"Learning the Art of Value Investing" - A new thread 22 posts by 11 authors in Intelligent Investor Forum

Wise Investor

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Hi IIfians, I and saurabh have thought upon to start this new thread on " Learning the Art of Value Investing" to share articles and information for our members to improve on our Investment Process. I request all members to actively participate in this Thread and share views and articles and information from various sources in this thread so as into improve our knowledge. More Hands if join together can help us dig into lot of available investment insights ,for us to improve in future. The Focus is to Improve our INVESTMENT PROCESS. regards, Wise Investor Seth Klarman On Preventing Mental Mistakes Seth Klarman, in his 2011 letter to Baupost investors, wrote: Understanding how our brains workour limitations, endless mental shortcuts, and deeply ingrained biasesis one of the keys to successful investing. He stressed a few key mental errors made by both individual and institutional investors. Here are some mental errors that we should all watch out for: Overreacting to the latest news Klarman had this to say about overreacting: Investors emotionally pile in on good news and rush for the exits on bad news, causing prices to overshoot. We tend to act in the heat of the moment and make quick buy and sell decisions without any significant thought. The average investors mindset, according to Klarman, is this: Most of us like a stock more when it has risen in price and less when it has fallen. If a company reports an increase in earnings, our brains might feel

something golden and jump on the bandwagon. Tech giant Intel (INTC) recently reported increased earnings for the 1st quarter of 2012. Does that mean we should buy it right away? What we should do is to reverse our thinking about the latest hot news and look for reasons why a company like Intel may not be a good investment. As Sir John Templeton once noted, The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell. So when the stock market is down, it is time to look for opportunities, not to sit back and do nothing. Klarman suggests a common error when searching for investment opportunities: The herd can irrationally lose sight of the underlying assets and long-term prospects of a business when it focuses on price movements. Looking in the rearview mirror As Klarman states, Our expectations about future events are distorted by past experience. When we think too much about the past, we become more hesitant to take risks. And Klarman further states: Actions that seemed prudent in foresight can look horribly negligent in hindsight. We likely fail to overcome the extreme fear that prevented smart decision-making. Fear, particularly upon suffering a loss, causes people to ignore bargains in the market. Banking businesses like Citigroup (C) were a bargain following the low point of the economic recession. But did anyone bother to look at Citigroups future outlook? People in the market today are scared due to their memories of the recent financial crisis. However, Protective actions, whether by individuals or governments, tend to be designed to prevent a recurrence of the worst such disaster previously experienced, wrote Klarman. We tend to become too cautious in trying to prevent the worst of such disasters. We tend to look back at the worst scenario that may not happen again. In Montiers words, we become afraid of the big, bad market. Focusing on results rather than processes Klarman makes the ultimate point about focusing less on results: A good result says nothing about whether the process involved was a good one and whether or not the success might be replicable. Montier takes this a step further: You could have a good process but a bad outcome. Or you could have a bad process but a lucky outcome. The bad process/lucky outcome combination is worse because it sets investors up for a higher likelihood of failure in the future. Klarman explained: The focus on benefits lessens our concern about what could go

wrong. The biggest mistake we make is not remembering our past mistakes. With a good outcome, we are less likely to remember and analyze our weaknesses. Klarman notes: Those who have been lucky are almost never punished for having taken too much risk. With good results that may turn out to be pure luck, we are quick to praise the positive outcome on genuine skill that we dont really have. Letting intuitive hunches take over rationality Klarman stressed the importance of being a rational thinker: It is good to buy investment bargains, but it is far better if you know why they are bargain-priced. In essence, it is important to focus on logic and rationality. Look no further than Warren Buffett, whose investment logic is to buy businesses with good-tosuperb underlying economics run by reliable people. Investor irrationality comes from the two systems in his or her brain: an intuitive brain, System One, and an analytical brain, System Two. Our intuitive brain makes quick, unconscious decisions on the spot. Our analytical brain takes more time to process the information and formulate solutions. This is how our brains tend to work, according to Klarman: When System One substitutes an easier question for a harder one, it is easy to make mistakes. The best investors are the ones with a strong analytical brain. We, by human nature, think we know the difference between right and wrong without extensive analysis, if we have been around the business for a long time. So we come to believe that our decisions are always rational no matter what. We need to always be conscious of whether we are making rational decisions or not. Klarman wrote: No one should be confident that they are immune from irrational behavior from time to time.

Regards, Wise Investor.

Guru

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Re: [IIF:20045] "Learning the Art of Value Investing" - A new thread Great Idea. I will be able to learn a lot because of this. Will share few details from my side too. - show quoted text - show quoted text Wise Investor. -DISCLAIMER IIF members recommending/discussing any stock/stock idea shall without prejudice, be deemed to be construed that, he/she may have vested interest in doing so. Fellow IIF members are requested to complete their own research /due dligence in addition to the stock idea and \ or consult a qualified financial advisor before taking any action.IIF, its members and managers do not take any responsibility for any consequences (financial, legal or otherwise) resulting from action based on views discussed in the forum. Only make investments that suit your particular goals and capital constraints. https://groups.google.com/group/intelligent-investor-forum?hl=en

Anuj Anandwala

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Re: [IIF:20046] "Learning the Art of Value Investing" - A new thread PFA some articles I found interesting & helpful.

Cheers ! - show quoted text -Warm Regards, ~ monkk ~ Attachments (2)

Stumbling on value investing.pdf 131 KB View Download

Charlie Munger - Art of Stock Picking.pdf 297 KB View Download

Constant Seeker

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Re: [IIF:20052] "Learning the Art of Value Investing" - A new thread Hi All, I would like to start by focusing on the various biases we have in investing and we can discuss each bias for a week or 3-4 days. BIAS 1:- AVAILABILITY BIAS The availability bias is a mental shortcut that operates on the notion that "if you can think of it, it must be important". In investing terms it is our tendency to make a judgment on whether to buy/sell a stock on basis of

How easy is information available on the price of stock so that you "feel" u have enough knowledge to buy that stock Remembering instances when how easily yourself or others have made money doing such trades.

As Prof. Bakshi puts it lightly " If the girl I like is not near me , i like the girl near me" :) Example:

Just have a look at any business channel to see this in action. Whenever any event happens like a rate cut or elections the price rises and falls of impacted stocks are shown in a very vivid and easy to absorb fashion. Due to the availability of this data in we tend to form an opinion on such events and start to base our buy sell decision on such instances rather than fundamentals. Similarly most of the times focus is on high volume stocks where even a small gain or loss is highlighted. So if someone has ideal cash his usual bias will be to enter these stocks for quick gains rather than looking at it on a fundamental level.

Ways to counter this ( i am still trying to follow them :P)

Underweight the extra, more attention grabbing news and focus more on silent undercurrents. An idea or a fact is not worth more because it is readily available to you- Munger. In other words initially be skeptical to any idea you generate

Views invited. Regards,

Saurabh - show quoted text -

Wise Investor

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Re: [IIF:20063] "Learning the Art of Value Investing" - A new thread Hi IiFians, Good Morning..... The file attached is a snapshot from Daniel Kahneman Book - Thinking Fast and Slow, It addresses the way our minds are designed to think and how r we forced to think in that pattern. The point which Saurabh has raised on Availability Bias could be addressed partially through Daniel work and research. Interesting Reading ... regards, Wise Investor.

DISCLAIMER IIF members recommending/discussing any stock/stock idea shall without prejudice, be deemed to be construed that, he/she may have vested interest in doing so. Fellow IIF members are requested to complete their own research /due dligence in addition to the stock idea and \ or consult a qualified financial advisor before taking any action.IIF, its members and managers do not take any responsibility for any consequences (financial, legal or otherwise) resulting from action based on views discussed in the forum. Only make investments that suit your particular goals and capital constraints. https://groups.google.com/group/intelligent-investor-forum?hl=en

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Bias, Blindness and How We Think- Daniel Kahnenam.pdf 129 KB View Download

Guru

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Re: [IIF:20080] "Learning the Art of Value Investing" - A new thread The mental habit of thinking backward forces objectivity. One of the ways you think a thing through backward is you take your initial assumption and say, Lets try and disprove it. For example, if you were hired by the World Bank to help India, it would be very helpful to determine the three best ways to increase man-years of misery in Indiaand, then, turn around and avoid those ways. So think it backward as well as forward. Its a trick that works in algebra and its a trick that works in life. If you dont, youll never be a really good thinker.---Charlie Munger

- show quoted text - show quoted text -DISCLAIMER IIF members recommending/discussing any stock/stock idea shall without prejudice, be deemed to be construed that, he/she may have vested interest in doing so. Fellow IIF members are requested to complete their own research /due dligence in addition to the stock idea and \ or consult a qualified financial advisor before taking any action.IIF, its members and managers do not take any responsibility for any consequences (financial, legal or otherwise) resulting from action based on views discussed in the forum. Only make investments that suit your particular goals and capital constraints.

https://groups.google.com/group/intelligent-investor-forum?hl=en

Guru

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Re: [IIF:20080] "Learning the Art of Value Investing" - A new thread "A lot of opportunities in life tend to last a short while, due to some temporary inefficiency... For each of us, reallygood investment opportunities aren't going to come along too often and won't last too long, so you've got to beready to act and have a prepared mind---Charlie Munger - show quoted text -

Guru

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Re: [IIF:20080] "Learning the Art of Value Investing" - A new thread "In many corporations, there is an obsession with meeting quarterly earnings targets. To do so, they'd fudge a little,sell stock at a capital gain, sell a building or two... Then, if that was not enough, they would engage in channel stuffing if you were selling through a middleman, you could unload your product at the end of the quarter and make the current quarter look better but, of course, the next quarter would be worse. For many major pharmaceutical, consumer products and software companies, at the end of quarter, this was very common. That is pretty well over. A few public hangings will really change behaviour."---Charlie Munger - show quoted text -

hardik gajra

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Re: [IIF:20115] "Learning the Art of Value Investing" - A new thread dear all, How to control emotion or how one can avoid himself from day trading ,I think almost near stock market doing intraday trade and no one can make money. there is only looser there thxxxxxxx regd,

deepakgajra On 5/4/12, Guru <gurudatta22@gmail.com> wrote: > *"In many corporations, there is an obsession with meeting quarterly > earnings targets. To do so, they'd fudge a little,sell stock at a capital > gain, sell a building or two... Then, if that was not enough, they would > engage in channel stuffing if you were selling through a middleman, you > could unload your product at the end of the quarter and make the current > quarter look better but, of course, the next quarter would be worse. For > many major pharmaceutical, consumer products and software companies, at the > end of quarter, this was very common. That is pretty well over. A few > public hangings will really change behaviour."---*Charlie Munger > > On Fri, May 4, 2012 at 8:36 AM, Guru <gurudatta22@gmail.com> wrote: > >> *"A lot of opportunities in life tend to last a short while, due to some >> temporary >> inefficiency... For each of us, reallygood investment opportunities >> aren't going to come along too often and won't last too long, so you've >> got to beready to act and have a prepared mind---*Charlie Munger

>> >> >> On Fri, May 4, 2012 at 8:17 AM, Guru <gurudatta22@gmail.com> wrote: >> >>> *The mental habit of thinking backward forces objectivity. One of the >>> ways you think a thing through backward is you take your initial >>> assumption >>> and say, Lets try and disprove it. For example, if you were hired by >>> the World Bank to help India, it would be very helpful to determine the >>> three best ways to increase man-years of misery in Indiaand, then, turn >>> around and avoid those ways. So think it backward as well as forward. >>> Its >>> a trick that works in algebra and its a trick that works in life. If you >>> dont, youll never be a really good thinker.---*Charlie Munger - show quoted text -

ANISH POOJARA

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May 8 Re: [IIF:20126] "Learning the Art of Value Investing" - A new thread They say that 10% of the people make 90% of the money in trading. So far I have come across only one guy who makes money in trading and that also positional trading in futures. No intraday for him also. anish poojara - show quoted text -

agnostic

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May 8

When it comes to investing (buy & hold), about 20% make money. When it comes to trading, barely 2-3% make and retain money. The above is based on my experience and whatever I have read so far. Shambo, Carlos. On May 8, 3:38 pm, Anish Poojara <anish.pooj...@gmail.com> wrote: > They say that 10% of the people make 90% of the money in trading. > So far I have come across only one guy who makes money in trading and that > also positional trading in futures. No intraday for him also. > anish poojara > > > > > > > > On Fri, May 4, 2012 at 12:09 PM, deepak Gajra <hardikga...@gmail.com> wrote: > > dear all, > > How to control emotion or how one can avoid himself from day trading > > ,I think almost near stock market doing intraday trade and no one can > > make money. there is only looser there > > > thxxxxxxx > > > regd, > > > deepakgajra > > > On 5/4/12, Guru <gurudatt...@gmail.com> wrote: > > > *"In many corporations, there is an obsession with meeting quarterly > > > earnings targets. To do so, they'd fudge a little,sell stock at a capital > > > gain, sell a building or two... Then, if that was not enough, they would > > > engage in channel stuffing if you were selling through a middleman, you

> > > could unload your product at the end of the quarter and make the current > > > quarter look better but, of course, the next quarter would be worse. For > > > many major pharmaceutical, consumer products and software companies, at > > the > > > end of quarter, this was very common. That is pretty well over. A few > > > public hangings will really change behaviour."---*Charlie Munger > > > > On Fri, May 4, 2012 at 8:36 AM, Guru <gurudatt...@gmail.com> wrote: > > > >> *"A lot of opportunities in life tend to last a short while, due to some > > >> temporary > > >> inefficiency... For each of us, reallygood investment opportunities > > >> aren't going to come along too often and won't last too long, so you've > > >> got to beready to act and have a prepared mind---*Charlie Munger > > > >> On Fri, May 4, 2012 at 8:17 AM, Guru <gurudatt...@gmail.com> wrote: > > > >>> *The mental habit of thinking backward forces objectivity. One of the > > >>> ways you think a thing through backward is you take your initial > > >>> assumption > > >>> and say, Lets try and disprove it. For example, if you were hired by > > >>> the World Bank to help India, it would be very helpful to determine the > > >>> three best ways to increase man-years of misery in Indiaand, then, > > turn > > >>> around and avoid those ways. So think it backward as well as forward. > > >>> Its > > >>> a trick that works in algebra and its a trick that works in life. If > > you > > >>> dont, youll never be a really good thinker.---*Charlie Munger > > > >>> On Thu, May 3, 2012 at 9:56 AM, Wise Investor < > > investor.wisd...@gmail.com - show quoted text -

Guru

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May 8 Re: [IIF:20394] Re: "Learning the Art of Value Investing" - A new thread Hi Carlos, Agree 100% with you. You being one of deep value investor and considering your patience to find gems at bottom and your vast knowledge, you are the right person to share few good articles and notes about great investors. Thanks, Guru - show quoted text -

Wise Investor

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May 9 Re: [IIF:20399] Re: "Learning the Art of Value Investing" - A new thread

Hi, Notes on Berkshire Hathways Annual Meeting 2012. regards, Wise Investor

-DISCLAIMER IIF members recommending/discussing any stock/stock idea shall without prejudice, be deemed to be construed that, he/she may have vested interest in doing

so. Fellow IIF members are requested to complete their own research /due dligence in addition to the stock idea and \ or consult a qualified financial advisor before taking any action.IIF, its members and managers do not take any responsibility for any consequences (financial, legal or otherwise) resulting from action based on views discussed in the forum. Only make investments that suit your particular goals and capital constraints. https://groups.google.com/group/intelligent-investor-forum?hl=en Attachments (1)

92763946-Berkshire-Hathaway-Annual-Meeting-2012.pdf 498 KB View Download

Shiv Kumar

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May 9 Re: [IIF:20418] Re: "Learning the Art of Value Investing" - A new thread the guy has neither a cleaning lady nor a cook at home! marrying a drudge has its own benefits! shiv kumar - show quoted text -

paringala

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May 9

The Power of Beliefs to Move Markets and Mindsets by Dominic Barton and Conor Kehoe | Mindsets matter. For more than two years, we and others have been talking about the need to shift the prevailing view among managers, boards of directors and investors from "quarterly capitalism" to what we call "capitalism for the long term". Together with Harvard Business Review and the Management Innovation eXchange, we have issued a challenge calling for the most instructive case studies and provocative ideas that will help us re-imagine capitalism for the long term.

Despite promising signs of change, such as a growing turn away from the standard practice of issuing quarterly earnings guidance, old attitudes die hard. More and more, we realize, the crucial first step is to tackle our deeply embedded intellectual frameworks. Beliefs drive actions and altering our belief systems will ultimately do more than anything else to amplify and reinforce the kinds of behavioral changes that, in the end, are the only measure that counts. In this blog post we'd like to focus on two belief shifts that are critical.

1) Believe in your power to make markets efficient but abandon the efficient market dogma

The global financial markets are an extraordinary information processing engine. Nothing beats the tracking mechanism of stock prices when it comes to quantifying the constant push-and-pull of thousands and thousands of investors and managers, pursuing and acting upon different strategies. And yet . . . it's an extraordinary leap of

faith to go from acknowledging this fact to believing, as orthodox efficient market theory holds, that markets are so efficient that all relevant information is always and immediately embedded in prices. Such a belief implies that any and all decisions that improve a company's short term share price must logically also be improving its long term health and vice versa. There can be no contradiction, or so the theory goes.

In fact, much evidence suggests that the market often gets it very wrong in the short term with the most telling example being the 2008 financial crash itself. Beyond such large and violent macro-swings, our own research at McKinsey suggests businesses that reallocate their capital more aggressively can generate higher long term returns than their more passive peers - even if, in the first few years, such actions initially reduce previously expected earnings (and thus may prompt a set of investors to sell down the stock, regardless of the long term value creation). Assuming the market is perfectly efficient, it appears, merely damns it to inefficiency.

Our suggestion: instead of passively accepting that the market is always right, investors, managers and boards of directors need to think in terms of how they can actively make it more efficient. In short, they need to develop and contribute viewpoints to the market not assume the market already contains them - and then be ready to stick to their guns. This is the way both to achieve higher returns and make the market more efficient.

2) Believe in the real game long-term value creation and stop acting as if you are meeting your highest calling if you simply play by the rules

We direct this urgent call less at operating managers, who are out there getting muddy and trying to score goals every day, than at other critical corporate players, such as the trustees of pension funds and sovereign wealth funds or a company's independent directors. Does anyone honestly think this crowd today are doing all they could to provide good governance and proper stewardship? Sadly no. Too often they focus more on checking the boxes and ensuring that they have met their (not inconsiderable) compliance obligations. But with a crucial mental reset, they could and should play a much more vital role in pursuing the real prize, which is long-term value creation.

For big pension fund and SWF managers, that role change starts with spending the real time required to understand and have a forwardlooking viewpoint on their investments. There are many ways to achieve this end, once belief systems shift. One path could be to concentrate one's portfolio. For example, Dutch pension fund PGGM, with over 100 billion euros under management, decided a few years ago to focus one of its 3 billion euros of its equity portfolio on 15-20 stocks, engage with those investments as an active long-term owner and stop tracking the indexes. Another course might be to take more activity 'in house', especially if contracting investment management out makes it difficult to achieve alignment with one's chosen asset managers. Or it may involve keeping a wide portfolio but concentrating governance efforts on shaping management and strategy at a few stocks at a time and doing so either alone or in collaboration with others.

Independent directors confront the same challenge: currently they too often serve as the box-checking last step in signing-off on a CEO-run strategic process. If they want to move beyond obeying the letter of the laws governing their fiduciary duties and delve deeply into the content of strategy, then they need to increase one critical

investment: their time. This won't be easy, but there are signs the core belief system may be changing. In a recent survey of some 1600 members of boards of directors, we found that their number one goal is to spend more time on strategy and the best way to achieve this, they believe, is to carve out 10 more days a year for their board duties (a third more time than they are currently spending).

The key step is to foster deeper board engagement. Beyond that, we have learned, it also helps if an active independent director's relevant skills match up with the strategy of the company he aims to steward. Our recent research on 110 large European companies managed by private equity firms found a strong correlation between successful value creation and the skill set of the partner serving as lead director. PE partners with extensive M&A experience delivered better results when the companies they were overseeing were also embarked on an aggressive M&A strategy. Similarly companies pursuing organic growth created more value when the lead directors from their PE owners had backgrounds with deep management expertise.

Obviously much more needs to be done to foster a capitalism that is truly patient, principled and socially accountable. The list stretches from adopting an investor relations policy that concentrates on fostering a long term investor base and developing better metrics to tackling, with guidance from active owners, some of the flaws and inequities in executive compensation. We intend to continue exploring those issues--and the solutions required to better address them--in our ongoing research. But the critical first step, we're convinced, is for more and more institutional investors and independent board members to abandon old orthodoxies and embrace a new belief: the belief that through greater engagement and more active ownership/ stewardship they can enhance the market's efficiency while delivering greater value creation for stakeholders and shareholder alike.

Parin. On May 8, 8:29 pm, Guru <gurudatt...@gmail.com> wrote: > Hi Carlos, > > Agree 100% with you. > > You being one of deep value investor and considering your patience to find > gems at bottom and your vast knowledge, you are the right person to share > few good articles and notes about great investors. > > Thanks, > > Guru > > On Tue, May 8, 2012 at 5:18 PM, agnostic <dartthrowingmon...@gmail.com>wrote: - show quoted text -

Wise Investor

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May 11 Re: [IIF:20448] Re: "Learning the Art of Value Investing" - A new thread Images are not displayed Display images in this post - Always display images from Wise Investor - Always display images in Intelligent Investor Forum HI IIFians Interesting paper by James Montier on Quants success over human ...., if anyone is following/ using such quants in its stock picking pls do share with the grp for everyone learning. Regards, Wise Investor.

Global Equity Strategy: Painting by numbers: an ode to quant James Montier discusses the superiority of models over human judgement What could baseball, wine pricing, medical diagnosis, university admissions, criminal recidivism and I have in common? They are examples of simple quant models consist-ently outperforming so-called experts. Why should financial markets be any different? So why aren't there more quant funds? Hubristic self belief, self-serving bias and inertia combine to maintain the status quo. * There is now an overwhelming amount of data to suggest that in many environments, simple quant models significantly outperform human (expert) judgements. For instance, in their study of over 130 different papers, covering decision-making contexts as wideranging as occupational choice to the diagnosis of heart attacks, Grove et al located a mere 8 studies that found in favour of human judgements over the quant models. * All 8 of these studies had one thing in common. The human participants had access to information not available to the quant models. Where quant models and human had the same information set, the models performed much better. Across the full range of papers that Grove et al examined, the average human participant had a 66.5% accuracy rating, whereas the quant models had an average hit ratio of 73.2%. * Even when the human participants were given access to the quant model's results as aninput for them to use if they chose, they still managed to underperform the model. This isan important point. One of the most common responses to quant superiority is that surelythis could be a base for qualitative improvements by skilled users? However, the evidence is clear:

quant models usually provide a ceiling (from which we detract performance)rather than a floor (on which we can build performance). We tend to overweight our ownopinions relative to those of the models. * The good news is that, in some fields, quant models have become relatively accepted.For instance, over half the states in the US use a quant model when considering parole for convicts. However, in finance a quant approach is far from common. Those that do pursue a quant path tend to be rocket scientist uber-geeks. Once in a while a fairly normal 'quant' fund comes to light. Two explicitly behavioural based funds stand out in my mind LSV and Fuller & Thaler. Both have admirable track records in terms of outperformance. Whilst this is far from conclusive proof of the superiority of quant, it is a step in the right direction. * So why don't we see more quant funds in the market? The first reason is overconfidence.We all think we can add something to a quant model. However, the quant model has theadvantage of a known error rate, whilst our own error rate remains unknown. Secondly,self-serving bias kicks in, after all what a mess our industry would look if 18 out of every 20 of us were replaced by computers. Thirdly, inertia plays a part. It is hard to imagine a large fund management firm turning around and scrapping most of the process they have used for the last 20 years. Finally, quant is often a much harder sell, terms like 'black box' get bandied around, and consultants may question why they are employing you at all, if 'all' you do is turn up and crank the handle of the model. It is for reasons like these that quant investing will

remain a fringe activity, no matter how successful it may be. Painting by numbers: an ode to quant Don't worry dear reader, there will be no gratuitous use of poetry in this missive, despitethe title - I promise. However, pause again for a moment and consider what baseball, wine,medical diagnosis, university admissions, criminal recidivism and I might have incommon. The answer is that they all represent realms where simple statistical models have outperformed so-called experts. Long-time readers may recall that a few years ago I designed a tactical asset allocation tool based on a combination of valuation and momentum. At first this model worked just fine, generating signals in line with my own bearish disposition. However, after a few months, the model started to output bullish signals. I chose to override the model, assuming that I knew much better than it did (despite the fact that I had both designed it and back-tested it to prove it worked). Of course, much to my chagrin and the amusement of many readers, I spent about 18 months being thrashed in performance terms by my own model. This is only anecdotal(and economist George Stigler once opined "The plural of anecdote is data"), but it setsthe scene for the studies to which I now turn. Neurosis or psychosis?

The first study I want to discuss is a classic in the field. It centres on the diagnosis of whether someone is neurotic or psychotic. A patient suffering psychosis has lost touch with the external world; whereas someone suffering neurosis is in touch with the external world but suffering from internal emotional distress, which may be immobilising. The treatments for the two conditions are very different, so the diagnosis is not one to be taken lightly. The standard test to distinguish the two is the Minnesota Multiphasic Personality Inventory (MMPI). This consists of around 600 statements with which the patient must express either agreement or disagreement. The statements range from "At times I think I am no good at all" to "I like mechanics magazines". Fairly obviously, those feeling depressed are much more likely to agree with the first statement than those in an upbeat mood. More bizarrely, those suffering paranoia are more likely to enjoy mechanics magazines that the rest of us! In 1968, Lewis Goldberg1obtained access to more than 1000 patients' MMPI test responses and final diagnoses as neurotic or psychotic. He developed a simple statistical formula, based on 10 MMPI scores, to predict the final diagnosis. His model was roughly 70% accurate when applied out of sample. Goldberg then gave MMPI scores to experienced and inexperienced clinical psychologists and asked them to diagnose the patient. As Fig.1 shows, the simple quant rule significantly outperformed even the best of the psychologists. Even when the results of the rules' predictions were made available to the psychologists, they still underperformed the model. This is a very important point: much as we all like to think we can add something to the quant model output, the truth is that very often quant models represent a ceiling in performance (from which we detract) rather than a floor (to which we can add).

Every so often, and always with the aid of a member of the quant team, I publish a quant note in Global Equity Strategy. The last one was based on the little book that beats the market (see Global Equity Strategy, 9 March 2006). Whenever we produce such a note, the standard response from fund managers is to ask for a list of stocks that the model would suggest. I can't help but wonder if the findings above apply here as well. Do the fund managers who receive the lists then pick the ones that they like, much like the psychologists above selectively using the Goldberg rule as an input? Brain damage detection Similar findings were reported by Leli and Filskov2, in the realm of assessing intellectual deficit due to brain damage. They studied progressive brain dysfunction and derived a simple rule based on standard tests of intellectual functioning. This model correctly identified 83% of new (out of sample) cases. However, groups of inexperienced and experienced professionals working from the same data underperformed the model with only 63% and 58% accuracy respectively (that isn't a typo; the inexperienced did better than the experienced!). When given the output from the model the scores improved to 68% and 75% respectively - still both significantly below the accuracy rate of the model. Intriguingly, the improvement appeared to depend upon the extent of the use of the model. University admissions Dawes3 gives a great example of the impotence of interviews (further bolstering our arguments as to the pointlessness of meeting company managements - The

seven sins of fund management, November 2005). In 1979, the Texas legislature required the University of Texas to increase its intake of medical students from 150 to 200. The prior 150 had been selected by first examining the academic credentials of approximately 2200 students, and then selecting the highest 800. These 800 were called for an interview by the admissions committee and one other faculty member. At the conclusion of the interview, each member of the committee ranked the interviewee on a scale of 0 (unacceptable) to 7 (excellent). These rankings were then averaged to give each applicant a score. The 150 applicants who ended up going to Texas were all in the top 350, as ranked by the interview procedure. When the school was told to add another 50 students, all that were available were those ranked between 700 and 800. 86% of this sample had failed to get into any medical school at all. No one within the academic staff was told which students had come from the first selection and which had come from the second. Robert DeVaul and colleagues4 decided to track the performance of the two groups at various stages - i.e. the end of the second year, the end of the clinical rotation (fourth year) and after their first year of residency. The results they obtained showed no difference between the two groups at any point in time; they were exactly equal at all stages. For instance, 82% of each group were granted the M.D. degree, and the proportion granted honours was constant etc. The obvious conclusion: the interview served absolutely no useful function at all. Criminal recidivism Between October 1977 and May 1987, 1035 convicts became eligible for parole in Pennsylvania. They were interviewed by a parole specialist who assigned them a score on a five point scale based on the prognosis for supervision, risk of future crime, etc. 743 of these cases were then put before a parole board. 85% of those appearing before the board were granted parole, the decisions (bar one) following the recommendation of the parole specialist. 25% of the parolees were recommitted to prison, absconded, or arrested for anothercrime within the year. The parole board predicted none of these. Carroll et al5 compared the accuracy of prediction from the parole board's ranking, with that of a prediction based on a three factor model driven by the type of offence, the number of past convictions andthe number of violations of prison rules. The parole board's ranking was correlated 6% with recidivism. The three factor model had a

correlation of 22%. Bordeaux wine So far we have tackled some pretty heavy areas of social importance. Now for somethinglighter. In 1995, a classic quant model was revealed to the world: a pricing equation forBordeaux wine. Ashenfelter et al6 computed a simple equation based on just four factors; the age of the vintage, the average temperature over the growing season (AprilSeptember), rain inSeptember and August, and the rain during the months preceding the vintage (October-March). This model could explain 83% of the variation of the prices of Bordeaux wines. Ashenfelter et al also uncovered that young wines are usually overpriced relative to whatone would expect based on the weather and the price of old wines. As the wine matures,prices converge to the predictions of the equation. This implies that "bad" vintages areoverpriced when they are young, and "good" vintages may be underpriced.

Fig.3 shows the basic pattern. It shows the price of a portfolio of wines fromeach vintage relative to the (simple average) price of the portfolio of wines from the 1961,62, 64 and 66 vintages. The second column gives the value of the benchmark portfolio inGBP. The entries for each of the vintages in the remaining columns are

simply the ratios of the prices of the wines in each vintage to the benchmark portfolio. The predicted price from the equation is also shown. Incidentally, this data is from a different sample than the original estimation of the equation, so it amounts to an out of sample test7. Purchasing managers Professor Chris Snijders has been examining the behaviour of models versus purchasing managers8. He has examined purchasing managers at 300 different organizations. Theresults will not be surprising to those reading this note. Snijders concludes "We find that (a) judgments of professional managers are meagre at best, and (b) certainly not betterthan the judgments by less experienced managers or even amateurs. Furthermore, (c)neither general nor specific human capital of managers has an impact on their performance, and (d) a simple formula outperforms the average (and the above average) manager even when the formula only has half of the information as compared to the manager." Meta-analysis Ok enough already, you may cry9. I agree. But, to conclude, let me show you that the range of evidence I've presented here is not somehow a biased selection designed to prove my point.

Grove et al10 consider an impressive 136 studies of simple quant models versus humanjudgements. The range of studies covered areas as diverse as criminal recidivism to occupational choice, diagnosis of heart attacks to academic performance. Across these studies 64 clearly favoured the model, 64 showed approximately the same result between the model and human judgement, and a mere 8 studies found in favour of human judgements. All of these eight shared one trait in common; the humans had more information than the quant models. If the quant models had the same information it is highly likely they would have outperformed.

Fig.4 shows the aggregate average 'hit' rate across the 136 studies that Grove et al examined. The average person in the study (remember they were all specialists in their respective fields) got 66.5% of the cases they were presented with correct. However, the quant models did significantly better with an average hit ratio of 73.2%. As Paul Meehl (one of the founding fathers of the importance of quant models versus human judgements) wrote: There is no controversy in social science which shows such a large body of qualitatively diverse studies coming out so uniformly in the same direction as this one... predicting everything from the outcomes of football games to the diagnosis of liver disease and when you can hardly come up with a half a dozen studies showing even a weak tendencyin favour of the clinician, it is time to draw a practical conclusion.

The good news The good news is that in some fields quant models have become far more accepted. For instance, Fig.5 shows the number of states in which the decision to parole has a quant prediction instrument involved. However, in the field of finance most still shy away from an explicit quant process. A few brave souls have gone down this road. Two explicitly behavioural finance groups stand out as using an explicitly quantitative process - LSV and Fuller & Thaler. Fig.6 shows the performance of their funds relative to benchmark since inception. With only one exception all of these funds have delivered pretty significant positive alpha. Of course, this doesn't prove that quant investing is superior; I would need a much larger sample to draw any valid conclusions. But it is a nice illustration of the point I suspect is true.

So why not quant? The most likely answer is overconfidence. We all think that we know better than simple models. The key to the quant model's performance is that it has a known error rate while our error rates are unknown. The most common response to these findings is to argue that surely a fund manager should be able to use quant as an input, with the flexibility to override the model when required. However, as mentioned above, the evidence suggests that quant models tend to act as a ceiling rather than a floor for our behaviour. Additionally there is plenty of evidence to suggest that we tend to overweight our own opinions and experiences against statistical evidence. For instance, Yaniv and Kleinberger11 have a clever experiment based on general knowledge questions such as: In which year were the Dead Sea scrolls discovered? Participants are asked to give a point estimate and a 95% confidence interval. Having done this they are then presented with an advisor's suggested answer, and asked for their final best estimate and rate of estimates. Fig.7 shows the average mean absolute error in years for the original answer and the final answer. The final answer is more accurate than the initial guess.

The most logical way of combining your view with that of the advisor is to give equal weight to each answer. However, participants were not doing this (they would have been even more accurate if they had done so). Instead they were putting a 71% weight on their own answer. In over half the trials the weight on their own view was actually 90-100%! This represents egocentric discounting - the weighing of one's own opinions as much more important than another's view. Similarly, Simonsohn et al12 showed that in a series of experiments direct experience is frequently much more heavily weighted than general experience, even if the information is equally relevant and objective. They note, "If people use their direct experience to assess the likelihood of events, they are likely to overweight the importance of unlikely events that have occurred to them, and to underestimate the importance of those that have not". In fact, in one of their experiments, Simonsohn et al found that personal experience was weighted twice as heavily as vicarious experience! This is an uncannily close estimate to that obtained by Yaniv and Kleinberger in an entirely different setting. Grove and Meehl13 suggest many possible reasons for ignoring the evidence presented in this note; two in particular stand out as relevant to the discussion here. Firstly, the fear of technological unemployment. This is obviously an example of a self serving bias. If, say, 18 out of every 20 analysts and fund managers could be replaced by a computer, the results are unlikely to be welcomed by the industry at large. Secondly, the industry has a large dose of inertia contained within it. It is pretty inconceivable for a large fund management house to turn around and say they are scrapping most of the processes they had used for the last 20 years, in

order to implement a quant model instead. Another consideration may be the ease of selling. We find it 'easy' to understand the idea of analysts searching for value, and fund managers rooting out hidden opportunities. However, selling a quant model will be much harder. The term 'black box' will be bandied around in a highly pejorative way. Consultants may question why they are employing you at all, if 'all' you do is turn up and run the model and then walk away again. It is for reasons like these that quant investing is likely to remain a fringe activity, no matter how successful it may be. regards, Wise Investor

-DISCLAIMER IIF members recommending/discussing any stock/stock idea shall without prejudice, be deemed to be construed that, he/she may have vested interest in doing so. Fellow IIF members are requested to complete their own research /due dligence in addition to the stock idea and \ or consult a qualified financial advisor before taking any action.IIF, its members and managers do not take any responsibility for any consequences (financial, legal or otherwise) resulting from action based on views discussed in the forum. Only make investments that suit your particular goals and capital constraints. https://groups.google.com/group/intelligent-investor-forum?hl=en

Saurabh Shankar

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May 1

Re: [IIF:20052] "Learning the Art of Value Investing" - A new thread Hi IIFians, This time we would look at another bias called the "anchoring bias", my favorite as i suffer often :( from this and the one where most investors can trip. BIAS-2 :ANCHORING BIAS This bias describes the common human tendency to rely too heavily, or "anchor," on one trait or piece of information when making decisions. During normal decision making, anchoring occurs when individuals overly rely on a specific piece of information to govern their thought-process. Once the anchor is set, there is a bias toward adjusting or interpreting other information to reflect the "anchored" information. For a moment stop here and think at the latest stock which you had bought and think how one single information has influenced your buying/selling heavily ( low P/E, bad sector, growth potentianl etc etc). If this has happened then we have unknowingly let bias come into our decision. For example, if say you are a ardent follower of Rakesh Jhunjhunwala and he buys Delta Corp. Internally, you will tend to ignore negatives of the company and start to justify why this seems a great story. Similarly, this anchor could be anything a person, an event, a ratio etc. Views and experiences invited. Regards, saurabh

- show quoted text -

Brijesh

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May 1 Re: [IIF:20526] "Learning the Art of Value Investing" - A new thread Hi saurabh, I think one should not only always think as a critic while investing (ultimately it is our hard earned money) but also note down the points both negative or positive. It seems very childish ( noting down ) but actually it help in a gr8 way. Human minds are very sharp and if we note down points then it actually help our brain to analyze the things from different perspectives which actually help to take better decision. One lesson which I learned from small experience that never rely on news like ( PE fund is investing, BIg FII like Goldman, Blackstone , GMO are buying or other Indian warren buffets kind buying...evething is useless these PE and FII are playing with others money and only interested in their fee and hence one should not carried away from their decision..their due diligence is ram bharose....we have numerous example before us....

QI

Constant Seeker

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May 1 Re: [IIF:20530] "Learning the Art of Value Investing" - A new thread

Hi QI,

I think one should not be a critic but rather should remain skeptical and always try and invert. Obviously in this process one should always note down one's thoughts and then decide Regard Saurabh On May 12, 2012 5:43 PM, "Quant Investor" <quantinvestor@gmail.com> wrote:

Wise Investor

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May 1 Re: [IIF:20536] "Learning the Art of Value Investing" - A new thread Hi Saurabh, Anchoring bias has big effect on decision making. Forget Stock market, if you just think abt in variuos fields, eg. 1 ) how media hooks us to topics and diverts our mind from ongoing affairs. 2) When we go for shopping, Anchoring plays a major role in it. In a store, even if we dont wanna buy, At times Discounts , Clubbed items in big bazaar, or Brands etc, we end up buying. 3) In our market also, Anchoring plays a very important role, Certain market participants, analyst, broking House, etc, play a role of an anchor when some information is given out through them. Our Decision gets linked by their information. There are lot areas if we start thinking we shall realise that Anchoring a major role in our daily life decision also.

If any one wants to read more about it do let me know, i hv few papers worth reading. regards, Wise Investor - show quoted text - show quoted text - show quoted text -DISCLAIMER IIF members recommending/discussing any stock/stock idea shall without prejudice, be deemed to be construed that, he/she may have vested interest in doing so. Fellow IIF members are requested to complete their own research /due dligence in addition to the stock idea and \ or consult a qualified financial advisor before taking any action.IIF, its members and managers do not take any responsibility for any consequences (financial, legal or otherwise) resulting from action based on views discussed in the forum. Only make investments that suit your particular goals and capital constraints. https://groups.google.com/group/intelligent-investor-forum?hl=en

Constant Seeker

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May 1 Re: [IIF:20536] "Learning the Art of Value Investing" - A new thread Hi Wise Investor, Please send across the papers. Yes, anchoring is a huge bias in all my decisions and i didn't even knew about this bias 4-5 month ago :P. Regards,

Saurabh - show quoted text -

Brijesh

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May 1 Re: [IIF:20536] "Learning the Art of Value Investing" - A new thread

Hi,

Interesting read....

It's earnings season, so before buying into an analyst recommendation make sure to sanity check it. Here are ways to spot outrageous claims. 1. Style over Substance Beware of the table-pounder who promotes stocks without hard evidence. These bulls are charismatic and personable, but rely on emotion sprinkled with faulty logic. They sometimes mask ulterior motives. Even after the embarrassing revelations of financial bubbles, analysts still push stocks of banking clients and are richly rewarded. [More from Forbes: How to pick a financial advisor] What stops the bulls? The cliff. In the endgame, a data point can nullify conventional wisdom sending the stock into a freefall. But not all analysts are shady salesmen. A small percentage has industry expertise and does homework. They do surveys for feedback, and they find contrary indicators. A tiny subset has forensic accounting skills and digs into financials cross-checking with third-party resources from the government, industry or other companies. These analysts look for inconsistencies and gather enough facts to make bold bearish calls. [More from Forbes: Is it time to fire your financial advisor?] 2. Vague Descriptions

A company description should be quantified and concise. An example is: "Cisco is a $45 B company that makes routers, switches and servers for enterprise networks". A bad one is, "Cisco is a global leader in communications innovation". You invest in products and services not vagaries. A key way to identify B.S. is to look for long streams of adjectives, like "state of the arts, low bit error rate equipment with many bells and whistles". My experience is the uninformed combine long descriptions with clichs. 3. Excessive Adjectives Confusing adjectives have no place in financial analysis. Calling a quarter "strong, weak, good or bad" connotes nothing. "Qualcomm missed the quarter based on component shortages but the outlook is good" is contradictory. It does not give the essential elements that investors need, namely catalysts (contracts or deals), costs (supply chain) and milestones (sales forecasts). The analyst should quantify performance and cite time periods. Without these details, the analysis should be ignored. [More from Forbes: How to give difficult feedback] 4. Hype and Hyperbole Financial analysis is not advertising, so claims of "truly amazing performance" or "enormous gains" and other exaggerations don't fit. Hyperbole and superlatives create buying frenzies, which are black holes for investors. 5. Techno-Speak Poor analysts lapse into industry jargon and stats, like "The New iPad has a 2048 X 1536 retina display, an A6 processor and supports 4G LTE". Analysts should explain cost-benefits for new features. An assessment of customer price sensitivity would be good. [More from Forbes: 10 ways to be more confident at work] 6. Questionable Valuations Stock valuations are standard formula to predict stock prices and are based on projected revenue or profits. Results may differ from reality as there are many unaccounted variables in future streams discounted to the present. Watch out for use non-standard metrics, like taking the company's cash out of the analysis. They make the valuation look lower (better). 7. Investor Saturation For the stock to go up, investor demand must exceed supply. If your nanny just bought a share of Apple, chances are the market is saturated and it won't climb even if revenues grow 70%. At some point, good news is discounted into the stock, or expectations may have run away. 8. Fantasy Price Targets

Price targets are an arms race that serves the analyst, not the investor. There is little downside for an analyst to bid up a price. When Amazon was trading at $200, Henry Blodget, who was later barred from the securities industry, set his one-year price target at $400. His rationale: if right, I will become a rock star and if wrong, no one will remember. The stock hit the target in a month, and emboldened Henry produced excessive hype mislabeled as financial analysis. He was wrong and everyone remembered. A reasonable analyst sets price targets with 20% headroom and recalibrates on news. The $1000 price targets on Apple, now trading at $560 may be fantasy. [More from Forbes: What makes emerging markets great investments] 9. Repetition Ignore the pump-and-dumpers that scream at every 2% contraction, it is "Christmas in June". 10. Starmine Sweepstakes A recent study suggests Starmine, which ranks analysts according to accuracy of forecasts, may be gamed. A serial winner in Starmine rankings with top marks across-the-board for most of their companies may be a cheat.

Rgds, QI