Circle of Competence

It sounds crazy that Warren Buffett and Jim Rogers might have something in common besides intellect and wealth. Buffett has owned the Washington Post for 35 years, Coca-Cola for 18 years. Jim Rogers owns exotic commodities and currencies, usually leveraged up to the hilt, and was once partners with the most famous speculator in the world, George Soros.

However, I’ve now read enough about Rogers where I see some terrific parallels between his approach and that of Mr. Buffett.

What’s the major parallel? They are looking for simple, painfully obvious investments. Buffett has said it over and over: a great investment should be apparent very quickly.

When you feel like you are shooting fish in a barrel, your thesis is going to be simpler and more understandable, and thus more likely to work out. The obvious ones are the best ones.

Often times when I say such things, people respond by saying “But if it’s too simple, you might be missing something!” Ah, but this is flawed thinking, and skews the idea of making investments simple: you still have to do all your homework, but the final thesis should be a few sentences. It always kills me when I hear these investment ideas; so convoluted and over analyzed that there is no possible way all of the moving parts I hear can be satisfied. It’s just not simple enough.

The great investors know their holdings like the roads leading to their house: eyes wide shut. Eddie Lampert has described his process as “Zen-like” focus, and his scuttlebutt research is legendary. Buffett can fawn on for hours about the history of Coca-Cola, or the Washington Post. David Einhorn probably knows more about Allied Capital than the people who run the place.

But their great investments are simple, obvious, and deeply discounted from their true value. Heck, Buffett’s Post investment was selling for $80mm when its liquidation value was north of $400mm! How many tabs do you need in your spreadsheet to figure out that you’ll make a ton of money there?

Instead of telling you myself, I’ll let you read some things Buffett and his disciple Mohnish Pabrai have said:

Q: In your letters you speak frequently of the importance of not over-complicating things. What are your secrets to keeping your life simple?

Buffett: When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in. Big money is made by obvious things. If using a discount rate of 8% vs. 10% is going to make or break an investment idea, it’s probably not a good idea.

At a Berkshire Annual Meeting, someone comments on discounted cash flow modeling:

Charlie Munger (Berkshire Hathaway’s vice chairman) said, “Warren talks about these discounted cash flows. I’ve never seen him do one.”

“It’s true,” replied Buffett. “If (the value of a company) doesn’t just scream out at you, it’s too close.”

In a talk with Wharton Students in 2003, Buffett reflects on the “obvious investment” approach:

“I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out.”

Mohnish Pabrai responded in a similar way when asked about his successful investments.

Question: Would you say that in your experience, your best investments have been derived from some obscure “hidden” asset value you find in an investment or from some traditional valuation measures?

Mohnish Pabrai: The best investments are total no-brainers that can be explained in a short paragraph or two. They are obvious investments. The more words and spreadsheet cells it takes to layout the case for an investment, the worse it’s likely to do. Frontline was obvious. Stewart Enterprises was obvious. Level 3 was obvious. Pinnacle Airlines was very obvious. More recently, Ipsco was very obvious and that was nearly a 300% return in less than 2 years.

Knowing this, I was re-reading some passages from a book I enjoy: Market Wizards, Interviews with Top Traders, one of the interviews being investing legend Jim Rogers. Rogers and George Soros were partners in the 70’s, and after a rough breakup Rogers has been managing his own money since. He’s been compounding at incredible rates for 40 years, north of 30% by some accounts.

While he has a different range of investments than most investors, he’ll just as likely invest in Malaysian Palm oil as General Motors, he has a laser like focus on finding investments that simply can’t lose; ones where the economics are too right to be wrong.

Mr. Rogers’ quotes on investing in Market Wizards are investing gems:

It sounds like you have a great deal of conviction when you put on a trade.

Yes, I do; otherwise I don’t bother doing it. One of the best rules anybody can learn about investing is to do nothing, absolutely nothing unless there is something to do.

Do you always wait for a situation to line up in your favor?

I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime. Even people who lose money in the market say, “I just lost my money now I have to do something to make it back.” No, you don’t.” You should sit there until you find something.

Going from ground zero in Sep. 1970, where did you start picking up tradingwise to build up to your ultimate trading success?

My early losses taught me a lot. Since then – I don’t like to say this kind of thing- I have made very few mistakes. I learned quickly not to do anything unless you know what you are doing. I learned that it is better to do nothing and wait until you get a concept so right, and a price so right, that even if you are wrong, it is not going to hurt you.

And lastly:

If you were counseling the average investor, what would you tell him?

Don’t do anything until you know what you are doing. If you make 50% two years in a row then lose 50% in the third year, you would be worse off than if you just put your money in a money market fund. Wait for something to come along that you know is right. Then take your profit, put it back in the money market fund, and just wait again. You will come out way ahead of everybody else.