The Bayesian Observer

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Walter Schloss: Ignoring Noise

I don’t seem to have very much influence on Walter. That is one of his strengths; no one has much influence on him.

- Warren Buffet, about Walter Schloss, value investor from the Graham-Dodd school.

The Super Investors of Graham-and-Doddsville

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The Super Investors of Graham-and-Doddsville is neat little a 13-page article by Warren Buffet that appeared in 1984 in a Columbia Business School magazine. In it, Buffet talks about the value-investing method of his teachers Graham and Dodd of Columbia University.

Main takeaways from the article:

I’m convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”

  • Graham made a distinction between investing and speculating:

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

  • The main tenet of Graham and Dodd’s school of investing is to look for inconsistencies between the current market price of a company and its true value. This requires analyzing a company’s balance sheet and activities in order to come up with a fair value. When the market price drops because of a silly reason, rather than a change in the company’s value, value investors argue that it will eventually rebound back. An example would be a company’s stock price nosediving if its CEO is found to be involved in a personal scandal and is about to be fired. When no value investing opportunities present themselves, value investors prefer to sit with cash and wait, rather than invest in risky investments. 
  • Value investors look for a margin of safety, that is a significant difference between the market price and the value.

… You don’t try and buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing

  • Value investors wait for the right opportunity to invest in a security with a large margin of safety. In absence of such opportunities, they prefer to sit on cash. Mohnish Pabrai, another student of the Graham-and-Dodd school, says of Charlie Munger, also of the Graham-and-Dodd school, and Buffet’s partner at Berkshire Hathaway:

You have to be like a man standing with a spear next to a stream. Most of the time he’s doing nothing. When a fat juicy salmon swims by, the man spears it. Then he goes back to doing nothing. It may be six month before the next salmon goes by.

  • Buffet argues that the value investing school of Graham and Dodd has produced a significantly large crop of disciples that have performed extremely well with that method, adding that this could not have been pure chance. 
  • Ridiculing complex mathematical models, Buffet has this to say about the practice of using multiple variables and seasonal trends in making ‘investment’ decisions:

I always find it extraordinary that so many studies are made of price and volume behavior, the stuff of chartists. Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before? Of course, the reason a lot of studies are made of these price and volume variables is that now, in the age of computers, there are almost endless data available about them. It isn’t necessarily because such studies have any utility; it’s simply that the data are there and academicians have worked hard to learn the mathematical skills needed to manipulate them. Once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility. As a friend said, to a man with a hammer, everything looks like a nail.

  • Risk and reward are not always positive correlated, case in point being Value Investing, where risk and reward are negatively correlated. I thought this was a significant point — most discussions on investing implicitly assume that risk and reward are positively correlated.

Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, “I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.” I would decline — perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice — now that would be a positive correlation between risk and reward! The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.

  • It appears to me that ‘investors’ who are looking for a gain in a specified short time scale (say 1 month) are more constrained that those willing to wait longer (i.e. value investors). The comparison is akin to a company only looking to show great quarterly results, versus a company willing to spend on R&D that would mature only over the next 5-10 years. This line of thinking suggests that professional money managers (the majority of which are not value investors according to Buffet) are less consistent in their performance because they fall in the former category of firms, since they must show their performance quarterly, or annually. What if the pressure to post a performance number every quarter/year-end was absent?
  • It struck me that it requires careful analysis of a company’s records and activities to figure out its fair value. If a significant fraction of users make investment decisions without making this analysis  (Graham calls this speculation, as opposed to investment), this amounts to a larger amount of herd mentality in the market, and by Buffet’s own quote above, this would lead to deviations from the efficient markets hypothesis. In a sense, the success of value investing relies on others not being value investors. Addressing this thought, Buffet ends the article befittingly:

… some of the more commercially minded among you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 30 years. It’s likely to continue that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.

Now, all I need to do is figure out how to come up with the true value of a company.

Creativity is Just Connecting Things

Creativity is just connecting things. When you ask creative people how they did something, they feel a little guilty because they didn’t really do it, they just saw something. It seemed obvious to them after a while. That’s because they were able to connect experiences they’ve had and synthesize new things. And the reason they were able to do that was that they’ve had more experiences or they have thought more about their experiences than other people.

(…)

Unfortunately, that’s too rare a commodity. A lot of people in our industry haven’t had very diverse experiences. So they don’t have enough dots to connect, and they end up with very linear solutions without a broad perspective on the problem. The broader one’s understanding of the human experience, the better design we will have.

— Steve Jobs

Lack of price discovery in the Healthcare Market

Price discovery is

… the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers.

Buyers and sellers of a good or service set the price by expressing how much they are willing to buy or sell for. When a very large number of buyers and sellers interact in this way, the final price of the good or service settles to one that incorporates all this information. However, in the healthcare market, this mechanism is absent.

When you are sick and you visit a doctor, you do not get to ask up front what you will be charged for seeing the doctor! Instead, you present your health insurance card to the receptionist, thereby disclosing information about your ability to pay, and creating information assymetry. The other party (i.e. the healthcare provider) can now select a price , taking into account the information you have just disclosed, and that too, after you have made use of their services, rather than before. This is akin to getting to know the price of a haircut in a barber shop, after you have had the haircut. There is no price discovery mechanism in the healthcare industry in US. I recommend:

  1. Providers should not be allowed to see the insurance coverage a patient has. Each patient should simply be treated. Claims and payments should be handled by a third party, such as a government agency, that acts as a mediator between the hospital and the patient.
  2. Providers should be mandated to disclose a menu of charges, like a restaurant or a barber.
  3. Providers should charge the same fee, irrespective of whether a patient has insurance or not, or how much insurance coverage she has.

Ostensibly, providers check a patient’s insurance card in order to make sure that the patient can pay for the services she is about to purchase. Instead, this function should be done by a ‘lookup’ over the internet on a server run by a government agency: Input = ‘name of the medical procedure’, Output = ‘Covered or not’. This will prevent the provider from learning about the extent of coverages available to the patient. Not learning about this will force providers to more honestly assess fees, and compete with each other more realistically, bringing down costs borne by the patients. I think this will also prevent providers from passing on large unnecessary fees to insurance companies.

A formal mechanism design formulation of the problem would be interesting to tackle. 4 players: patients, providers, insurance companies, government.

Religion, GDP and Happiness

The percentage of a country’s population that feels religion plays an important role in their lives (x-axis) seems negatively correlated with the GDP per capita (Y-axis, in log-scale):

Screen Shot 2012-12-18 at 11.57.08 PM

One cannot help but be reminded of the famous verse in the bible that alludes to camels and needles. But, of course correlation does not imply causation!

Here are the heatmaps, first for religion:

Religion_in_the_world

and per capita GDP (PPP):

GDP_nominal_per_capita_world_map_IMF_2009

From the heat maps above, several countries in Africa and Asia stand out as having low per capita GDP and high importance of religion, while all of Scandinavia and Australia stand out as places with high per capita GDP and low importance of religion. The US is somewhat of an outlier with with highest per capita GDP in the world of ~$35k and about 65% of the population reporting that religion plays an important role in their lives.

For completeness sake, here is the heat map for life satisfaction, or long-term happiness:

World_Map_of_Happiness

Combining data on religion and GDP with data with data on long term happiness, we get roughly the following picture:

  1. Long term happiness correlates positively with per capita GDP.
  2. Long term happiness correlates negatively with importance of religion.
  3. Importance of religion correlates negatively with per capita GDP.

My guess is that the causal structure between the 3 variables: Religion (R), Happiness (H) and per capita GDP is the following:

Screen shot 2013-01-09 at 2.51.17 PM

When per capita  GDP is high, the basic needs of life are met, people are relatively comfortable, and therefore long term happiness is high, but for the same reason, very few people feel compelled to ask fundamental questions of the type that people turn to religion for. This has the effect of creating a negative correlation between Religion and Happiness. In the causal structure above, religion and happiness are related, but given per capita GDP, they are independent.

Understanding Happiness

Happiness is as hard to define as it is to achieve. Everybody wants to be happy. Even masochists. I think it is best to use  a non-constructive definition:

Happiness is the goal that drives all human actions and desires.

If long term happiness if everybody’s ultimate goal, then it is worth learning how to achieve long term happiness. In fact, if being happy is the ultimate goal (as opposed to say, being wealthy), then our education system should also be teaching us how to be happy over a life time, rather than purely technical or vocational skills. Simple GDP growth does not imply an increase in the happiness of a society — as indicated by data from the last ~40 years in the US, comparing per capita GDP and happiness levels:

Screen Shot 2012-12-17 at 3.09.43 PM

While per capita GDP has risen more or less steadily, happiness levels have remained more or less stagnant in the last ~40 years.

Should countries develop public policy with the goal of making a society happier, rather than with the goal of increasing GDP? I think it is an idea worth exploring (Scandinavian countries seem to rank highest in in the world in happiness scores, despite high taxes). The government of Bhutan came up with the Gross National Happiness index, which measures the average life satisfaction of the citizens in a country.

World_Map_of_Happiness

This correlates well with health, access to education, and wealth (GDP per capita). At any given time, the relationship between average happiness of a country and per capita GDP seems to log-linear, meaning that happiness is roughly linear in the log of the per capita GDP.

Screen Shot 2012-12-15 at 6.07.29 PM

This is because in order to increase the happiness level of a society by 1 unit, the increase in wealth required is proportional to the current welath. For e.g., if the required amount of increase in personal wealth for a group with per capita income of $1000 is $x, then it is $10x for a group with per capita income of $10,000.

Near the end of this talk, Daniel Kahneman says that in a study done with the Gallup organization, he found that:

Below an income of … $60,000 a year, people are unhappy, and they get progressively unhappier the poorer they get. Above that, we get an absolutely flat line. … Money does not buy you experiential happiness, but lack of money certainly buys you misery.

Kahneman distinguishes between two types of happiness: that of the experiencing self and that of the reflecting self. It is possible to be happy in the experiencing self but have a poor happiness score when reflecting on a long time frame in the past, and vice-versa. For the type of happiness that measure life satisfaction in retrospect, there is no flat time — i.e. it continues to increase with increasing wealth. I don’t find this too surprising. It is the difference between short term and long term happiness. It is easy to be happy in the short term at the expense of the long term. On the other hand, tolerating displeasure during hard work in the present can have a huge payoff in long term happiness in the future.

In this TED talk, Dan Gilbert showcases his research that shows that happiness can be synthesized by individuals. So happiness is not some finite resource that needs to be distributed among people, instead one can simply choose to be happy, despite seemingly adverse conditions. This is fascinating, because it provides experimental evidence that happiness has to do not just with our external circumstances (such as GDP per capita), but also with how we process information in our minds. Several religions have the concept of expressing gratitude. The act of being grateful basically synthesizes happiness out of thin air.

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