the behavior in the future.” A more concrete example may be useful here.

One of Skinners favourite subjects was pigeons. Skinner placed a series of hungry pigeons in a cage attached to an automatic mechanism that delivered food to the pigeon “at regular intervals with no reference whatsoever to the bird’s behaviour”. He discovered that the pigeons associated the delivery of the food with whatever chance actions they had been performing as it was delivered, and that they continued to perform the same actions:

One bird was conditioned to turn counter-clockwise about the cage, making two or three turns between reinforcements. Another repeatedly thrust its head into one of the upper corners of the cage. A third developed a ‘tossing’ response, as if placing its head beneath an invisible bar and lifting it repeatedly. Two birds developed a pendulum motion of the head and body, in which the head was extended forward and swung from right to left with a sharp movement followed by a somewhat slower return. (Superstition in the Pigeon, B.F. Skinner, Journal of Experimental Psychology 38, 1947)

Skinner suggested that the pigeons believed that they were influencing the automatic mechanism with their “rituals” and that the experiment also shed light on human behaviour:

The experiment might be said to demonstrate a sort of superstition. The bird behaves as if there were a causal relation between its behavior and the presentation of food, although such a relation is lacking. There are many analogies in human behavior. Rituals for changing one’s fortune at cards are good examples. A few accidental connections between a ritual and favorable consequences suffice to set up and maintain the behavior in spite of many unreinforced instances. The bowler who has released a ball down the alley but continues to behave as if she were controlling it by twisting and turning her arm and shoulder is another case in point. These behaviors have, of course, no real effect upon one’s luck or upon a ball halfway down an alley, just as in the present case the food would appear as often if the pigeon did nothing – or, more strictly speaking, did something else. (Ibid.)

Indeed, some experiments by Ono in 1987 showed that Skinner’s findings were applicable to humans. He placed humans into the equivalent of Skinner boxes: rooms with a counting machine to score points, a signal light and three boxes with levers. The instructions were simple:

You may not leave the experimental booth… during the experiment. The experimenter doesn’t require you to do anything specific. But if you do something, you may get points on the counter. Try to get as many points as possible.

In fact, participants would receive points on either a fixed time interval or a variable time interval. Nothing they did could have influenced the outcome in terms of points awarded. However, Ono recorded some pretty odd behaviour. Several subjects developed “persistent idiosyncratic and stereotyped superstitious behaviour”. Effectively they began to try and find patterns to behaviour, such as pulling the left lever four times, and then the right lever twice, and the middle lever once.

My favourite behaviour was displayed by one young lady in Ono’s study. He records, “A point was delivered just as she jumped to the floor (from the table)… after about five jumps, a point was delivered when she jumped and touched the ceiling with her slipper in her hand. Jumping to touch the ceiling continued repeatedly and was followed by more points until she stopped about 25 minutes into the session, perhaps because of fatigue.”

Could it be that investors are like Skinner’s pigeons, drawing lessons by observing the world’s response to their actions? It is certainly possible. The basic failure with the pigeons and Ono’s human experiments is that they only look at the positive concurrences, rather than looking at the percentage of the times the strategy paid off, relative to all the times they tried.

Illusion of control

We love to be in control. We generally hate the feeling of not being able to influence the outcome of an event. It is probably this control freak aspect of our nature that leads to us to behave like Skinner’s pigeons. My favourite example of the illusion of control concerns lottery tickets from the classic paper by Langer8. She asked some people to choose their own lottery numbers, whilst others were just given a random assignment of numbers. Those who chose their own numbers wanted an average $9 to give the ticket up. Those who received a random assignment/lucky dip lottery ticket wanted only $2!

Another great example comes from Langer and Roth. Subjects were asked to predict the outcome of 30 coin tosses. In reality, the accuracy of the participants was rigged so that everyone guessed correctly in 15 of the trials, but roughly one-third of the subjects began by doing very well (guessing correctly on the first four tosses), one-third began very badly, and one-third met with random success. After the 30 tosses, people were asked to rate their performance. Those who started well, rated themselves as considerably better at guessing the outcomes than those who started badly.

In their analysis of a wide range of illusion of control studies, Presson and Benassi summarize that the illusion is more likely when lots of choices are available, you have early success at the task (as per above), the task you are undertaking is familiar to you, the amount of information available is high, and you have personal involvement. Large portfolios, high turnover and short time horizons all seem to be the financial equivalents of conditions that Presson and Benassi outline. Little wonder that the illusion of control bedevils our industry.

Feedback distortion

Not only are we prone to behave like Skinner’s pigeons but we also know how to reach the conclusions we want to find (known as ‘motivated reasoning’ amongst psychologists). For instance, if we jump on the bathroom scales in the morning, and they give us a reading that we don’t like, we tend to get off and have another go (just to make sure we weren’t standing in an odd fashion11). However, if the scales have delivered a number under our expectations, we would have hopped off the scales into the shower, feeling very good about life.

Strangely enough, we see exactly the same sort of behaviour in other areas of life. Ditto and Lopez12 set up a clever experiment to examine just such behaviour. Participants were told that they would be tested for the presence of TAA enzyme. Some were told that the TAA enzyme was beneficial (i.e. “people who are TAA positive are 10 times less likely to experience pancreatic disease than are people whose secretory fluids don’t contain TAA”), others were told TAA was harmful (“10 times more likely to suffer pancreatic disease”).

Half of the subjects in the experiment were asked to fill out a set of questions before they took the test, the other half were asked to fill out the questions after the test. In particular two questions were important. The first stated that several factors (such a lack of sleep) may impact the test, and participants were asked to list any such factors that they had experienced in the week before the test. The other question asked participants to rate the accuracy of the TAA enzyme test on a scale of 0 to 10 (with 10 being a perfect test).

The charts below show the results that Ditto and Lopez uncovered. In both questions there was little difference in the answers offered by those who were told having the TAA enzyme was healthy and those who were told it was unhealthy provided they were asked before they were given the result. However, massive differences were observed once the results were given.

Those who were told the enzyme was healthy and answered the questions after they had received the test results, gave less life irregularities and thought the test was better than those who answered the questions before they knew the test result.

Similarly, those who were told the enzyme was unhealthy and answered the questions after the test results, provided considerably more life irregularities and thought the test was less reliable than those who answered before knowing the test result. Both groups behaved exactly as we do on the scales in the bathroom. Thus, we seem to be very good at accepting feedback that we want to hear while not only ignoring, but actively arguing against, feedback that we don’t want to hear.

Interestingly, Westen et al found that such motivated reasoning is associated with parts of the brain that control emotion, rather than logic (the x-system, rather than the csystem, for those who have attended one of my behavioural teach-ins). Committed Democrats and Republicans were shown statements from both Bush and Kerry and a neutral person. Then a contradictory piece of behaviour was shown, illustrating a gap between the rhetoric of the candidates and their actions. Participants were asked to rate how contradictory the words and deeds were (on a scale of 1 to 4). An exculpatory statement was then provided, giving some explanation as to why the mismatch between words and deeds occurred, and finally participants were asked to rate whether the mismatch now seemed so bad in the light of the exculpatory statement.

Strangely enough, the Republicans thought that the Bush contradiction was far milder than the Democrats, and vice versa when considering the Kerry contradiction. Similar findings were reported for the question on whether the exculpatory statement mitigated the mismatched words and deeds.

Westen et al found that the neural correlates of motivated reasoning where associated with parts of the brain known to be used in the processing of emotional activity rather than logical analysis. They note “Neural information processing related to motivated reasoning appears to be qualitatively different from reasoning in the absence of a strong emotional stake in the conclusions reached.”

Furthermore, Westen et al found that after the emotional conflict of the contradiction has been resolved a burst of activity in one of the brain’s pleasure centres can be observed (the ventral striatum). That is to say, the brain rewards itself once an emotionally consistent outcome has been reached. Westen et al conclude “The combination of reduced negative affect… and increased positive affect or reward… once subjects had ample time to reach biased conclusions, suggests why motivated judgments may be so difficult to change (i.e. they are doubly reinforcing).”

Conclusions

Experience is a dear teacher – Benjamin Franklin

Experience is a good teacher, but she sends in terrific bills – Minna Antrim

Experience is the name that everyone gives their mistakes – Oscar Wilde

We have outlined four major hurdles when it comes to learning from our own mistakes. Firstly, we often fail to recognize our mistakes because we attribute them to bad luck rather than poor decision making. Secondly, when we are looking back, we often can’t separate what we believed beforehand from what we now know. Thirdly, thanks to the illusion of control, we often end up assuming outcomes are the result of our actions. Finally, we are adept at distorting the feedback we do receive, so that it fits into our own view of our abilities.

Some of these behavioural problems can be countered by keeping written records of decisions and the ‘logic’ behind those decisions. But this requires discipline and a willingness to re-examine our past decisions. Psychologists have found that it takes far more information about mistakes than it should do, to get us to change our minds.

As Ward Edwards notes:

An abundance of research has shown that human beings are conservative processors of fallible information. Such experiments compare human behaviour with the outputs of Bayes’s theorem, the formal optimal rule about how opinions… should be revised on the basis of new information. It turns out that opinion change is very orderly, and usually proportional to numbers calculated from Bayes’s theorem – but it is insufficient in amount. A convenient first approximation to the data would say that it takes anywhere from two to five observations to do one observations’ worth of work in inducing a subject to change his opinion.

So little wonder that learning from past mistakes is a difficult process. However, as always, being aware of the potential problems is a first step to guarding against them.

Filed Under: Richard Russell

Make your Investment Returns Take Off

July 9, 2006 by Kyith Leave a Comment

by Bryan Kelleher

The point of investing your hard-earned capital is to attain a lot more money in the future by giving up the enjoyment and use of your cash today.

You want your returns to soar like a jet plane.

But think about how much work goes into pre-flight planning. The ground crew maintains and inspects all mechanical systems. Air traffic controllers make certain all routes are clear. The pilot consults his checklist of procedures that must be completed before take-off. Great amounts of time and resources are spent to keep airline passengers as safe as possible.

In the same way, investors should develop a mental safety checklist before making serious investments in the stock market.

This is why Warren Buffett says that the first rule of investing is never to lose money and the second rule is never to forget rule number one.

The math is simple: if you lose 50% on an investment, you must gain 100% to reach your breakeven level. Another interesting mathematical truth is to look at the performance of two portfolios:

Portfolio A: $1,000 invested, compounding at 8% per year for 4 Years would result in an account balance of $1,360.

Portfolio B: $1,000 invested, compounding at 15% for 3 years, and then losing 15% in the fourth year would result in an account balance of $1,293.

The point is that you want to avoid losses as much as possible.

Sometimes investors tend to emphasize their anticipated returns over all other factors. They get so excited and enamored with sell side analyst opinions and company projections that they often fail to consider all of the problems that can occur with stocks. Buffett has stated that investors would be well advised to pay more attention to credit analysts than sell side analysts.

You cannot control how much your stocks make. But you can control the risks you take when making stock picks.

What are you to do?

As Charles Munger has stated on several occasions:” Invert, always invert.” Instead of thinking about the upside of your investments, you should emphasize the downside that can beset your stocks. The internet bubble of the late 1990’s taught us all powerful lessons about what can happen when focus is applied to promised returns as opposed to all the things that can go wrong. A lot of portfolios crashed and burned.

Just as an airline pilot, most of your efforts and preparation should be directed at avoiding mistakes.

Businesses and markets are competitive and unpredictable. Investors that have prepared for worst-case scenarios, and have not paid too much for their investments will fare the best when inevitable setbacks happen.

Successful investors have developed the skills to assess the financial strength of the companies they have invested in. How much cash does a company have? How much debt does the company carry? Is the company using strange techniques to get debts off the balance sheet?

Next, as an investor, you need to assess a floor value of an investment. You need a method of calculating a “worst case scenario”. If the company were to fall on hard times, or if the stock market goes south, what would the company trade for? An adjusted book value – (tangible assets less all liabilities) would be a good place to start. By focusing on this number, you will get an idea how far a current price of a stock could fall. If you identify an investment where this number is not too far from the current market price, you might have an interesting stock investment idea.

Your final analysis should be to measure the true or intrinsic worth of the security you are considering. Remember, stocks are not just pieces of paper that float around day to day based on nothing. Stocks are actual assets that represent claims to assets that throw off real cash at some point. Companies pay dividends, buyback their shares, merge, reorganize or liquidate. Your job is to estimate the fair value of these future cash flows.

Since you can’t possibly know with certainty the exact value of a company, the key to being successful is to use conservative values and compare these values with the current price of the security in question. Your aim is to find companies with upside potential that are trading near the floor level you have established, and are trading below what you believe is the real intrinsic worth of the company.

You can generate a lot of investment ideas by looking at what the investment masters are doing right here at Gurufocus.com. They are buying fallen angels like Dell and Pfizer.

Often this approach will take you to unpopular or out-of-favor companies. You just have to do more homework than the average investor, and once you arrive at logical conclusions, stick to your assessments.

These steps will not only ensure that you will not overpay for a stock, but they also have the effect of magnifying your returns if the gap between the current market price and intrinsic value narrows. If the intrinsic value of the company also grows, and the market value eventually follows – this is when investment returns soar.

Remember: Before taking off, ask yourself how safe your investments are.

Filed Under: Uncategorized

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