Quote for the Week

Warren Buffett refers to staying within your circle of competence. Social psychologists tell us, though, that we are prone to overconfidence when it comes to assessing our abilities, so even when we think we have an advantage, we may well be mistaken.

In markets, competitive advantages are three: informational, analytical, or behavioral. Informational advantage is when you know something material that someone else doesn’t. It is the easiest to exploit and the hardest to find…

Analytical advantages come from taking publicly available information and processing or weighting it differently from the others…

Behavioral advantages are the most interesting because they are the most durable. The field of behavioral finance is still in its infancy yet has already yielded results that can be incorporated profitably into a sound investment process. The best part is that such results are likely to be systematically exploitable and not able to be arbitraged away as they become more widely known. That is because they represent broad findings about how large groups of people are likely to behave under well-defined circumstances. Until large numbers of people are able to alter their psychology (don’t hold your breath), there is money to be made from prospect theory, support theory, cognitive psychology, and neuroscience. — Bill Miller (source)

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In the summer of 1999, Warren Buffett stood in front of a group of business leaders to share his views on the “new economy.” He believed that the exceptional rate of return on the stock market at the time was unsustainable. His audience wasn’t impressed.

A year later the Dotcom Bubble burst and Buffett was proved right. His “outdated views” had substance. After all, he had history on his side. Anytime innovation created a booming new industry it was followed by a collapse.

I thought it would be instructive to go back and look at a couple of industries that transformed this country much earlier in this century: automobiles and aviation. Take automobiles first: I have here a page, out of 70 in total, of car and truck manufacturers that have operated in this country…

All told, there appear to have been at least 2,000 car makes, in an industry that had an incredible impact on people’s lives. If you had foreseen in the early days of cars how this industry would develop, you would have said, “Here is the road to riches.” So what did we progress to by the 1990s? After corporate carnage that never let up, we came down to three U.S. car companies — themselves no lollapaloozas for investors. So here is an industry that had an enormous impact on America — and also an enormous impact, though not the anticipated one, on investors.

Sometimes, incidentally, it’s much easier in these transforming events to figure out the losers. You could have grasped the importance of the auto when it came along but still found it hard to pick companies that would make money.

Buffett’s tale of the airplane industry was similar. The number of airplane companies ballooned to roughly 300 by 1939 before declining to a handful today. Picking the winners from the outset was practically impossible.

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Quote for the Week

People want to buy today what they should have bought 5 or 6 years ago; call it the 5 year psychological cycle.

Today people want commodities, emerging market, non U.S. assets, and small and mid-cap stocks. Those were all cheap 5 years ago and had you bought them then you would be sitting on enormous gains. But 5 or 6 years ago, everyone wanted tech and internet and telecom stocks, and venture capital and U.S. mega caps. The time to buy them was in 1994 or 1995, when they were cheap.

But in 1994 or 1995, people wanted banks and small and mid caps, which should have been bought in 1990, and well, you get the picture.

In general, you can get a good sense of what to buy now by looking to see what the worst performing assets or groups were over the past five or six years. That is long term for most people, and long enough to convince them that the malaise is permanent and to have migrated their money elsewhere, such as to whatever has done best in the past 5 or 6 years. — Bill Miller, 2006 (source)

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The 10 largest U.S. companies now account for roughly 39% of the S&P 500. These companies are big for a reason. Most are growing high margin businesses. They trade at a premium relative to a typical company because they’re viewed as high quality.

The Dotcom Bubble’s insane P/E multiples can be seen on the left. The biggest companies barely had earnings back then. Everything was priced on hope.

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Quote for the Week

After more than thirty years of studying stock speculation and speculators, I have arrived at the conclusion that, in the order of their importance, the principal contributory causes to the public’s losses during all booms are the following:

1. The public itself. I mean the motives that make the public go to Wall Street. This is true of rich and poor, of heads of business houses and of salaried clerks, since all of them overstay the market. By “all” I really mean only 99.7 percent. Those who didn’t lose in ’29 lost in ’30 or ’31.
2. Remediable evils. You might say, old trade customs, to Wall Street’s antiquated point of view. Many things are done or left undone by commission houses which tend to make more certain the certainty of losses by their customers. Nevertheless, I am convinced that commission brokers did less to damage the public that speculated than those banks and banking houses which worked by themselves or in association with promoters and pools and syndicates. They perceived that the public’s capacity for absorbing stocks was practically unlimited and they overcapitalized that appetite the way they overcapitalized everything else. Some day the history of the worse than blindness of our banks, bankers, and corporation heads in 1928 and 1929 will be written — and not believed.
3. The average stockbroker’s perfectly human desire to do as much business as he can, when he remembers the long spells of fasting that go with the occasional gorging. — Edwin Lefevre (source)

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How do you invest money for the ultra-long term? This came as a question from a reader on how to invest a dynasty trust. It’s also a question that endowments, charities, and foundations face.

A few questions come to mind when the time horizon is a century or more. What obstacles exist around management? What type of investment philosophy do you embrace? How do you ensure that what’s set in motion doesn’t diverge from its initial path?

First, this a good but difficult problem to have. The hardest part is getting things setup properly from a legal and tax perspective (a bit outside my purview). The U.S. tax system is complex and requires estate planning expertise to legally maximize long-term tax savings in relation to the client’s goals.

On the investment side, three things come to mind when thinking in terms of a century or more.

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