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Invest only in things you know something about. The mistake most people make is that they listen to hot tips, or act on something they read in magazines. Most people know a lot about something, so they should just stick to what they know and buy an investment in that area. That is how you get rich. You don’t get rich investing in things you know nothing about.” – Jim Rogers

“We invest in what we know and understand.” – Jon Gray of Blackstone

“We do anything I think I understand, where I think the odds strongly favor making money.” – Warren Buffett

True that! Peter Lynch had this saying that retail investors spend dozens of hours researching what stereo or washing machine to buy, but then have no qualms about investing $10,000 in a company they know nothing about because of a “hot stock tip”. Think about how irrational that is.

What I see on Twitter is a lot of people chasing micro-caps because they are up big on silly hype press releases and “greater fool theory” momentum. It’s ALWAYS ends in tears for almost everyone that trades those kind of names. They are called micro-CRAPS for a reason. The fundamentals ALWAYS win in the end.

Want to get rich? It’s simple. Stick to what you know and nail a fundamental trend doing deep intensive research. There are no short cuts. If someone says otherwise, run away.

There are a lot of corollaries between sports and investing. We all know that winning begets winning. When things are going well, the baseball looks like a basketball. You trade better and react better. On the other hand it works the other way, where losing begets losing. Where it sometimes seems the emotional death spiral will never end.

The trick of course in having long-term success is to stay on the winning track. Some of the keys are getting back to the basics, keeping it simple, trusting in your skill-set and what you do best.

“There’s a great piece of pitching advice which is also pretty good writing advice: pitch, don’t aim. If you try too carefully to throw the ball to the exact spot you want – lower inside corner, say – you’ll lose all your natural motion and throw the ball in a straight line, incredibly easy to predict and thus to hit. A better approach is to trust your stuff. You know what you’re doing, you’ve been practicing forever. Let it fly. That’s how to throw that curve ball high over the strike zone that suddenly surprises everyone by breaking at the last second and dropping into the zone for strike three.” Source

I believe this old pitching axiom of “trust your stuff” is applicable to investing. Often I’ve tried to get too cute with an entry point or get too scared about market conditions that I wind up not executing a trade.

If you have a strong fundamental case, have done your home-work, and see a good risk/reward setup, GO FOR IT. Don’t get scared out of the position due to market volatility. Like in my Annie Duke poker trading tips post, to be a winner you have to have A LOT OF HEART.

The worst feeling in the world is missing out on a big potential gain where you had the fundamentals nailed because you were too chicken to step up to the plate and swing (missing a big trade often leads to the negative emotional death spiral). You have to “trust your stuff”

I find that Annie Duke’s tips on poker are directly applicable to trading.

Skills needed to be a good poker player (trader)
-grasp of math, probability, and game theory
-have to have “a lot of heart.” The ability to understand not only what the right play is, but to follow through with it (when you have a good trading setup, GO FOR IT)
-what separates the good from the great, is that the good know the right answer, but they don’t follow through with it
-it’s not about winning right now, but making the right decision to win in the long-run (process over specific outcome)
-be a very good reader of people and bet pattern analyzer (read what the market is discounting)

What makes a successful poker player
-someone who manages their money really well (use rational position sizes and cut losses)
-bankroll requirement for certain game (asset size), how much you can risk in a certain game (position size)
-someone who has a lot of control over the emotional aspect of the game
-poker players lose a lot because there is variance to the game. Being able to emotional handle the losses and to not allow those to affect your play going forward is KEY (don’t get emotional over losses and then try to gamble/over-trade your way back to break-even)
-there are lots of players out there who have more talent in their pinky than my whole entire body, but they’re broke and I’m not
-you work with the skills that you have and recognize the games you should be playing in (what stocks and sectors do you know? what’s your circle of competence)
-don’t play in games where other players are better than you, which is ego-driven (trading sectors and stocks you don’t know)
-manage your money well and manage your emotions well will make you successful

-no-one wants to hear you moan. what productive thing is coming out of moaning? do something constructive. analyze your hand (trade), should I have been involved in first place? don’t focus on the one piece of bad variance (bad luck)
-don’t get emotionally invested on anything at the table (be rational in trading decisions)
-you take what the opponent has done in the past hands. are they conservative? are they wild? how have they bet good/bad hands? how did they behave? constantly update that based on what they do (look for patterns in the market after news)
-come up with best strategy to efficiently and precisely take someone’s chips. she is always willing to flirt with someone on the table (just win baby. making money is the only goal)

Annie Duke Big Think Videos

I’ve been reading Sun Tzu on the Art on War and found that many of his insights are applicable to trading and investing.

—

“Now the general who wins a battle makes many calculations in his temple ere the battle is fought. The general who loses a battle makes but few calculations beforehand. Thus do many calculations lead to victory, and few calculations to defeat: how much more no calculation at all! It is by attention to this point that I can foresee who is likely to win or lose.”

“Ponder and deliberate before you make a move”

Think deeply and have a rational plan before you trade. Don’t act impulsively or recklessly.

—

“It is the rule in war, if our forces are ten to the enemy’s one, to surround him; if five to one, to attack him; if twice as numerous, to divide our army into two. If equally matched, we can offer battle; if slightly inferior in numbers, we can avoid the enemy; if quite unequal in every way, we can flee from him.”

“He will win who knows when to fight and when not to fight.”

Only trade (attack) when the conditions are right and you have the edge. When you are over-matched, out-gunned capital-wise, and things don’t make any sense, do nothing and go play videogames. Deciding on when to fight and not to fight is the critical element in victory or defeat.

—

“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.”

Know your own strengths and weaknesses before the battle. If you can’t take volatility and tend to panic puke, lower your position size to a point where you can stay in the battle.

—

“Disciplined and calm, to await the appearance of disorder and hubbub amongst the enemy:–this is the art of retaining self-possession.”

When you are buying know why the other side is selling and why they are wrong. If the other side is selling because they can’t take the pain or due to margin calls, all the better. If they other side is selling due to temporary short-term news, all the better. If the other side is selling due to false news, all the better.

—

“He wins his battles by making no mistakes. Making no mistakes is what establishes the certainty of victory, for it means conquering an enemy that is already defeated.”

“The consummate leader cultivates the moral law, and strictly adheres to method and discipline; thus it is in his power to control success.”

99% of trading is about having steel hard emotional control and not making dumb mistakes. Most losses come from errors in judgement and throwing good money after bad (averaging losers) when the battle is already lost. When your initial thesis is wrong, just GET OUT.

—

“There are five dangerous faults which may affect a general:
(1) Recklessness, which leads to destruction;
(2) cowardice, which leads to capture;
(3) a hasty temper, which can be provoked by insults;
(4) a delicacy of honor which is sensitive to shame;
(5) over-solicitude for his men, which exposes him
to worry and trouble.
These are the five besetting sins of a general, ruinous to the conduct of war.”

After a hard loss don’t go into emotional levered gambling mode (”on tilt” as they say in poker). Be brave when the right opportunity comes to attack. Don’t care about what other people think of your strategy. It’s not about how brilliant or smart your method is, it’s only about making money. Just win baby.

If you liked this, be sure to check out some of my other recommended posts.

-Looks for situations where mis-pricing is large and risk is small
-He wants to understand why it is cheap and misunderstood
-Buy it cheap and don’t worry about price targets
-If he decides he is wrong on something in terms of why he bought it, he exits. Period
-Never invent reasons to hold a position if original reasons are no longer valid
-Write-up outline: what’s it worth to a value buyer, market position, profitability/cash flow. Is it a great business? What’s the FCF with normalized margins 2 years out? Why is it misunderstood? What is the opportunity? Do a valuation and business analysis of each segment of the business, comparison to other companies in the sector, financial engineering potential?
-Einhorn is known to be very disciplined at sticking to what he is good at. He is excellent at figuring out the 3 key drivers to analyze, has the courage of his convictions, and is active on the short side
-“There are lots of smart people out there. I don’t think all of them have the ability to read the rest of the players as well as David. He can actually see how stocks move on different pieces of news and judge what facts the market seems to be acting on. Then he assesses what analytical edge he has over the other players”

Sources: articles on David Einhorn and interviews with people that know him

Warren Buffett didn’t really hit his stride until he met his investment partner Charlie Munger. He is famous for converting the best investor in history from last puff cigar butt value investing to buying great franchise businesses for the long-term. Here are some general investment tips from Charlie:

-Bet very seldom
-You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence
-Bet big when you have the odds in your favor and know something is mis-priced. Berkshire, all the billions of gains, top 10 insights account for most of it
-What determines behavior are incentives of the decision maker. Management matters
-Ultimate no-brainer, will find a few times in a lifetime, huge untapped pricing power they’re are not using
-Look for superb business hidden inside a bad mess, once you cut out the folly, big winner. (Geico)
-”Good jockeys will do well on good horses, but not broken-down nags.”

The Ben Graham Centre for Value Investing had a great video conference with Seth Klarman of the Baupost Group on March 17th, 2009. These are my notes. Mr. Klarman has produced a net annual return of over 20% since 1983 with only one down year and no use of leverage. Source – H/T to Todd

-Graduated from Harvard Business school in 1982 during a time of high interest rates (12% U.S. treasuries going to 14%) and with a stock market at Dow 700 which had done nothing in 18 years
-Worked for Mutual Shares for couple of years when it was a $40 million no-load mutual fund
-Value investing is a risk-averse approach – first focus is on risk before you focus on return
-Ben Graham, Buffett, and himself started with a small amount of capital rummaging around for mis-priced situations. He likes to find the reason for the mis-pricing and a catalyst to cause you to make money
-He is not in favor of investing by a few simple math formulas like P/B, P/E, P/CF, and dividend yield. Value investing by itself only adds 1-2% a year vs. the market. Why trust a blind formula when you can do better with your own analysis?
-He can tell if something is superficially cheap from 1) inventories being obsolete 2) receivables being uncollectible 3) bad assets on the books 4) off balance sheet liabilities like litigation and environmental problems
-He suggest following value principles, but improve upon them through in-depth fundamental analysis and detailed research
-3 underlying pillars: 1) Focus on risk before return using multiple scenarios. How much can you lose? What are the probabilities of each scenario? 2) World is oriented to relative performance as everyone is an asset gatherer. He is focused on “absolute returns” 3) importance of being bottoms-up, not top-down (macro)
-When he formed Baupost in 1982, he wanted 1) flexibility from his clients for a broader mandate. He wanted more weapons at his disposal to investing in real estate, equities, debt, or stay in cash 2) He put his own money alongside his clients 3) He identified his “edge” that is legal and legitimate and reasons why he thinks he will out-perform. a) biggest edge is long-term orientation. Since he only has clients that are wealthy families and institutions. No fund-of-funds, pensions funds, sovereign wealth funds, and public mutual fund money. How can you invest for a 3-5 years long-term hold when you might get a redemption in 6 months? b) relationships with best brokers. He wants to be the best or 2nd best client, especially in real-estate where he gets first shot at mis-priced assets and can move fast
-He doesn’t think they are the word’s best business analysts. He does think they are very good at complicated situations, “the messier the better.”
-His favorite areas are 1) distressed debt. Senior debt has it’s own catalyst going into a bankruptcy. There is a huge constituency of forced sellers as many of owners can’t own debt in a bankrupt company. You wanted to buy when people don’t know what they are doing. 2) spin-offs 3) index changes.
-For equities, he likes off-the-beaten path type ideas that have some kind of event catalyst. He wants egregious mis-pricings, low risk/high return situations, and is very careful with his analysis
-They never hold for the last nickle. They sell near fair value. If a stock is worth $20 and they bought it at $10, they are out by $18-18.50. Always sell too soon and always buy too soon. Never use margin, don’t use leverage, and have minimal short exposure. Position sizing is 3-5% and at times 8-10%. Always act with integrity
-To hedge they use out of the money put options for disaster insurance. He doesn’t think shorting adds any value most of the time. It makes you focus on short-term analysis, whether they will beat or miss a quarter. This impacts your thinking into a short-term orientation, which is not good for a long-term investor
-They entered 2008 with 35% cash (did he mean 2009?). They are in the high-teens/low 20s now
-Financials got to be 40% of SP500′s earnings. In early 2007, he realized things could be really bad as the housing market started to turn down
-When doing analysis, they look for a range of value using book value, PV of CF, P/E, P/CF, sum of parts, and private market value. If it’s below this range, it’s of interest. If it’s in the middle of this range, it’s not interesting. Try to look at things differently than consensus. When the world thinks of a stock as a business, he thinks of it as pile of assets.
-He owns a couple Oil/gas LPs that are trading at 20% and 30% yields and 1/2 or 1/3 of their reserve value.
-He owns PDL Biopharma, which he thinks as a 30% IRR due to its royalty stream
-He like News Corp. Fox News is incredibly valuable. He thinks break-up value is $10-20 today and $20-30 in a normal environment. Debt maturities are 10 years out. They bought it too soon, but they have been adding
-He admires Buffett and Munger. On long-only side, he like Bob Rodriguez at FPA Crescent, Southeaster Management, and Tweedy Brown. On hedge-fund side, he likes Paul Singer, David Abrams, Perry Capital, Jeff Hallis at Tindall (sp?), Mike Lowenstein at Kensico, Steve Mandel at Lone Pine, and Brookside Capital

-U.S. economy: “It’s fallen off a cliff” “Luxury goods (business)… sort of stopped”
-This is close to the “worst case” scenario. “We are in a very negative vicious cycle”
-Economy: “can’t turnaround on a dime”
-”Unemployment will go a fair amount higher”
-He is critical of the 8000 earmarks Congress rammed through in this time of economic crisis
-Job 1, job 2, and job 3 should be to “win the economic war.” You should not use crisis to push through things you know is contentious (implying carbon cap and trade energy taxes, earmark pet-projects, card check “secret ballot”, etc.)
-M2 is growing very rapidly as you can check on the Federal Reserve web-site. Potential of being worse than inflation in the 1970s
-In 19th century had 6 financial panics when people lost confidence in the banks
-FDIC moved 8% of deposits last year and has assisted 3600 banks in its life-time
-We have a system that works started with 4 million people in 1790. Free markets, rule of law, and equal opportunity that “unleashed the human potential”
-World almost stopped last September when the Reserve fund broke the buck and money market/commercial paper markets hemorrhaged. He gives credit to Bernanke for doing the right thing and saving the system then
-Government should guarantee all deposits at all banks to give clarity and confidence to the financial system. The President should speak to this to be totally clear to the American people
-Over a 10 year period, you will do considerably better in equities vs. 10 year or short-term Treasuries. With Treasuries, you are guaranteed to lose purchasing power
-2008 mistakes include buying ConocoPhillips when oil was over $100 and buying two Irish banks
-He likes Wells Fargo and U.S. Bancorp. Wells Fargo has 1.44% average cost of funds. In 2-3 years can have $40 billion in income and $10-12 billion in losses. The spreads are enormous today and earnings power is great. Prospects 2-3 years out is better than ever
-250 million cars and trucks on road today. U.S. auto companies need to restructure where the business model can work at 13 million cars a year
-Free markets over-shoot, but works better than anything else
-Forget the (stock) quote, look at the business (fundamentals)
-Best asset during inflation is invest in your own abilities, be the best at what you do. Second best is own good businesses
-$14 trillion dollar economy U.S. GDP, stimulus bill won’t have that much impact in short-term. More important other things to do (fixing banking and financial system)
-4.5 million houses will change hands out of 80 million this year
-Obama should defer pushing his big agenda and focus on the economy
-He supports mark-to-market
-Bringing back the uptick rule is a good idea
-He is against union card-check and supports the secret ballot

Net-net: Economy is currently horrendous with no turnaround in the short-term.   He goes after Obama pretty directly to not “muddle up” job 1 of fixing the economy with the other things on his agenda.  He still likes his bank positions of Wells Fargo and U.S. Bancorp.

These are my notes from a book signing event Alice Schroeder gave on her Buffett biography called “Snowball.”

-Buffett as “very hurt” during the tech bubble on any criticism that he “lost his touch”
-She got on Buffett’s 200 people Christmas card list
-He has a silly child-like side. He is like a little kid that wants to be loved by everyone
-When he organized a Hooter’s gag Christmas card photograph with Bill Gates, he was upset that all the girls wanted Bill’s autograph on their shirt, not one asked for his
-He was excited for weeks when Asia Carrera, online porn star, cited Buffett as one of her heroes
-In a way he wants everyone to be his mom. Alice felt that tug also, but at the end of writing her book she had to back away from that role. It is “really awkward” between them now. There is “no friction” per se, but he has “mixed feelings” and “ambivalent” about the book. She thinks it was “painful” for him to have all his personal details out there for everyone to read. They have some “email correspondence”, but other than that they don’t talk
-She had extensive interviews with Charlie Munger. He said, “I only listen when I’m talking”, which she says is “very true”
-The most surprising thing about Buffett was how “very vulnerable and insecure he is” personally compared to his unshakeable confidence in his business decisions.
-Warren is one of the toughest negotiators. He is a “dangler”. He never commits to anything, but makes you feel if you do what he wants, maybe he’ll give you want you want
-”Writing a biography is difficult if you don’t have a life.” It was hard to structure the book between his personal and business sides as they were completely separate. Also there were extended periods of time where he didn’t have a personal life. He was obsessed with investing, money, and working. He was driven. He loved it. He “didn’t have a choice, it’s who he is”
-One of his important qualities as a leader was his ability to stay on message. He can repeat the same 10 things over and over and never deviate
-She enjoyed being around Bill Gates as he and Buffett had a wonderful relationship. Bill looks up to Buffett like a father. Bill also has broader interests and is a really good investor
-She doesn’t think Ajit Jain will be the next CEO of Berkshire. He doesn’t want it and isn’t a manager
-Buffett gets no pleasure from giving away or spending money. His life’s purpose was growing the snowball
-Buffett’s biggest mistake, he would say in private, is doing whatever it was that caused his wife to move away. He would do anything to get her back, dancing etc., but Alice says “except change who he was”
-She is working on her next book. She will also continue public speaking and work on different kinds of writing

Avoiding 99% of frauds like Madoff and Bayou is pretty easy if you do some basic due diligence. Madoff used itself as the administrator and custodian for its own assets. Every reputable investment fund uses 3rd-party administrators and custodians. For obvious reasons, it’s a lot harder to fake numbers if a 3rd-party is holding your assets and doing administration.

If you only invest in firms that use reputable 3rd-party administrators, custodians, auditors, and law firms, you will avoid most frauds PERIOD. Be sure to verify that they are using the firms they say they are by calling and asking for email verification from the partner in charge of the investment firm client.

1) Custodians: You want prime brokers and custodians that are part of the chosen nine, explicitly backed by the U.S. government: JP Morgan, Goldman Sachs, Bank of New York Mellon for cash custodial accounts, etc.

2) Administrators: IFS, division of State Street and Citco Fund services.

3) Auditors: You don’t want unknown 3-person audit firms like the one Madoff used. You want brand-names like Deloitte & Touche, Rothstein Kass, etc.

To reiterate if you only invest in firms that use reputable 3rd-party service providers and verify that those providers are serving the firm, you will avoid Madoffs and Bayous.