Abstract
- Apply your ‘rationality quotient’ (RQ) to evaluate whether e.g. a stock or index’ price level “makes sense”. Use your System 2 line of thinking, which emphasizes rationality and skepticism whereas System 1 is vulnerable to impulses and herd mentality.
- Think like an owner when you acquire a stock. Hence, select owner-friendly stocks with reliable and trustworthy management teams and option programs that incentivize the creation of long-term shareholder value.
- Choose companies with wide moats that enable them to achieve and sustain high returns on capital.
- There are two types of value opportunities: 1) stable, bond-like businesses, or 2) cyclical stocks with a Tobins Q factor below 0.5.
A few months back, I attended an event where the author of The Rational Investor (Danish title is Den Rationelle Investor), Kurt Kara, gave a presentation (read Take-aways from a lecture by Kurt Kara). It was a great lecture, so I thought it was worthwhile to pick-up a copy of his book. It’s a fine all-around book like The Little Book of Value Investing and Value Investing Made Easy that’ll make sure you can navigate in the value investing sphere.
Use your RQ – not your IQ
In one of the book’s first chapters, Kurt explains that it’s not your IQ that’ll define your success on the stock markets. No, it’s rather your rationality quotient, RQ. He recommends that you regard investment ideas from a “does it makes sense?”-perspective. If you keep this attitude through thick and thin, you’ll avoid being gripped by the euphoria that once in a while seduces investors. You – the rational investor – chooses to strike when the euphoria has evaporated, when the bubbles burst, when the financial roads are littered with bargains; that is the time to dig into the stock buffet if you have a high RQ.
Kurt presents two lines of thought, System 1 and 2. I have outlined these in my review of The Black Swan, but in short, System 1 is the machinery we put to work when we’re thinking uncritically and System 2 prioritizes rationality and a healthy degree of skepticism. A classic System 1 argument goes something along the lines of: “Everybody is buying, so should I!”. If you had instead turned on your heavy-thinking engine, you would have asked: “Does it make sense that …?” Kurt presents the “seven psychological death sins” you should be aware of in an attempt to downtone System 1 and advance System 2: 1) excessive self-confidence, 2) herd mentality, 3) blind orthodoxy, 4) denial, 5) confirmation bias, 6) deadlocked ideas and attitudes, 7) cognitive dissonance (the tendency to go with the thought that ‘feels best’ when stuck with the choice between two contradicting ideas rather than investigating which is more rational).
Think like an owner
One of the most frequently proclaimed attitudes Warren Buffett has voiced throughout the years is this: You should approach investment ideas and your portfolio with an owner’s mindset, i.e. as if you owned or wanted to acquire the entire business. Warren doesn’t treat a stock as a piece of paper that is traded in the hope that a greater fool will come around willing to pay more for the same piece of paper. No, he treats a stock certificate as a prove of a fractional ownership of a business.
Kurt obviously shares Warren’s conviction. He repeatedly underscores the importance of acquiring stakes in owner-friendly companies. First, you need to evaluate if you have confidence in the business strategy as well as the company’s ability to produce profits for its owners (you!). Kurt recommends that you invest in companies that are managed by persons with the same ultimate goal as you: making money! Hence, Kurt suggests that you favor companies where the managers are incentivized to create long-term shareholder value. In other words: The management team should preferably be co-owners or have value-adding options programs in place that ensure the shareholders and managers’ interests are aligned. For all that is holy, you must avoid companies where the management team drains the resources on the investors’ expense.
Moats that keep the enemies at bay
To my knowledge, Warren Buffett invented the moat term to describe companies with a competitive advantage that enable them to achieve and sustain a high return on capital (e.g. ROE and ROIC). This is a recurring theme in practically all books on value investing, including Kurt’s. He explains that companies, which are able to consistently achieve a high ROE, are more likely to add value for its owners far into the future. Kurt highlights businesses such as Coca-Cola, Gillette and Apple. These all have 1) moats that protect them from competitors’ attacks, and 2) a pricing power that allows them to increase their prices, since the consumers are able to pay a premium for said companies’ products. Industries with monopolies and duopolies are good places to look for value candidates that have a natural (sometimes legally secured) pricing power.
Two types of value opportunities
Towards the end of the book, Kurt deals more specifically with the hunt for value opportunities. He assumes that you have found an interesting candidate based on one of two grounds: 1) you have spotted a bond-like business, or 2) a cyclical stock with a Tobins Q factor below 0.5.
In regards to the former, the crux of the matter is how well and consistently the business is able to compound its equity/capital You should investigate whether the business has historically been able to let profits drip down to the equity, and to what degree that equity has been compounded above the level you could get on alternative investments (e.g. an index fund, government bond etc.).
With the latter sphere of value opportunities, you’re on the look-out for companies that are in a cyclical downturn. During these cyclical headwinds, the prices can get so depressed that the stock is traded below the price it would cost to reproduce the business anew: the Tobins Q factor. This factor is closely tied with P/BV, which is why this metric can be used as a screening criteria (If you wish to read more about reproduction value, you can stop by my review of Value Investing: From Graham to Buffett and Beyond).
Regardless of the candidate type, there are some common characteristics that definitely do not hurt the quality of the investment. Kurt recommends asking oneself: Is the company owner-friendly? Is the profit margins above the industry average? How has it historically navigated in crisis situations and headwinds? Is there a moat? Has there been a historical decent dividend policy or share buyback programmes in place? In the end of the book, Kurt outlines a checklist with questions that deal with three domains: 1) the business, 2) the stock, 3) yourself.
All in all, a fine book with many good inputs. It’s similar to many other ‘all-around’ value investing books, but it has a innate benefit to many Danes: it’s written in Danish!