Street Capitalist: Event Driven Value Investments

I woke up at 7AM yesterday to have a chance to read Warren Buffett’s Berkshire Hathaway 2009 letter to shareholders (PDF). This year’s letter did not disappoint. I would like to highlight a few key ideas from the letter.

Intrinsic Value

At the beginning of each letter, you will see a table of how Berkshire Hathaway’s growth in book value fared versus the S&P 500’s. Now, as Buffett states below, book value does not precisely peg intrinsic value but it comes close:

The ideal standard for measuring our yearly progress would be the change in Berkshire’s per-share intrinsic value. Alas, that value cannot be calculated with anything close to precision, so we instead use a crude proxy for it: per-share book value. Relying on this yardstick has its shortcomings, which we discuss on pages 92 and 93. Additionally, book value at most companies understates intrinsic value, and that is certainly the case at Berkshire. In aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie and I believe that our book value – understated though it is – supplies the most useful tracking device for changes in intrinsic value. By this measurement, as the opening paragraph of this letter states, our book value since the start of fiscal 1965 has grown at a rate of 20.3% compounded annually.

Whitney Tilson takes a different approach for figuring out the company’s intrinsic value: you take the company’s per share investments and add them to pretax earnings per share with a multiple attached. This is closer to what Warren Buffett has recommended for pegging Berkshire’s intrinsic value, but it is also more difficult to determine. For most people, the book value approach should be sufficient enough.

Float

Most people don’t understand float, but it is probably the key factor in Berkshire Hathaway’s growth over the last 40 years. Let’s say you are a value investor and you manage to take control of a company. In general, your opportunities range from reinvesting in the business you have acquired, to looking at outside opportunities. These can be acquisitions of other businesses or simple investments in securities. Normally, such investments must be paid for using free cash flow or debt. But if you were to acquire an insurance company, you would have one more weapon in your arsenal, float:

Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.

If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money – and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float…

Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.

Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses. Our insurance CEOs deserve your thanks, having added many billions of dollars to Berkshire’s value. It’s a pleasure for me to tell you about these all-stars.

Bolded for emphasis. The $16M to $62B figure is absolutely amazing and speaks to the power of a disciplined insurance operation. Not to detract from the 2009 letter, but I think the following discussion on National Indemnity from the 2004 is quite insightful here. Indeed, in Buffett’s 2004 letter, he said that without the acquisition of National Indemnity, Berkshire would be nowhere close to its size today:

So, you may ask, how do Berkshire’s insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage? We’ve attacked that problem in several ways. Let’s look first at NICO’s strategy.

When we purchased the company – a specialist in commercial auto and general liability insurance – it did not appear to have any attributes that would overcome the industry’s chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.

What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.

Many insurance companies end up chasing premiums without adequate risk management and blow up. They never have the time to really endure and grow, the way that Berkshire has done with National Indemnity and its other operations. Now, back to the 2009 letter.

Buffett uses the rest of the insurance section of the letter to praise Ajit Jain’s activities at Berkshire Reinsurance and mentions that GEICO has gone from the country’s 6th largest auto insurer to the third largest in just 15 years. One of the best things about Buffett is he always owns up to his mistakes. It seems as if a foray into the credit card business did not work out so well for GEICO:

And now a painful confession: Last year your chairman closed the book on a very expensive business fiasco entirely of his own making.

For many years I had struggled to think of side products that we could offer our millions of loyal GEICO customers. Unfortunately, I finally succeeded, coming up with a brilliant insight that we should market our own credit card. I reasoned that GEICO policyholders were likely to be good credit risks and, assuming we offered an attractive card, would likely favor us with their business. We got business all right – but of the wrong type.

Our pre-tax losses from credit-card operations came to about $6.3 million before I finally woke up. We then sold our $98 million portfolio of troubled receivables for 55¢ on the dollar, losing an additional $44 million.

GEICO’s managers, it should be emphasized, were never enthusiastic about my idea. They warned me that instead of getting the cream of GEICO’s customers we would get the – – – – – well, let’s call it the non-cream. I subtly indicated that I was older and wiser.

I was just older.

That kind of honesty is unparalleled in shareholder letters, which usually read more like corporate propaganda than honest assessments of the business.

Burlington Northern Santa Fe

(Flickr: SP8254)

The regulated utilities section of the letter provides some insights on why the Buffett chose to acquire Burlington Northern. I think that for the most part, guys like Bruce Berkowitz were right in their assessment on Burlington Northern:

CONSUELO MACK: Let me ask you about the Burlington Northern acquisition, the largest acquisition that Berkshire Hathaway has ever made. The Wall Street Journal coverage of it saidWarren Buffett is turning Berkshire Hathaway into a big industrial operator and it’s no longer thenimble investment firm that it was once. What’s your view of what Warren is doing in buying thesebig industrial companies?

BRUCE BERKOWITZ: Berkshire has a tremendous amount of flow from the premiums received from long-term insurance policies. That flow has to be invested in very secure, sound financial instruments such as: electric utilities cost plus or a railroad business which has the stability unlikemany businesses. So here he’s taking money that’s actually got a zero cost to it and then investing itat a reasonable, not at an egregious yield, but at a reasonable investment yield. But when the cost iszero, the returns are phenomenal. He’s brilliant. Warren Buffett is being Warren Buffett in that he’smarried another great big business to Berkshire Hathaway that’s going to make a sizeable difference overtime

Buffett believes that BNSF should be looked at as a utility as well:

Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come. Both must also plan far ahead to satisfy demand that is expected to outstrip the needs of the past. Finally, both require wise regulators who will provide certainty about allowable returns so that we can confidently make the huge investments required to maintain, replace and expand the plant…

In the future, BNSF results will be included in this “regulated utility” section. Aside from the two businesses having similar underlying economic characteristics, both are logical users of substantial amounts of debt that is not guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens – yes, tens – of billions of dollars of incremental equity capital.

Buffett does not say explicitly what he thinks the returns on invested capital will be for the railroad business but that it should increase over time. Burlington Northern should definitely have the kind of pricing power it needs to ward off the frictional forces of inflation, should regulators act properly.

NetJets

(Course Correction: NetJets)

When David Sokol took the reigns at NetJets, I think people looked at the situation in two ways. 1. This would be a test for Sokol, to see if he has what it takes to be the CEO of Berkshire Hathaway. 2. Berkshire’s businesses aren’t infallible and may need guidance from time to time. Here is what Buffett said of the situation:

We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that both operating and capital decisions are occasionally made with which Charlie and I would have disagreed had we been consulted…

The major problem for Berkshire last year was NetJets, an aviation operation that offers fractional ownership of jets. Over the years, it has been enormously successful in establishing itself as the premier company in its industry, with the value of its fleet far exceeding that of its three major competitors combined. Overall, our dominance in the field remains unchallenged.

NetJets’ business operation, however, has been another story. In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million. Moreover, the company’s debt has soared from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire’s guarantee of this debt, NetJets would have been out of business. It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.

Dave Sokol, the enormously talented builder and operator of MidAmerican Energy, became CEO of NetJets in August. His leadership has been transforming: Debt has already been reduced to $1.4 billion, and, after suffering a staggering loss of $711 million in 2009, the company is now solidly profitable.

Most important, none of the changes wrought by Dave have in any way undercut the top-of-the-line standards for safety and service that Rich Santulli, NetJets’ previous CEO and the father of the fractional- ownership industry, insisted upon.

With the debt reduced to $1.4B and the company profitable, David Sokol looks as if he has passed the test. Sokol has gradually had the opportunity to get more face time with the media. We saw this with his activities at NetJets and the investment in BYD. I think he is poised to be the right operations guy at Berkshire, with Ajit Jain handling the insurance operations and the still unnamed CIO handling investments.

Financial Products and Derivatives

On occasion, Buffett has criticized the government’s lending policies with good reason. Berkshire is unable to get the kinds of lending rates that TARP recipients received in the past, which put the company at a decided disadvantage when it came to bidding on parts of companies such as AIG. But in this year’s letter, Buffett sheds light on another problem:

The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 51⁄4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels.

In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan. For the all-cash buyer, Clayton’s homes offer terrific value. If the buyer needs mortgage financing, however – and, of course, most buyers do – the difference in financing costs too often negates the attractive price of a factory-built home…

Our product is first-class, inexpensive and constantly being improved. Moreover, we will continue to use Berkshire’s credit to support Clayton’s mortgage program, convinced as we are of its soundness. Even so, Berkshire can’t borrow at a rate approaching that available to government agencies. This handicap will limit sales, hurting both Clayton and a multitude of worthy families who long for a low-cost home.

These kinds of double standards hurt buyers of Clayton’s homes, especially considering that Clayton’s buyers are not speculators. Most are simply people looking to buy a home and live in it. They aren’t the gluttonous home flippers that helped fuel the excess supply in the housing market.

One of the problems with the media and Warren Buffett is that they often try to over simplify what he says, boiling things down into sound bytes that don’t give the full picture. This is definitely the case with derivatives.

A number of commentators have criticized Buffett for investing in derivatives contracts after calling derivatives weapons of mass destruction. The thing is, Buffett was criticizing how most financial institutions were using derivatives. For the most part, companies like AIG were writing billions upon billions of dollars worth of CDS contracts using faulty math behind defaults. They were totally unrealistic. We see now that Greece tried to use contracts to fudge their budgetary accounting and make their deficits appear artificially lower. These kinds of uses of derivatives are pretty stupid and can cause the mass destruction that Buffett described. Actually, if you look at AIG and the state of Greece, you could argue that they have already caused that destruction.

The Berkshire approach to derivatives is different. For the most part, Buffett looks at these like he does insurance. He is trying to find mispricings where the risk is limited and the duration from now till when money must be exchanged is sufficiently long enough to earn enough from the float to limit any kind of damage that would occur if Berkshire is on the losing side of these contracts:

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998. The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it.

It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.

Most people incorrectly assume that value investing means just investing in well run large cap stocks. It doesn’t. Value investing is buying a dollar for 50 cents. Where that dollar exists should not matter. A good investor should be willing to travel across asset classes in search of these bargains, and that is what great investors like Seth Klarman, Prem Watsa, and Warren Buffett have done in the past.

The entire letter is worth reading, especially for getting a more detailed insight into some of Berkshire Hathaway’s lesser known subsidiaries and overall performance for 2009.

Atul Gawande has a new book called the Checklist Manifesto. Obviously, the book is about checklists and Gawande analyzes their use with in a multidisciplinary manner. He looks at checklists and how they are used by individuals in various occupations where he finds that using them yields successful results. I have not read the book yet, but it looks good and hope to do so soon.

One of my most popular posts dealt with the use of checklists and how they could be adapted for use by value investors. I first wrote about the possible use back in July 2008 after reading Atul Gawande’s article on the same subject with this post. Since then Gawande’s work has made it onto Gurufocus and used by the likes of Mohnish Pabrai:

Gawande tells the story of Mohnish Pabrai, an investment manager in Irvine, California, who may be best known for paying $650,100 along with a friend to eat lunch with the billionaire investor Warren Buffett. Pabrai says many types of investing mistakes — even some made by Buffett — can be avoided by using written checklists.

Lists help Pabrai analyze potential investments more efficiently, Gawande writes. He says Pabrai’s investments more than doubled in a year after he developed checklists to prevent about 70 kinds of errors, such as failing to look for effects tied to boom or bust cycles.

Buffett’s Lunch Date, Surgeons Improve Results With Checklists (Bloomberg)

Checklists have in one way or another been popular among value investors for a long time. Pabrai often cites Charlie Munger’s work in the area and Walter Schloss is said to have used the same kinds of checklist criteria used at the Graham-Newmann partnership when he went off on his own to start his own investment partnership.

To get an idea for how the checklist is applied in disciplines outside of medicine, try looking at these examples from Gawande’s interview with Charlie Rose:

CHARLIE ROSE: You told me that story. Tell me about the B-17 story,
about the checklist.

ATUL GAWANDE: Well, this was part of what I get to think about by being this mixed role. I had a project for the World Health Organization where they asked me to lead a team trying to come up with ways to reduce deaths in surgery.

And what we looked to is we weren’t finding answers in our part of the world, so we looked to the aviation world. And there was a moment where aviation changed. There was a request by the army for a new long-range bomber in 1935, and Boeing came up with a plan to put four engines on the plane.

This was a massive breakthrough. That plane could fly higher, farther, faster. It was clearly the answer for the military. They did a test run, they actually had a flight competition, and the plane crashed, killing the crew onboard.

And the investigation showed nothing wrong mechanically with the plane. The pilot had forgotten to release the elevator controls, and so the plane could climb and climb but couldn’t level out, and so it just lost air and crashed to the ground.

And the reason he forgot was that putting four engines on the plane increased the complexity of how many things he had to remember so much that the army deemed it too much airplane for one man to fly.

What did they do to try to solve that problem? When Boeing built the first production models and the pilot said “I think we can fly this,” they did not make a three-year specialty fellowship in flying the B-17 airplane. They did not throw more and more technology into it.

They just made a checklist. A, before takeoff a few checks on one page, and following those basic checks they were able to fly that plane over almost two million miles without a single mishap and ended up having 13,000 of these planes in World War II. It was the backbone of our air superiority.

And what I realized following that story was that not only in surgery but all across medicine, we’ve hit our B-17 moment. Medicine has become more complex than one person can remember for themselves, too much airplane for one person to fly.

CHARLIE ROSE: Go ahead. So who writes the checklist?

ATUL GAWANDE: So what it almost has to be that the people at the front line write their own checklist.

But what we had to do, we had to learn from Boeing, who has tons of experience on how to do this, how to make a good checklist instead of a bad checklist. Make a way that you are not distracting people, not making it so long that it’s impossible to deal with.

And so they showed us. We ended up following their rules and conducted a two-minute checklist for operating rooms that when we implemented it in eight hospitals, just asking teams to follow this checklist every time, it reduced deaths 46 percent.

CHARLIE ROSE: Forty-six percent?

ATUL GAWANDE: Forty-six percent.

CHARLIE ROSE: Reduced death in the operating room?

ATUL GAWANDE: In 8,000 patients.

I implemented it in my operating room not because I thought we needed it in my hospital. At the Brigham and Women’s hospital we know what we’re doing. I didn’t want to be a hypocrite because I was asking these other hospitals to implement it.

And then, to my surprise, I have not gotten through a week where it has not caught problems that we would have missed.

CHARLIE ROSE: Doesn’t that say something about how many people might have been killed because there was no checklist if these numbers are as astounding as they are? You haven’t gone a week in which you didn’t find you missed something or would have missed something?

ATUL GAWANDE: Not that it would have killed people, but it would have harmed them.

And the striking this is we haven’t taken these lessons elsewhere. I got a note from a patient who — it was just heartrending. He had an merge spleenectomy. And when you lose your spleen, there’s certain vaccines you’re supposed to get. But we forgot to give the vaccines, meaning my profession, we surgeons.

CHARLIE ROSE: He lost his spleen, and if you lose your spleen, you have to have vaccines, and somebody forgot that?

ATUL GAWANDE: Right. And so the result was instead of getting this pneumococcal vaccine he got this infection which you need a spleen to fight off. He ended up losing nearly all of his fingers and toes from a completely preventable problem.

And I’ve seen in my own hospital that we’ve forgotten this kind of a vaccine. We’ve seen these kinds of steps across the board, and we missed them because we think using a checklist is a sign of weakness. Experts don’t need checklists. You become an expert so you don’t have to have a checklist.

But when complexity has exceeded the capability of our brains to handle it, it’s actually more important than technology and more important than any of the things that we fall back on. It’s this very simple, mundane thing.

CHARLIE ROSE: How is it applicable to other areas beyond a surgeon?

ATUL GAWANDE: The fascinating thing to me and the reason — I never imagined I’d write a book about checklists.

CHARLIE ROSE: And look at this little check here.

ATUL GAWANDE: I know.

The profound thing that I found was that as I looked for ideas outside of medicine to apply in medicine, I ran into people in multiple lines of work, whether it’s the skyscraper world or investment world or teaching, who are struggling with the fact that we’ve gone from a world where our main problem was ignorance, we didn’t know what to do, to a world where now we actually have a lot of knowledge, but it’s so voluminous and so complex you can’t keep up with it anymore.

And people are struggling with understanding how do I make sure I do he right thing at the right time the right place. In pockets of areas, people have started applying the checklist, a handful of people in the investment world, a handful of people in restaurants and places like that.

CHARLIE ROSE: A checklist in a restaurant, how would that work?

ATUL GAWANDE: I spent a day in a gourmet kitchen with Jody Adams, a chef in Boston who runs a fabulous restaurant. And I was there because I wanted to see how people really make the art of cooking work when you have to do it for 150 people a night.

And the answer to my surprise was that even for a gourmet chef, you’d think she would carry it in her head. She has a checklist called as recipe that she follows, even the 300th time she’s making a lobster dish, because she says “That’s the moment when I forget to add that crucial spice or ingredient.”

And to make that kitchen run like a symphony with all of its specialists — it’s grill cook, it’s baker, and so on — they have a check in process to make sure that nothing goes in or out, including a little check before the dish goes out the door where the souse chef looks at it before it leaves.

Charlie Rose interviews Atul Gawande (transcript)

You should understand that in each case from the above, the checklist was used to prevent a disastrous outcome. For Boeing a crashed plane, a death in the operating room, or a bad dish produced by Jody Adams’ kitchen. In every case the checklist is strictly adhered to so that mistakes are not made. I think that if you choose to adopt a checklist in your investing process, you need to strictly adhere to it. If not, you will only be giving yourself a false sense of safety.

For an investor, here are some places where I could see checklists work:

1. The net-net hunter: you could easily formulate a list of rules to look for before investing in a net-net. Some of these could be picking a satisfactory discount to net current asset value (current assets – total liabilities), checking inventory levels and what that inventory actually consists of, the burn rate of cash, management’s view on capital allocation, including PP&E that can be easily liquidated, and any other long term assets that would be attractive to buyers.

2. The bank investor: before looking at a bank you really need to give them a quick look over quantitatively. Most of the mistakes I see by people investing in banks is that they fall in love with the story and qualitative factors without rigorously analyzing the bank on the quantitative side. I like to see banks that are well-capitalized, have loan portfolios that are light in commercial real estate, feature diverse income streams, appear to be working through their credit problems, and are putting the excess capital to work by either pursuing buybacks or dividends.

3. The Memento Mori list: when Roman commanders returned from battle, they often had slaves whispering “memento mori” into their ears or, “you are only mortal.” You end up picking up a lot of knowledge about companies, industries, and accounting details over the course of your investing career, particularly by learning from your failures. I saw during the crisis that many engineering contracting firms appeared to be trading at close to the value of their cash. But what happened was as the crisis intensified, contracts were canceled and the cash that was recorded from those contracts vanished from the balance sheet. That would be something to look out for when analyzing similar companies, some investors like Joel Greenblatt actually advocate discounting cash up front. Another lesson that is applicable today is the fact that banks are capable of writing down the value of assets. A lot of investors thought they were getting Bank XYZ at 1/2 book value during the crisis, when in the next quarter book value would drop in response to asset write downs. You could add more to this list, given areas where you failed.

Most investment failures stem from A. buying a business above its intrinsic value, B. misjudging the company’s management, or C. investing in a business where the long term economics were worse than expected. Those are what you would want to be making a checklist to protect against. These are just some checklists that I have thought about, but if you have your own, feel free to use the comments section and share.

(from one of my favorite films: Searching for Bobby Fischer)

In 2009, Charlie Munger recommended Malcolm Gladwell’s book Outliers which studiers outliers throughout history and discipline to find commonalities. One of the ideas professed by Gladwell is a 10,000 hour rule, where if you want to master something you must practice it for at least 10,000 hours. Gladwell uses the Beatles as evidence of this rule, pointing out that their time in Germany was spent constantly performing live which helped them gain the mastery needed to become great musicians when playing concerts and on TV.

The folks over at Study Hacks find that in chess, to become a grandmaster, you do not just need to spend 10,000 hours practicing chess. You must also spend those hours doing the right kind of work or deliberate practice.

1. It’s designed to improve performance. “The essence of deliberate practice is continually stretching an individual just beyond his or her current abilities. That may sound obvious, but most of us don’t do it in the activities we think of as practice.”

2. It’s repeated a lot. “High repetition is the most important difference between deliberate practice of a task and performing the task for real, when it counts.”

3. Feedback on results is continuously available. “You may think that your rehearsal of a job interview was flawless, but your opinion isn’t what counts.”

4. It’s highly demanding mentally. “Deliberate practice is above all an effort of focus and concentration. That is what makes it ‘deliberate,’ as distinct from the mindless playing of scales or hitting of tennis balls that most people engage in.”

5. It’s hard. “Doing things we know how to do well is enjoyable, and that’s exactly the opposite of what deliberate practice demands.”

6. It requires (good) goals. “The best performers set goals that are not about the outcome but rather about the process of reaching the outcome.”

If you’re in a field that has clear rules and objective measures of success — like playing chess, golf, or the violin — you can’t escape thousands of hours of DP if you want to be a star. But what if you’re in a field without these clear structures, such as knowledge work, writing, or growing a student club?

…It seems, then, that if you integrate any amount of DP into your regular schedule, you’ll be able to punch through the acceptable-level plateau holding back your peers. And breaking through this plateau is exactly what is required to train an ability that’s both rare and valuable (which, as I’ve argued, is the key to building a remarkable life).

This motivates a crucial question: What does DP look like for fields that don’t have a tradition of performance-optimization, such as knowledge work, freelance writing, entrepreneurship, or, of course, college?

The Grandmaster in the Corner Office: What the Study of Chess Experts Teaches Us about Building a Remarkable Life (Study Hacks)

For any investor seeking to become better, deliberate practice is essential. The key is figuring out what deliberate practice should consist of in investing. Most of us read newspapers and blogs daily. This helps keep up to date with what is going on in the world. But is that enough? I am not too sure.

I think that taking a more active approach with news reading would be helpful. Recently, the Wall Street Journal ran an article about how David Tepper bought Bank of America stock at its low. A good exercise would be to actually sit around and try to reverse engineer that investment. Eddie Lampert has said that in college he reverse engineered many of Warren Buffett’s investment. This kind of activity would not only increase your understanding of investing but also build a model for you to look at if you ever find a similar investment.

Other investors strive to read one 10K a day. This can help build your circle of competence, but I believe it has some shortcomings. A more targeted approach with 10Ks will be more beneficial than simply jumping from reading about Exxon to reading about Bank of America. You should define goals where you are mastering knowledge of a specific industry or area of the market.

Maybe you want to learn the billboard/outdoor advertising business. Instead of looking at just Lamar Advertising (NASDAQ:LAMR) you would look at Clear Channel Outdoors (NYSE:CCO) as well. If you want to master restaurants, you would maybe start at a fast food company like McDonalds (NYSE:MCD) which is the best in its class. Then seek out Chipotle (reputed to have the best economics in the fast food business) and branch out so that you build familiarity with the industry which will help you evaluate lesser known companies like Steak N Shake (NYSE:SNS).

Feel free to use the comments or e-mail me with suggestions for implementing deliberate practice in investing.

Jared Diamond’s Guns, Germs, and Steel is yet another book that I read after hearing it garnered a recommendation by Charlie Munger (and a Pulitzer). It’s a great book that helps provide an explanation based in science for why Europe conquered and colonized most of the world. The book’s theories are often debated and even controversial, but it’s well worth taking the time to read. I was pleased to see Jared Diamond as the feature of this week’s Lunch with the FT (one of my favorite features of the newspaper):

“There is a parallel based on the same fundamental mechanisms of the economic collapse that we’re seeing now and the collapse of past civilisations such as the Maya,” he continues. “The message is that when you have a large society that consumes lots of resources, that society is likely to collapse once it hits its peak.”

He helps himself to a mouthful of vegetables, bought from the supermarket but as fresh-tasting as if he had dug them from the garden. Chewing slowly, he continues: “The Maya collapse began in the late 700s, and then simply the most advanced society in the New World collapsed over the course of several decades. They were mostly gone a century later,” he says wistfully. “When a complex structure like that starts collapsing, you are pulling out dominoes in the whole structure.”

I ask whether Lehman Brothers is such a domino. “The events of last October have crept up seemingly so suddenly,” he replies: “I say ‘seemingly’ because, in a sense, it is not at all sudden. Any idiot knows that if you are drawing more money out of your bank than you are paying into your bank, then eventually something is going to happen. Somehow this lesson escaped the decision-makers in the US government.”

Lunch With The FT: Jared Diamond (FT.com)

As always, be sure to read the rest of the article.

Charlie Munger often talks about his hero, Benjamin Franklin and sometimes offers his perspective on what Franklin would do in certain situations. I found the following series by Maira Kalman at the New York Times to be pretty interesting:

I also liked this bit at the end:

Be sure to view the whole thing: Can Do – And the Pursuit of Happiness (NYTimes)

Most of you have probably read some book by Robert Ciladini, whose books on psychology are often recommended by Charlie Munger. His latest book Yes!: 50 Scientifically Proven Ways tobbe Persuasive is great because 50 different models of human psychology and persuasion are broken out into an easy to understand manner. If you’re too lazy to read the book though, check out this link where you’ll find a good summary.

Today’s WSJ though had a good article by Carl Bialik on how these “Most Popular” lists create positive feedback loops and influence our perception. There is a great bit with Cialdini in the article:

Other recent studies have quantified the popularity of popularity in other settings. Signs telling guests at a hotel in the Phoenix area that towel reuse was the No. 1 choice among their peers increased the rate of this practice by 34%, compared with other signs with messages stressing the impact on the environment. Arizona State University psychology Prof. Robert Cialdini and colleagues found that rates went even higher when the signs specified that most prior guests in the same room reused towels.

“To the extent you can convince that, not just a lot of people are doing this, but a lot of people like [them] are doing this,” you’ll get greater buy-in, Prof. Cialdini says.

Another group of researchers demonstrated this with restaurant diners in Beijing. Table cards at Mei Zhou Dong Po, a Szechuan restaurant chain, touting the five most popular items boosted ordering of these items by 13% to 20%, according to a forthcoming paper by a team from Peking University and Duke University. “Part of it is reassurance that something is good and worth buying,” says Bill Paul, a restaurant-menu designer.

Calling these items popular is crucial, the researchers found, because other table cards that highlighted five sample items but made no claim on their popularity had little effect on sales. And the diners liked following the pack: “Diners who were exposed to the popularity information treatment are more satisfied,” says co-author Hanming Fang, a Duke economist.

Look at This Article. It’s One of Our Most Popular (WSJ)

That’s just an excerpt, be sure to check out the rest of the article. There are some other good examples of popularity being used to persuade us.

Check out this fantastic interview with Charlie Munger at the Stanford Lawyer.

Here are some great quotes:

Harry Markopolos, a hedge fund expert, sent a detailed memo to the Securities and Exchange Commission (SEC) articulating why Madoff must have been a fraud. The SEC did nothing with it. We don’t know the reason why, but I’m willing to suggest that the lawyers who received Markopolos’s warning simply didn’t understand the finance or math that Markopolos relied on.

Lawyers who only know a mass of legal doctrine and very little about the disciplines that are intertwined with that doctrine are a menace to the wider civilization.

Why didn’t the SEC understand the warning that was clearly placed at its door?

The SEC is pretty good at going after some little scumbag whom everybody regards as a scumbag. But once a person becomes respectable and has a high position in life, there’s a great reticence to act. And Madoff was such a person.

Why aren’t our regulators capable of addressing many of the issues that we confront in the market today?

Most of them plan to go back to living off money made in the system they are supposed to regulate. You can argue that financial regulation is so important that no one in such a position should ever be allowed to do as you partially did—serve and then leave to make money in the regulated field. Such considerations led to lifetime appointments for federal judges. And we got better judges with that system.

So government service should be a little like a monastery from which you can never escape?

What you can opt to do is retire, which is pretty much what our judges do.

What about the idea that investors should be able to fend for themselves?

We want the sophisticated investor to protect himself, but we also want a system that identifies crooks and comes down like the wrath of God on them. We need both.

Q&A: Legal Matters with Charles T. Munger (Stanford Lawyer)

Be sure to read the full interview.

Yesterday, Liz Claman at Fox Business had a really great interview/roundtable with Warren Buffett, Charlie Munger, and Bill Gates. It was awesome to see and hear Munger, since out of the three, he’s much less exposed in the media. They cover a wide range of topics, so it was nice to see the different perspectives.

If you missed the interview, they’ll be re-airing it this weekend. Saturday at 9PM EST and Sunday at 10PM EST.

Rather than embed the videos and slow the blog’s loading time, I’ve provided direct links to each one of them.

1. Buffett: Right time to Buy Stocks

2. Buffett: Had Best Year in a Recession

3. Buffett on Banks, Ratings Downgrade

4. Buffett and Gates on the Future of Capitalism

5. Buffett and Bill Gates on the Estate Tax

6. Charlie Munger on Citi Bonuses

7. Charlie Munger on BYD

8. On Succession, the Future

I don’t know if anyone’s ever asked Bill Gates about Google, but it was nice to get his thoughts on the company’s competitive advantages — or in this case it’s wide, shark filled moat. As he said in the interview, Microsoft is not deterred by the moat or the sharks and will continue to charge ahead.

Munger’s views on harnessing solar power were pretty optimistic. I like that Buffett and Munger were quick to point out that it isn’t a space they would invest in. Simply because it’s too difficult to pick winners. I remember reading about John D. Rockfeller’s Standard Oil, and how before it, the refinery space was fragmented and situated atop shaky financial foundations. Many, many, many refineries failed. That’s how I view the solar / renewable space right now. There’s still more experimenting that has to be done in terms of getting the actual business right.

I wonder why Berkshire didn’t just sell Moody’s. It seems like both Buffett and Munger believed that Moody’s actions were incorrect. In the past, when this has happened, the security was simply sold. But it cold be that the position in Moody’s was too big to unwind, or more likely — Buffett believes that the ratings agencies will have to continue their existence. It may be impractical to do away with the ratings agencies all together, so the demand for their services will continue to persist.

One of the things I always like to hear from Buffett and Munger are their book recommendations. The topic didn’t appear to come up during the annual meeting, but yesterday Claman asked them the question.

Buffett:
1. Poor Charlie’s Almanack
2. Personal History: Katharine Graham

Munger:
3. Outliers by Malcolm Gladwell

Gates:
4. Showing Up For Life by Bill Gates Sr.

Unfortunately I haven’t read any of these, but I know that Bill Gates and his father were on Charlie Rose a few days ago talking about the book. Malcolm Gladwell always pens a good article for the New Yorker, but sometimes his concepts seem a bit fluffy. I’ve never read any of his books, but I think I may take a look at Outliers because of Munger’s recommendation.