[The Weekend Bulletin] #168: Rohit Chauhan - Value Investing with Momentum, Tiny Titans Screening Model, Lucretius Problem,...

...Managements as Moats, Errors, Reducing Your Surface Area, and more.

A digest of some interesting reading material from around the world-wide-web. Your weekly dose of multi-disciplinary reading.

Investing Wisdom

• Rohit Chauhan has been investing in the Indian equity markets for over two decades. He also runs an investment advisory service as well as writes regularly on his blog. I have really enjoyed reading his articles over the years. Recently, Rohit interviewed on the Stoic Talks podcast where he laid bare his value investing principles along with his recent style drift. This is as detailed an interview as any you would hear of any value investor talking about his craft.

• This short article details an interesting quantitative screening strategy for small cap stocks. The strategy is based on James O’Shaugnessy’s Tiny Titans screening model, which he has outlined in his books. The reason it is interesting is that the model has delivered annual gains since inception of 24% vs 7.5% for the S&P Smallcap 600 index, as of July 31.

  • If you heard the podcast above, you should be able to connect some common threads between Rohit’s recent pivot and the article above.

• This article makes an important point about small companies - their biggest moat is their management. However, the key to understand here is that the founder or management that runs the business at a certain scale may not be the best choice to run it at a larger scale. The article explains why and provides some hints to identify managements that can really scale small businesses.

• In a lecture that I had attended by Prof. Sanjay Bakshi, he spoke about an interesting concept - ‘return per unit of stress’. This article explains that concept very well.

Mental Models & Behavioral Biases

• This blog post does a very neat job of tackling the subject of errors. The author explains how the two types of errors - omission and commission are actually joined at the hip, and how minimising on can lead to an increase in the other. The author looks at the examples of Amazon and Warren Buffett to explain this.

• There is a running joke about how back-tests always work in history, but seldom in reality. The reason this happens is a concept called the Lucretius Problem. This article explains this issue, and suggests using ‘margin of safety’ as a solution.

Personal Development

• This tweet is a beautiful rumination on what makes us feel so busy, stressed, and anxious. The idea of looking at connections, possessions, and desires through the lens of surface area is an interesting way to think.

  • On a related note, this article by the author expands on the idea about based on a book.

Blast From The Past

Revisiting articles from a past issue for the benefits of refreshing memory and spaced repetition, as well as for a fresh perspective. Below are articles from #92:

• What's the most important thing in investing? Capital? Philosophy? Resources? Access? Talent? When I was younger (and naive), I would have picked up one of those things. Now that I am not (young), I'd say it's character. What good will a philosophy do, if you cant stick to it? What's the point in having capital, when price movements dictate your actions? Character is the bond that holds all of these inputs - capital, philosophy, access, talent etc - in their right place (Warren Buffett: EQ>IQ). Character is what reminds you of your north star, just when you are about to lose sight of it. Here's what you need to build a strong character.

• What's the next important thing in investing? IMHO, compounding. And what's the most important rule of compounding - to not disturb it. Which would mean: no rebalancing, no trimming, no in and out. What else could it mean? This article provides a few uncommon views on compounding, including investing in IPOs. Loved it.

• Lastly, what gets the most attention in investing? Returns, yes. But what else? Valuations. What really is a valuation? A number from today, multiplied by a story about tomorrow, says Morgan Housel in this well written piece. The trick when forecasting is realizing that’s what you’re doing.

• Most people reading this bulletin are finance blokes. So we all understand the time value of money, and the opportunity cost of money. However, if you were to turn this on its head, not many appreciate the concept of the money value of time. Just as there is an opportunity cost of money, so is there an opportunity cost of your time. Read on to find out what it means.

Readworthy Passage

Let's read together a random, but read-worthy, passage from a randomly picked book.

So how do great chess players approach the game? Chess master Bruce Pandolfini observes four behaviors that are consistent among chess cham- pions and useful in thinking through the short-term/long-term debate.

1. Don’t look too far ahead: Most people believe that great players strategize by thinking far into the future, by thinking 10 or 15 moves ahead. That’s just not true. Chess players look only as far into the future as they need to, and that usually means thinking just a few moves ahead. Thinking too far ahead is a waste of time: The information is uncertain.

2. Develop options and continuously revise them based on the changing condi- tions (see exhibit 18.1): Great players consider their next move without playing it. You should never play the first good move that comes into your head. Put that move on your list, and then ask yourself if there’s an ever better move. If you see a good idea, look for a better one—that’s my motto. Good thinking is a matter of making comparisons.

3. Know your competition: Being good at chess also requires being good at reading people. Few people think of chess as an intimate, personal game. But that’s what it is. Players learn a lot about their opponents, and exceptional chess players learn to interpret every gesture that their opponents make.

4. Seek small advantages: You play for seemingly insignificant advantages— advantages that your opponent doesn’t notice or that he dismisses, thinking, “Big deal, you can have that.” It could be slightly better development, or a slightly safer king’s position. Slightly, slightly, slightly. None of those “slightlys” mean anything on their own, but add up seven or eight of them, and you have control.

Pandolfini stresses to his students that his goal is not to make them great chess players but great thinkers:

My goal is to help them develop what I consider to be two of the most important forms of intelligence: the ability to read other people, and the ability to under- stand oneself. Those are the two kinds of intelligence you need to succeed at chess—and in life.

There are limits to the business-as-chess analogy. Besides the added com- plexity of business, the most significant limitation is that chess is a zero-sum game: for every winner, there’s a loser. The business world is not zero-sum, and the game between players has an unspecified tenure. So how can we apply these lessons from chess to the business world?

One of the characteristics of a complex system is that highly variable out- comes emerge from simple rules. Unless you deliberately replay a chess game, you’ll never see the same game twice. Herein lies the key to resolving the tension between the short term and the long.

Companies should develop long-term decision rules that are flexible enough to allow managers to make the right decisions in the short term. In this way, the company is managing for the long run even when it has no information about what the future holds. No company knows how the business landscape will develop—just as chess players don’t know how the board will develop—but decision rules provide action guidelines no matter what happens.

Kathy Eisenhardt and Don Sull call this “strategy as simple rules.”5 They argue that companies, especially in fast-changing markets, should not embrace complex strategies but rather adopt and stick to “a few straightfor- ward, hard-and-fast rules that define direction without containing it.”

Eisenhardt and Sull specifically suggest five types of rules:

1. How-to rules spell out key features of how a company should execute a pro- cess. It answers the question, What makes our process unique?

2. Boundary rules focus managers on which opportunities they should pursue and which are outside the pale.

3. Priority rules help managers rank the opportunities they accept.

4. Timing rules synchronize managers with the pace of opportunities that emerge in other parts of the company.

5. Exit rules help managers decide when to pull out of yesterday’s opportunities.

- From More Than You Know by Michael Mauboussin

Quotable Quotes

"Our bias toward buying and holding has at times made us too quick to rationalize a problem that hits one of our companies as temporary and “already priced into the stock.” If the problem turns out to be more long-term and fundamental, it’s likely not fully discounted into the current price at all. We’ve been blind at times to fundamental changes in a company’s business because we think the quick 25-30% drop in the share price makes the stock too cheap to sell."

- Francois Rochon

[My take: if you are a patient long term investor, you are going to be patient with your mistakes as well - in effect selling late. on the other hand, if you are a nimble investor, you might get out of your mistakes soon enough, but you might also miss out ona great business going through a temporary setback. there is a downside in each case, a trade off. you have to choose the devil that you are more comfortable with.]

“Frugality, quite simply, is about choosing the things you love enough to spend extravagantly on—and then cutting costs mercilessly on the things you don’t love.”

- Ramit Sethi

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That's it for this weekend folks.

Have a wonderful week ahead!!

- Tejas Gutka

[Aug 19, 2023]