Meeting With Triumph and Disaster: Some Lessons

Here’s a the transcript of something I wanted to tell my BFBV class students yesterday and today but the time ran out. So, I am putting it down here…

Danny Kahneman’s famous work on Prospect theory can best be described by an image and a quote from Charlie Munger. Here’s the image:

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And here’s the quote:

“The quantity of a man’s pleasure from a ten dollar gain does not exactly match the quantity of his displeasure from a ten dollar loss.” — Charlie Munger

A few days ago I had presented you with a problem. You had to choose between an 85% chance of winning $100 (the gamble) or a sure gain of $85 (the sure thing). Most of you chose the sure thing, presumably because you thought of yourself as a conservative person who thought at a bird in hand is worth two in the bush.

So far so good. But look what happened when I presented the exact same problem by changing a “gain frame” to a “loss frame.” That is, when I asked you to choose between an 85% chance of losing $100 (the gamble) or a sure loss of $85 (the sure thing), most of you became gamblers! Think about that and the power of words. Just by changing a few words, without changing the problem, I turned you from being a conservative person to a gambler. That, dear students is loss aversion. As Danny Kahneman writes:

The reason you like the idea of gaining $85 and dislike the idea of losing $85 is not that these amounts change your wealth. You just like winning and dislike losing—and you almost certainly dislike losing more than you like winning.

Loss aversion made you a risk seeking person.

Loss aversion explains human behaviour in situations of conflict such as labor negotiations. Kahneman wrote:

It is well understood by both sides that the anchor is the existing contract and that the negotiations will focus on mutual demands for concessions relative to that anchor. The role of loss aversion in bargaining is also well understood: making concessions hurts.

The concessions you make to me are my gains, but they are your losses; they cause you much more pain than they give me pleasure. Inevitably, you will place a higher value on them than I do. The same is true, of course, of the very painful concessions you demand from me, which you do not appear to value sufficiently!

Negotiations over a shrinking pie are especially difficult, because they require an allocation of losses. People tend to be much more easygoing when they bargain over an expanding pie.

Loss aversion also explains the difficulty in carrying out “reorganizations” and “restructuring” of companies, or rationalizing a bureaucracy. Kahneman writes:

As initially conceived, plans for reform almost always produce many winners and some losers while achieving an overall improvement. If the affected parties have any political influence, however, potential losers will be more active and determined than potential winners; the outcome will be biased in their favor and inevitably more expensive and less effective than initially planned. Reforms commonly include grandfather clauses that protect current stake-holders—for example, when the existing workforce is reduced by attrition rather than by dismissals, or when cuts in salaries and benefits apply only to future workers.

Loss aversion also explains the behaviour of gamblers (and day traders and even stock market investors) who become risk seeking immediately after experiencing a string of losses. They will do almost anything just to “get back in the game.”

Indeed, this inability of most human beings to treat losses and gains equivalently explains many things about human nature. The rational person, on the other hand, treats losses and gains equivalently. For them, the quantity of pleasure from a ten dollar gain is no different from the quantity of misery from a ten dollar loss.

One such rational person, of course, is Warren Buffett. Over the years he has not only demonstrated his ability to treat losses and gains equivalently, he has also taken advantage of those who don’t (or can’t given their dependence on the need to not look foolish.)

Here are a few excerpts from Buffett’s letters which illustrate this point:

Extract from 1989 Letter

Our willingness to put such a huge sum on the line for a loss that could occur tomorrow sets us apart from any reinsurer in the world. There are, of course, companies that sometimes write $250 million or even far more of catastrophe coverage. But they do so only when they can, in turn, reinsure a large percentage of the business with other companies. When they can’t “lay off” in size, they disappear from the market.

Berkshire’s policy, conversely, is to retain the business we write rather than lay it off. When rates carry an expectation of profit, we want to assume as much risk as is prudent. And in our case, that’s a lot.

We will accept more reinsurance risk for our own account than any other company because of two factors: (1) by the standards of regulatory accounting, we have a net worth in our insurance companies of about $6 billion – the second highest amount in the United States; and (2) we simply don’t care what earnings we report quarterly, or even annually, just as long as the decisions leading to those earnings (or losses) were reached intelligently.

Obviously, if we write $250 million of catastrophe coverage and retain it all ourselves, there is some probability that we will lose the full $250 million in a single quarter. That
probability is low, but it is not zero. If we had a loss of that magnitude, our after-tax cost would be about $165 million. Though that is far more than Berkshire normally earns in a quarter, the damage would be a blow only to our pride, not to our well-being.

This posture is one few insurance managements will assume. Typically, they are willing to write scads of business on terms that almost guarantee them mediocre returns on equity. But they do not want to expose themselves to an embarrassing single- quarter loss, even if the managerial strategy that causes the loss promises, over time, to produce superior results. I can understand their thinking: What is best for their owners is not necessarily best for the managers. Fortunately Charlie and I have both total job security and financial interests that are identical with those of our shareholders. We are willing to look foolish as long as we don’t feel we have acted foolishly.

Extract from 2000 Letter

In another example of his versatility, Ajit last fall negotiated a very interesting deal with, an Internet company whose goal was to attract millions of people to its site and there to extract information from them that would be useful to marketers. To lure these people, held out the possibility of a $1 billion prize (having a $170 million present value) and we insured its payment. A message on the site explained that the chance of anyone winning the prize was low, and indeed no one won. But the possibility of a win was far from nil.

Writing such a policy, we receive a modest premium, face the possibility of a huge loss, and get good odds. Very few insurers like that equation. And they’re unable to cure their unhappiness by reinsurance. Because each policy has unusual  and sometimes unique  characteristics, insurers can’t lay off the occasional shock loss through their standard reinsurance arrangements. Therefore, any insurance CEO doing a piece of business like this must run the small, but real, risk of a horrible quarterly earnings number, one that he would not enjoy explaining to his board or shareholders. Charlie and I, however, like any proposition that makes compelling mathematical sense, regardless of its effect on reported earnings.

Extract from 2006 Letter

Lloyd’s, Equitas and Retroactive Reinsurance

Last year – we are getting now to Equitas – Berkshire agreed to enter into a huge retroactive reinsurance contract, a policy that protects an insurer against losses that have already happened, but whose cost is not yet known. I’ll give you details of the agreement shortly. But let’s first take a journey through insurance history, following the route that led to our deal.

Our tale begins around 1688, when Edward Lloyd opened a small coffee house in London. Though no Starbucks, his shop was destined to achieve worldwide fame because of the commercial activities of its clientele – shipowners, merchants and venturesome British capitalists. As these parties sipped Edward’s brew, they began to write contracts transferring the risk of a disaster at sea from the owners of ships and their cargo to the capitalists, who wagered that a given voyage would be completed without incident. These capitalists eventually became known as “underwriters at Lloyd’s.”

Though many people believe Lloyd’s to be an insurance company, that is not the case. It is instead a place where many member-insurers transact business, just as they did centuries ago.

Over time, the underwriters solicited passive investors to join in syndicates. Additionally, the business broadened beyond marine risks into every imaginable form of insurance, including exotic coverages that spread the fame of Lloyd’s far and wide. The underwriters left the coffee house, found grander quarters and formalized some rules of association. And those persons who passively backed the underwriters became known as “names.”

Eventually, the names came to include many thousands of people from around the world, who joined expecting to pick up some extra change without effort or serious risk. True, prospective names were always solemnly told that they would have unlimited and everlasting liability for the consequences of their syndicate’s underwriting – “down to the last cufflink,” as the quaint description went. But that warning came to be viewed as perfunctory. Three hundred years of retained cufflinks acted as a powerful sedative to the names poised to sign up.

Then came asbestos. When its prospective costs were added to the tidal wave of environmental and product claims that surfaced in the 1980s, Lloyd’s began to implode. Policies written decades earlier – and largely forgotten about – were developing huge losses. No one could intelligently estimate their total, but it was certain to be many tens of billions of dollars. The specter of unending and unlimited losses terrified existing names and scared away prospects. Many names opted for bankruptcy; some even chose suicide.

From these shambles, there came a desperate effort to resuscitate Lloyd’s. In 1996, the powers that be at the institution allotted £11.1 billion to a new company, Equitas, and made it responsible for paying all claims on policies written before 1993. In effect, this plan pooled the misery of the many syndicates in trouble. Of course, the money allotted could prove to be insufficient – and if that happened, the names remained liable for the shortfall.

But the new plan, by concentrating all of the liabilities in one place, had the advantage of eliminating much of the costly intramural squabbling that went on among syndicates. Moreover, the pooling allowed claims evaluation, negotiation and litigation to be handled more intelligently than had been the case previously. Equitas embraced Ben Franklin’s thinking: “We must all hang together, or assuredly we shall hang separately.”

From the start, many people predicted Equitas would eventually fail. But as Ajit and I reviewed the facts in the spring of 2006 – 13 years after the last exposed policy had been written and after the payment of £11.3 billion in claims – we concluded that the patient was likely to survive. And so we decided to offer a huge reinsurance policy to Equitas.

Because plenty of imponderables continue to exist, Berkshire could not provide Equitas, and its 27,972 names, unlimited protection. But we said – and I’m simplifying – that if Equitas would give us $7.12 billion in cash and securities (this is the float I spoke about), we would pay all of its future claims and expenses up to $13.9 billion. That amount was $5.7 billion above what Equitas had recently guessed its ultimate liabilities to be. Thus the names received a huge – and almost certainly sufficient – amount of future protection against unpleasant surprises. Indeed the protection is so large that Equitas plans a cash payment to its thousands of names, an event few of them had ever dreamed possible.

And how will Berkshire fare? That depends on how much “known” claims will end up costing us, how many yet-to-be-presented claims will surface and what they will cost, how soon claim payments will be made and how much we earn on the cash we receive before it must be paid out. Ajit and I think the odds are in our favor. And should we be wrong, Berkshire can handle it.

Scott Moser, the CEO of Equitas, summarized the transaction neatly: “Names wanted to sleep easy at night, and we think we’ve just bought them the world’s best mattress.”

Needless to say, that was an expensive mattress but one that offered its loss averse owners a lot of comfort.

These examples show that risk aversion and loss aversion are not the same. Buffett, for example, is risk averse, but not loss averse. He gladly accepts bets where he could lose a large sum of money but where there is an expectancy of a gain, provided that if a loss does occur, it will not impair Berkshire’s balance sheet.

As an investor, you should seek businesses which are risk averse but not loss averse. You should avoid businesses who don’t want to even experiment a bit because they are petrified of losses should the experiments fail. Most of the time, you really don’t want to be an investor in businesses like this one:


The way Warren Buffett thinks about loss aversion is very rare. It has to be rare where people do not wish to look like fools even though they haven’t acted foolishly.

It is also the kind of thinking Kipling recommends in his beautiful, deeply inspirational poem “If.”

This poem has a number of lessons for you, but let’s focus on just one of them today, which is highlighted in below.

If, by Rudyard Kipling

If, by Rudyard Kipling

A few years ago, in a shareholders’ meeting, Mr. Munger spoke about Kipling’s poem.

Shareholder: When Bell Rich Oil goes up 35 times, it’s pretty…I imagine myself have a lot of regret or debilitating. How does one recuperate from something like that? A big missed opportunity? How does one recover from that? How do you end up not dwelling on that?

Munger: You know what Kipling said? Treat those two imposters just the same — success and failure. Of course, there’s going to be some failure in making the correct decisions… I think it’s important to review your past stupidities so you are less likely to repeat them, but I’m not gnashing my teeth over it or suffering or enduring it. I regard it as perfectly normal to fail and make bad decisions. I think the tragedy in life is to be so timid that you don’t play hard enough so you have some reverses.

And he spoke about Kipling’s poem again elaborating on what it teaches us about how to live a useful life in this wonderful interview with Becky Quick.

Munger is telling you to listen to Kipling who suggests that great success shouldn’t give you a swelled head, and great failure shouldn’t discourage you, since both are in a sense flukish anomalies. Rather, you should react the same way to both.

Kipling’s words “If you can meet with Triumph and Disaster And treat those two impostors just the same” are inscribed on the top of a passage inside the Wimbledon tunnel as a reminder to the players entering that temple on how to behave inside the stadium.

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Watch this old video which shows Kipling’s inspirational words have been inside the stadium for decades…

To many of you, I hope, all this will look a bit familiar, and remind you about Indian spiritual thought on detachment as described in some of its most important works. Take, for example, this small passage from the Mundaka Upanishad:


The two golden birds, of course, are the ego and the self. The ego is what you need to control.

In his wonderful book, “The Practicing Mind: Bringing Discipline and Focus Into Your Life,” Thomas Sterner writes:

If you are aware of anything you are doing, that implies that there are two entities involved: one who is doing something and one who is aware or observing you do it. If you are talking to yourself, you probably think you are doing the talking. That seems reasonable enough, but who is listening to you talk to yourself? Who is aware that you are observing the process of an internal dialogue? Who is this second party that is aware that you are aware?

The answer is your true self. The one who is talking is your ego or personality. The one who is quietly aware is who you really are, the Observer. The more you become aligned to the quiet Observer, your true self, the less you judge. Your internal dialogue begins to shut down and you become more detached about the various external stimuli that come at you all day long. You begin to actually view your internal dialogue with an unbiased and sometimes amused perspective. I have had times where my ego is going on and on about something someone said to me that “it” considered “irritating,” and I am very separate and unaffected. I feel as if I am invisible in a room watching someone complain about something that is completely unimportant to me. This also extends into experiences of personal stress such as job deadlines or finances. I have witnessed my ego rambling on about how I am not going to finish a job on time. When I am aligned to my true self, the Observer, I find myself aware of the stress that my ego is experiencing, but also unaffected by it. I have a sense of “that’s just my ego fretting that it will experience disapproval by a certain party if it disappoints them by taking longer than it originally anticipated.”

When you are aligned with your true self you are immune to other peoples’ behaviors. When you feel that someone is acting inappropriately towards you, that comes from a judgment of the ego. From the perspective of the Observer, you find yourself just watching their ego rant and rave while you are listening quietly and unaffected.

The importance of knowing this is that when you decide to engage your practicing mind in any activity, you are evoking this alignment to the Observer, your true self. The ego is subjective. It judges everything, including itself, and it is never content with where it is, what it has, or what it has accomplished. The Observer is objective and there in the present moment. It does not judge anything as good or bad. It just sees the circumstance or action as “being.” In other words, the circumstance “just is.” Thus the Observer is always experiencing tranquility and equanimity.

In his “Upanishads (Classic of Indian Spirituality),” Eknath Easwaran writes about The Brihadaranyaka Upanishad

9. The human being has two states of consciousness: one in this world, the other in the next. But there is a third state between them, not unlike the world of dreams, in which we are aware of both worlds, with their sorrows and joys. When a person dies, it is only the physical body that dies; that person lives on in a nonphysical body, which carries the impressions of his past life. It is these impressions that determine his next life. In this intermediate state he makes and dissolves impressions by the light of the Self.

10. In that third state of consciousness there are no chariots, no horses drawing them or roads on which to travel, but he makes up his own chariots, horses, and roads. In that state there are no joys or pleasures, but he makes up his own joys and pleasures. In that state there are no lotus ponds, no lakes, no rivers, but he makes up his own lotus ponds, lakes, and rivers. It is he who makes up all these from the impressions of his past or waking life.

11–13 It is said of these states of consciousness that in the dreaming state, when one is sleeping, the shining Self, who never dreams, who is ever awake, watches by his own light the dreams woven out of past deeds and present desires. In the dreaming state, when one is sleeping, the shining Self keeps the body alive with the vital force of prana, and wanders wherever he wills. In the dreaming state, when one is sleeping, the shining Self assumes many forms, eats with friends, indulges in sex, sees fearsome spectacles.

16–17 But he is not affected by anything because he is detached and free; and after wandering here and there in the state of dreaming, enjoying pleasures and seeing good and evil, he returns to the state from which he began.


Interview with Farnam Street

Recently, I had the privilege of interacting with Shane Parrish, who is the publisher of Farnam Street blog.


Talk @ Google: The Prejudices of Mr. Market

I had the privilege of addressing Googlers at their wonderful campus recently.

You can see the video from here.

Transcript from here.

Seven Intelligent Fanatics from India

Yesterday, I delivered a talk titled “Seven Intelligent Fanatics from India” at Value Investing Seminar, Trani, Italy.

None of the stocks of companies run by any of these seven entrepreneurs were recommended for purchase. Nor am I recommending them now.

I know that some of you may disagree with me about the conclusions about some (or even all) of the individuals profiled by me in my talk. However, I do not wish to get into a public debate on the subject. Think of what I said as my own personal views please.

Why did I choose these seven or only seven? Well, I had only 20 minutes to deliver this talk (I actually took 21). And I chose the ones I was more familiar with. To be sure, there are many more intelligent fanatics out there.

The reason I am publishing this is to help investors understand that: (1) an intelligent fanatic has the ability to turn what looks like a poor business into a very good one; and (2) the force (I call it “fire in the belly”)” of an intelligent fanatic, when combined with a good business, has a tendency to produce what Charlie Munger calls a “lollapalooza” outcome.

You can get the transcript of the talk from here.

Interview with Ian Cassel of MicroCapClub

I became a twitter follower of Ian last year and have enjoyed interacting with him on that platform, and through email over the last few months.

Ian runs MicroCapClub in the U.S — a forum meant for microcap value investors. Over the months, I have enjoyed reading up the materials posted on that site. But even more interesting has been receiving Ian’s wisdom through his wonderful tweets. Here are some of them:

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These are just some of Ian’s tweets that I loved. There are dozens of others. Follow him on twitter and learn from his wisdom and experience.

I am overwhelmingly in sync with Ian’s thoughts on investing, some of which are expressed in his tweets above.

A few weeks ago, Ian persuaded me to answer a few questions for an interview which you can read from here.


What is Staying Power?

A few days ago I asked a question on twitter: What is Pricing Power?

Yesterday, I asked another one: What is Staying Power?

I wanted to illustrate the power of focused thinking by “letting your mind wander.” What happens when you think about an idea and that idea only from multiple points of view?

Well, you get insights you wouldn’t get if you were distracted by other ideas.

Staying power is a very powerful idea. But where does it come from? The common answer I get from people is that it comes from a strong balance sheet. But that’s only part of the answer.

You have to keep asking where else does it come from. And one way to find out is by asking where does a strong balance sheet come from?

The insights gained through focused thinking on a question and that question alone produced some answers which I think will be useful for you. These are listed below. Remember that this is not an exhaustive list but is a pretty good first attempt to answer the question.

Business Model

From the vantage point of a business model, staying power comes from:

  1. A product or service that will not be obsoleted for a long time – usually these are things that serve basic human needs and aspirations.
  2. Multiple sources of revenue streams.
  3. Low customer concentration risk.
  4. Low supplier concentration risk especially when dealing with critical raw materials.
  5. A business which does not derive its key advantages from political clout.
  6. Slack in the form of un-utilised capacity especially in case of industries when most money is made during periods of shortages.
  7. High customer switching costs (financial or psychological e.g. in brands)
  8. Solid entry barriers which prevent a business from a competitive attack that can destroy it.

Corporate Culture

From the vantage point of corporate culture, staying power comes from:

  1. Willingness to cede market share when irrational competition drives down potential returns – and in the extreme case exiting a businesses.
  2. Refusal to invest in a business which deserves to die – i.e. not throwing good money after bad – and conserving it for productive uses.
  3. Unwillingness to bet the bank on a single idea – intelligent risk management as part of the DNA of the firm (including avoidance of gambling in the garb of risk management through derivatives).
  4. Willingness to make multiple small bets to grow the business so that no single bet or a group of bets, if they turn bad, can destroy the business.

Ownership Structure

From the vantage point of ownership structure, staying power comes from:

  1. Rich promoters who will, when needed, add financial strength to the business by infusing their own cash when no one else will (usually happens in family run businesses)
  2. Controlling stockholders who support investment for future prosperity instead of treating the business like a cash cow (although doing that makes sense in many circumstances)
  3. An ownership structure which, when combined with a great management team, creates stability for the firm e.g. through non voting shares (e.g. Google)

Balance Sheet

From the vantage point of balance sheet, staying power comes from:

  1. Low or no debt levels whether on or off balance sheet.
  2. A liquid balance sheet.
  3. Presence of non operating assets that can be sold for cash to save the business when needed.
  4. Absence of other encumbrances e.g. litigation that can drain resources or managerial focus.
  5. Low short-term debt, especially during cyclical downturns.

Profit and Loss Account

From the vantage point of P&L, staying power comes from:

  1. Size of revenues – generally speaking large businesses have better ability to withstand economic shocks than smaller ones.
  2. Multiple sources of earnings.
  3. Pricing power.
  4. Low cost advantage over competition so when industry conditions worsen the others suffer a lot more than you.
  5. Flexible cost structure – the ability to shrink the business without losing profit margins – low operating leverage.
  6. Low financial leverage as reflected by low interest cost in relation to earnings available to pay interest.
  7. Low economic depreciation – coming from a business that is not very capital intensive, and one that is not prone to become obsolete soon.
  8. Significant discretionary spending which can be curtailed during really bad economic and industry conditions – e.g. advertising.

Cash Flow Statement

From the vantage point of cash flow statement, staying power comes from:

  1. Low interest and principal repayments in relation to operating cash flow.
  2. Low maintenance capex and maintenance working capital needs.
  3. Ability to fund even growth and maintenance capex with internal resources.
  4. Low dividend payouts.

The Investor

From the vantage point of the investor, staying power comes from:

  1. Large number of years left to invest.
  2. Ability to handle volatility through financial strength – low or no debt and significant disposable income preventing the need to liquidate portfolio during inappropriate times.
  3. A frugal nature.
  4. Ability to handle volatility through psychological strength.
  5. A very long-term view about investing.
  6. Structural advantages – investing your own money or other people’s money who will not or cannot withdraw it for a long long time.
  7. Family support during tough times.

Creative thinking can be taught. It can be learnt. It requires deliberate practice. One of my favourite tools for creative thinking is Creative Whack Pack — a pack of cards that make my creative juices flow. Buy these cards. The author also sells them as an app for your smartphone. Buy the app. Here are a few cards I used for this particular exercise. Creative Whack Pack - Be Dissatisfied

Creative Whack Pack - Let Your Mind Wander

Creative Whack Pack - Change Viewpoints

Creative Whack Pack - See the Big Picture

Creative Whack Pack - Look Somewhere Else

This post is the outcome of the efforts of many twitter followers. Thank you.



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