Wednesday, July 25, 2018

Value Investing Is Really Like Cave Diving

About 18 months ago, we discussed that value investing could be compared to riding a bicycle up a Finnish mountain. It was a really stretched analogy that was perhaps too difficult for most people to understand. Two weeks ago, the successful rescue of 13 Thai boys trapped in a cave caught the world's and my attention. As with many others, I followed the saga closely. I was woefully saddened when one of the rescuer died and jubilantly rejoiced when they were finally saved! It was truly a triumph for human innovation and a story worthy for Hollywood!

It also opened up my mind to the world of cave diving. This is really an extreme sport that is only suitable for the most courageous as simple mistakes could result in life-and-death situations. Cave diving rescue by extension goes beyond the realm of difficult tasks. It's crazily arduous as we had seen. To rescue the 13 boys, hundreds of people were involved. There were 90 divers, a team of pumpers to pump and drain the water out of the caves round the clock, 24 by 7. 

The logistics people numbered in the hundreds, chefs cooking, doing the laundry, ushers, volunteers and all the unsung heroes, including farmers who allowed the cave water to flood their lands, destroying their crops. They do it because lives are at stake, they needed to beat the clock and the odds to get the boys out alive.

Cave diving and rescue: treacherous operation!

The whole operation was akin to an investing firm, also usually with a few hundred people, asked to generate above average returns to beat the market. Most professional investors fail. They do well in a year or two, only to falter and then forgotten. Rarely we see an investment operation succeed for decades. Hence Warren Buffett, with his 50 odd years of track record is revered and adored not just by other investors but by everyone.

Cave diving, in my mind, is really analogous to practising value investing. It is not easy to appreciate how tough it is. We know it's not a walk in the park but most people certainly don't think it's rocket science. But the truth is, it's almost as tough as rocket science but in a different sense. Cave diving and investing requires a different mentality - taming our minds and most people fail to appreciate that. In cave diving, bad moves result in death. In investing, it's permanent loss of wealth, sometimes, a lot of wealth. The other important learning point: mediation helps in both! The boys meditated for days so that panic did not seize them while they waited for help.

As we had seen in the previous analogy about riding up a mountain, investing requires experience, technical skills and most importantly dealing with uncertainty. The CG above depicted how treacherous the path was from the cave entrance to the boys' location. To some extent, it looked like a stock price chart! Value investing by individuals is no less treacherous in a few ways. Here's the few aspects that we ought to discuss: 

1. Technical Skills: Math and Science
2. Experience and Real Training
3. Navigating in Darkness
4. Build in Contingencies

Investing usually starts with technical skills. I recall how sessions with students interested in investing always involve Excel and modelling. They are very keen to build the most sophisticated models, learn all the intricacies about Black-Scholes, the math and science behind it all. Unfortunately, the stock price wouldn't know how you modelled the firm. 99.9% of the time, the revenue forecast would not match reality. While I don't do cave diving, I believe the theory and technical skills behind would be very important. You need to know scuba diving basics. You need to understand decompression risk. You need to know geology and physics. You need to do your math well, don't get the oxygen content wrong. Because the cave would not care if you don't have enough oxygen. 

Cave Diving = University Math

It is said that scuba diving and cave diving is like primary school math vs university math. Cave diving is no child's play. You need to be proficient to be in the game. In cave diving, there are high risks of getting decompression sickness. This is caused by nitrogen bubbles going into the divers' bloodstream as a result of mismanaged pressure changes with the oxygen tanks. This requires careful calibration. Decompression sickness can result in deathInvesting is not very different, you don't need university math but you do need to know accounting, corporate finance, efficient market theory, equity and bond analysis well enough. Yes, those Excel modelling is important, but it's the building block for something more. It's also all about calibration.

Calibration requires experience. Cave diving and investing is therefore a lot about experience. It cannot be taught in classrooms. After we learnt all the technical skills, we need to apply them correctly in the field. Every cave is different. Some are more treacherous than others and you never know how the conditions will change. Most of the time, visibility is very poor. Caves are dark places. You can use torches but sometimes the water turns muddy! Imagine that!

Real investing also cannot be taught (as with riding a bicycle). You must experience it. You also cannot see the future. You will never know which way the stock would go from today's price. When someone buys his first stock, watching it fall 30% and then panic. That's the experience we are talking about! So always start small with stable names. For every 10 stocks we choose to buy, 4 to 5 would go south, or not make our desired return! That's the best hit rate for most professional investors.

Since we cannot see the future or the cave tunnels clearly in front of us. We have to move slowly and be very prudent. Know the risks well. Never bet the house. Build in contingencies. In investing, we need our margin of safety. This is the most important thing according to the grandfather of value investing - Ben Graham. It means we only buy if the gap between the stock price and the actual value is really, really huge. We want to buy something we think is worth a dollar with 60 cents.

Cave diving contingencies

Navigating the markets and navigating dark caves also share many similarities. The diagram above does look even more like a stock price chart right? If  you are going into a new cave for the first time, you will not know what lies ahead. When there is a fork, you would have no idea which route would lead you forward. You wouldn't know where the water table levels off and you get back to dry land again. You wouldn't know how much oxygen you have in the cave and how long you can take off your mask. In the same vein, when we are investing in the markets, we have no certainty about where the stock will go, where oil price will be next month, or what is the earnings or the GDP numbers next quarter. 

Talking heads are forever predicting. They talk as if they know for sure what the future would be. The truth is, like navigating new cave terrain, nobody has any idea. If people claim they knew, avoid them like the plague. It is also like the weather. Can you say whether it will rain or shine next week? For weather, we now have the technology to predict a week or two in advance, but in the markets unfortunately, there is no way to know, unless you are an insider. But we do know that quality stocks compound over time. These are great companies with strong business moats and strong track records that had proven themselves. Value investing is about identifying these companies.

Since we cannot predict the future. We have to prepare well. This means building in contingencies. In cave diving, it's about having guide ropes and extra oxygen tanks. It's about having good torches with enough batteries in them. The picture above showed how the rescue built in even more safety measures. In investing, we can do two things: always size our bets correctly and always insist on a good margin of safety. Contingencies like buying put options are also available to sophisticated investors but for most of us, they are too expensive and hence not deployable.

To sum up, value investing is about navigating well when there are a lot of uncertainties. We learnt all the skills and theories in the early years but they are barely enough. It's also about many buy and sell calls to hone our acumen and to build on our experience. To most people, it's basically just too hard and hence Warren Buffett's advice to just buy ETFs and forget about stock picking. In this analogy, buying ETFs would be like scuba diving. It's easier and you would certainly have a lot more fun (i.e. earning good returns on your capital). Most importantly, you won't die.

However, to true value investors, the world's stock markets are our caves and every detailed stock analysis, our finest dive. Huat Ah!