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 death. Investing 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!

Tangible Thoughts #6: Contrarian Thinking

Sometimes the best opportunities come when most people don't agree with you but the one or two trusted smart friends do. Or maybe they also didn't agree but you are smart enough to figure out they were wrong.

Here's two quotes reflecting this:

John Malone: Most of the money I've made in my life has been when other people don't like what's going on. When things are cheap, that's opportunity.

Jack Ma said something to the same extent. If 10 out of 10 people agrees with you, then nothing needs to be done. If there is just one or two smart, close friends who criticize your idea but think there might be something worth pursuing that is interesting.

Book Lessons #2: The Selfish Gene Part 1

I just read the seminar work of Richard Dawkins, The Selfish Gene. I would say this is a must-read for everyone. Not just investors, but everyone. Amazingly, this book was listed as the most influential science book of all time in a poll to celebrate the 30th anniversary of the Royal Society Science Book Prize. To think that it was published in 1976 and I only read it now.

This book put forth so many concepts that it's actually quite daunting to absorb everything. Hence this post serves to really crystallize some the important ideas. Interesting, Dawkins also coined the word meme which became one of my son's most searched word on Google. We spent hours searching for funny Star Wars meme like the one below. Haha!

Star Wars Meme

The word meme came from another Greek word mimema which means imitate. Dawkins used the word to describe how ideas, music, stories can be copied like genes in the human society. This later became popularized into jokes like the one above that is copied and spread rapidly by internet users. The origins of meme is like genes, which according to the book, exist to propagate, by hook or by crook.

For years I have tend to look at the world with dualism lens i.e. good vs evil or black vs white. While I also acknowledge everthing is not binary and no one is pure good or evil. This is a very important concept in investing. A stock is never good or bad, it is about whether it is cheap enough. This book however really opened up my thinking. It argued that there isn't really good and evil. We are all just programs, like computer programs. Our code is written in our genes. Genes want to propagate and deploy strategies to do so. Some are "evil" while others are good or altruistic. The evil strategies tend to do better but when evil overwhelms the system, good comes back.

One of the most interesting examples came from an analogy with hawks and doves to represent aggressive or docile behaviour in a population. I like to think of them as people who would do anything to get what they want (hawk) and people who would to do the right things (dove). We can put different dualism here and but the lesson drawn is important. First though, we must explain how this works. So the analogy goes as follows, if a hawk fights a dove, the hawk always wins, but the doves run away with minor injuries. If a hawk fights a hawk, one would get seriously injured or even die. Finally, when a dove fights a dove, no one gets hurt. 

So in a population full of doves, a single hawk will win all the fights and hence his genes propagate until he keeps finding hawks which he has to fight. Either one of them would be seriously injured or die and thus doves would come back again. This is analogous to a single aggressive corporate climber out to get everyone, but if the whole firm are filled these people, eventually the firm collapses or it gets taken over and the real doers come back to save the day. Hence good firms that we see today likely have a good pool of doers (doves) vs aggressive people (hawks).

Here's where things get interesting. According to game theory, there would be a steady ratio of hawks and doves after many evolutions. This would be 7/12 hawks vs 5/12 doves. Now if you think about it, this tend to reflect our corporate world (or perhaps the real world as well) where aggressive people who do anything to get what they want would be somewhat more than people who are righteous. So most firms are like that and they accomplish little. But great firms would probably have more doves and they go on to achieve great things, create great products, change the world.

The other important lesson for me is also about learning to run away to fight another day. Aggressive players always fight to win until they kill off each other. So the way to beat them is to have better strategies which will be discussed. Again here, while there are good and altruistic strategies, in the world of genes, some strategies are usually quite evil and they would tend to also be more than 50% of the strategies.

Cuckoo Strategy

One of thediscussed strategy was the cuckoo bird strategy. Cuckoo birds do not build their own nests and tend to deposit their eggs in other bird's nests. They can do this because evolution had allowed them to lay eggs that are so similar to other birds' ones that the foster parents cannot tell the difference. Also when they hatch, cuckoo birds can scream louder and also has redder beaks (see pic above) such that foster parents would always feed them until they grow to become adults and go mate with other cuckoos to continue this cycle.

This despicable strategy works until it doesn't when the world run out of foster parents for young cuckoos. It is also hard to beat this strategy because to the foster parents the damage done is not big enough for them to counterattack. Foster parents might lose 1 or 2 eggs because the cuckoo mummy tend to kick out one egg to make space for her own parasite egg. The chicks also lose some food to the cuckoo chicks but that's the maximum damage. Meanwhile, before the cuckoo evolve to build their own nests, this is their only strategy to breed, so that's why they go all out to win.

Even so, nature always find a way as recent studies have shown that some birds began laying eggs that have tell-tale signature that makes them different from the cuckoo eggs. When the mothers figured out which are the cuckoo eggs, she throws them out of the nest. Other birds like the fairy-wren had taught their chicks pre-natally to chirp differently to tell their mothers they are the real deal. This is the evolutionary arms race!

As to the implications to investing, I guess it might pay to know the culture of some companies we are interested to invest in. Do they have a lot more hawks determined to kill everyone? Are their strategies sustainable? These are not easy questions and the answers won't be in annual reports. That's what make investing interesting. It's forever asking questions and trying to understand better!

Stay tuned for Part 2!

Chart #13: Race to a trillion

The FT published a series by the same name. The following chart really shows it best. One of them would be the first trillion dollar company in the history of mankind. The candidates are:

1. A Window (Microsoft)
2. A River (Amazon)
3. The Alphabet (Google)
4. A Fruit (Apple)

My bet is on the fruit! At 935 billion dollars just a few weeks back, it's really just a stone's throw away!