Learning By Thinking

“By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third, by experience, which is the bitterest.” – Confucius

According to a very recent HBS paper titled Learning by Thinking: How Reflection Aids Performance, Di Stefano, Gino, Pisano and Staats argue that by “reflecting on and articulating the key lessons learned from experience, a person boosts her self-efficacy, which in turn has a positive effect on learning. In this respect, (…) the process of transforming a tacit into codified knowledge requires a cognitive investment that generates a deeper understanding of this knowledge.”

In other words, reflection is as important as experience and is often underrated. If you haven’t read the post on sense-making, you should, as both subjects (learning and sense-making) are correlated.

Learn smarter, not harder.

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Is Patient Capital The Ultimate Competitive Advantage?

“Recently, when Page was challenged on an earnings call about the sums he was pouring into R&D, he made no effort to excuse it. “My struggle in general is to get people to spend money on long-term R&D,” he said, noting that the amounts he was investing were modest in light of Google’s profits. Then he chided the financial community: Shouldn’t they be asking him to make more big, risky, long-term investments, not fewer?”

The struggle to build a long term capital base coupled with patience and the right incentives might be the ultimate competitive advantage.

Barry Schwartz Framework Re-framed: Profile Of An Outstanding Investor

“A wise person knows when and how to make the exception to every rule… A wise person knows how to improvise… Real-world problems are often ambiguous and ill-defined and the context is always changing. A wise person is like a jazz musician — using the notes on the page, but dancing around them, inventing combinations that are appropriate for the situation and the people at hand. A wise person knows how to use these moral skills in the service of the right aims. To serve other people, not to manipulate other people. And finally, perhaps most important, a wise person is made, not born. Wisdom depends on experience, and not just any experience. You need the time to get to know the people that you’re serving. You need permission to be allowed to improvise, try new things, occasionally to fail and to learn from your failures. And you need to be mentored by wise teachers”. – Barry Schwartz

Substitute the term “wise person” for “investor”. There you go!

Dare to be Great – Howard Marks

Howard Marks latest piece made a commonsensical though forgotten in our day-to-day: overperformance requires differentiation. He breaks down this tenet in 3 more basic principles:

  1. Define an explicit investment creed with sound principles;
  2. Define what success is for you;
  3. Are you willing to be different? And wrong?
As a Brazilian investor, I`m used to hear from potential investors that portfolios of local funds look too similar despite somewhat different investment thesis on the same company. At the end of the day, skill defined as intellectual capability is on average very similar across different investment firms. 
Although, as Marks cleverly puts it, “there’s only one thing in the investment world that isn’t two-edged, and that’s alpha: superior insight or skill.” Even not being a big fan of what the term ‘alpha’ coins as my principle guides me towards great absolute long term performance, i.e., mid-teens, insight or skill as he frames it is perspective for me, not higher IQ (or EQ). This “eternal preparation” B.S. definitely works, though in the longer term. Our minds are biased towards shorter timeframes, so it’s nearly impossible for human beings speak out they are long term investors and indeed become one. As the old proverb says, “easier said than done”. 

Another way to be different is through concentration. Without preparation though it is nearly impossible (imprudent would be the best fit here) to have a concentrated portfolio. With experience and mental models lacking, one can’t overperform in the long run. So if you want to dare to LOOK wrong, better be prepared.

What Does Sense-making Can Teach Investors?

Sense-making is a qualitative, multi-disciplinary approach to make something sensible, i.e., how we structure the unknown as so to be able to act in it. In other words, it consists in constructing, filtering, framing, creating facticity and rendering the subjective into something more tangible. According to Karl Weick,

sense-making is about plausibility, pragmatism, coherence, reasonableness, creation, invention and instrumentality.

In this synthesis exercise in which accuracy is secondary, I found a couple parallels and antithesis to equity research, investing and managing an asset management firm.
On equity research and investing:
  • Sense-making is a synthesis exercise which usually benefits from mental models utilization to simplify complex and open-ended problems – it does not rely on extensive analysis and accuracy as enactment is needed in the learning process. This one is partially correct for investing in my point of view, since extensive analysis is a pre-requisite before synthetizing what the analyst has learned. A complete due diligence is required to mitigate risks, although it will never be complete due to the ever changing landscape and eternal unknown unknowns;
  • As I’ve just watched the True Detective TV series, I’ve learned from detectives this time (instead of Munger) that reading and studying different topics from a variety of sources helps us arm our brains with bits & bytes which can be combined later on our professional and personal lives. Although, we need previous knowledge and context to successfully use them “to consolidate bits and pieces into a compact, sensible pattern frequently requires that one look beyond those bits and pieces to understand what they might mean. Often, it is necessary to move outside a system in order to see the patterns within. (…) Of course, there is always more than one metaphor that can capture a situation, which means that any given metaphor is likely to be contested.”
  • And when we are unprepared, the man-with-a-hammer syndrome unleashes:  “operators who have specialized expertise do not see the big picture as crises develop and therefore miss key events.” We will try to frame the problem within our pre-existing models, unfortunately;
  • We are more likely to uncover unanticipated and potentially valuable viewpoints and information armed with open-ended questions. Moreover, in this way we avoid confirmation bias;
  • Marcel Proust helped me out in this one: “The real voyage of discovery consists not in seeking new landscapes but in having new eyes.” Again, it’s all about having perspective;
  • Sense-making benefits from past data (quant, social, etc.) in a given context to extrapolate necessary actions – just like investors learning from post mortem analysis/financial markets history to be better prepared for decision making;
  • Consequences are difficult to forecast in advance, though scenario planning could help out with this one;
  • Sense-making opposes scenario planning as “explanations that are developed retrospectively to justify committed actions are often stronger than beliefs developed under other, less involving, conditions.” This one is screaming for me since I live in Brazil and we are used to see growth embedded in 99% of potential investments here, thus we aren’t THAT creative imagining different scenarios. Unfortunately, we usually classify then as improbable as a preconception;
  • Learn not only what financial statements represent, but what is behind it: “e very sensitive to operations. Learn from those closest to the front line, to customer, and to new technologies.
On risk:
  • “Human errors are fundamentally caused by human variability, which cannon be designed anyway – so our function is to be risk mitigators which must be embedded in the capital allocator job description;
  • Compounding mistakes: “Small events are carried forward, cumulate with other events, and over time systematically construct an environment that is a rare combination of unexpected simultaneous failures.”
  • Constant learning, perspective and team complementarity as a knowledge growth vector and risk mitigator: “Capacity and response repertoire affect crisis perception, because people see those events they feel they have the capacity to do something about. As capacities change, so too do perceptions and actions. This relationship is one of the crucial leverage points to improve crisis management.” As investors, we should only act or react when we are prepared and comfortable with what we know and what we don’t know;
On governance:

  • “The dark side of commitment is that it produces blind spots” – This one I’ve learned from Malcolm Gladwell article in The New Yorker Magazine: do not engage in negotiation with fanatics, nor trust entrepreneurs living their dreams in listed companies. In other words, do not them live their dreams with your money;
  • “Turnover is as much a threat to capacity as is understaffing, but for a different reason. Institutional memory is an important component of crisis management”
  • “Perception, however, is never free of preconceptions, and when people perceive without institutional memories, they are likely to be influenced by salient distractions or by experience gained in settings that are irrelevant to present problems.”
  •  “In a globally competitive environment our reward structures are geared toward rewarding immediate action and hence we may be signaling that sense-making is not a valued activity.”
  • “Sense-making is inherently collective; it is not nearly as effective to be the lone leader at the top doing all the sense-making by yourself. It is far better to compare your views with those of others – blending, negotiating, and integrating, until some mutually acceptable version is achieved. Soliciting and valuing divergent views and analytic perspectives, and staying open to a wide variety of inputs, results in a greater ability to create large numbers of possible responses, thus facilitating resilient action.” – Sutcliffe & Vogus, 2003
At the end of the day, no single discipline or tenet will solve any problem alone, although sense-making might be useful when analyzing the past performance or story of a company in order to understand how things went out. It is like a mapmaking process. Sensemaking also uses mental models from previous experiences and disciplines. 

I do not agree though that it necessarily is a better exercise than scenario planning because it relies on past facts, as (i) facts are not as clean as they see, afterall someone made the fact up and you don’t know in what context and motivation and (ii) in a constant changing landscape it’s better to elucubrate about the future and try to foresee through group simulations what scenarios can come up.

References:

Enacted sensemaking in crisis situations – Karl Weick

Sensemaking in organizations – Karl Weick

Incentives & Financial Shenanigans

After talking a little bit about incentives, nothing better than debating some of the possible outcomes. As we’ve learned in the previous entry, high paychecks with misaligned terms may be an issue: CEOs feeling pressured about beating analysts’ short-term quarterly estimates may ‘play dumb’ destroying shareholder value in detriment of his own paycheck. As one CEO has put it,

“The most important thing we do is meet our numbers. It’s more important than any individual product. It’s more important than any individual philosophy. It’s more important than any individual cultural change we’re making. We must stop everything else when we don’t make the numbers.” – Joseph Nacchio, speech at January 2001 employee meeting, disclosed in a U.S. SEC complaint (March 2005)

Aggressive accounting may take its form in different ways, such as booking revenues too soon, recognizing undue revenue (nevermind PoC accounting method!), misclassifying items so they don’t pass through the P&L, shifting current expenses to the next period, boosting operating income by one-offs and so on.

Since executives are well regarded, competent and competitive people, they do not like to lose – I get that. But how could both (i) investors analyze companies financial results in a proper timeframe and (ii) executives be aligned with the right incentives and KPIs so performance evaluation for both parties would be fair and accretive for the three entities in question, namely investors, executives and the company itself?

As Munger put it in one of his speeches,

“The system is responsible in proportion to the degree that the people who make the decisions bear the consequences.”

I do not aspire to share a proposal, but things such as

  1. A shareholder base aligned with the strategic planning horizon of a company;
  2. A well calibrated compensation package, with the vesting period aligned with the strategic planning timeframe (even in Brazil there are companies with 10-year vesting periods);
  3. A more spaced financial results release (half yearly, maybe?); 

should be steps in the more correct direction. That’s my 2 cents. What do you think?


While below you may find the transcript of this another talk, right here you can find the video.