Framing Ever-Changing Business Environments

Analogies between chess and investing are somewhat frequent. What those usually fails to address is that the chess game is a closed-end system (masters usually memorize thousands of game set-ups like an algorithm so they can outplay opponents), while investments analysts and investors are required to constantly assess the ever-changing business environment. Taking a step back, sometimes the definition of what the business environment is not that linear. At the end of the day, it’s like investing is a matter of perspective and framing, not data collection and processing per se.

Additionally, it’s worth emphasizing what Heuer put brilliantly when he addressed the downside of mental models: it’s the principal source of inertia in recognizing and adapting to a changing environment.

There is a crucial difference between the chess master and the master intelligence analyst. Although the chess master faces a different opponent in each match, the environment in which each contest takes place remains stable and unchanging: the permissible moves of the diverse pieces are rigidly determined, and the rules cannot be changed without the master’s knowledge. Once the chess master develops an accurate schema, there is no need to change it. The intelligence analyst, however, must cope with a rapidly changing world. (…) Schemata that were valid yesterday may no longer be functional tomorrow.

Learning new schemata often requires the unlearning of existing ones, and this is exceedingly difficult. It is always easier to learn a new habit than to unlearn an old one. Schemata in long-term memory that are so essential to effective analysis are also the principal source of inertia in recognizing and adapting to a changing environment. 

From Psychology of Intelligence Analysis; Richard Heuer

Sequoia Annual Letter to Shareholders

I’d rather just quote this outstanding team than say the words by myself. For the full letter, click here.
Investment philosophy in their words:

Rather than try to guess what might happen next, we think it more prudent to own a portfolio of market leading companies that earn high returns on capital, boast strong balance sheets and self-fund their growth. We try to invest alongside motivated and ethical management teams and to identify businesses with many years of growth ahead of them. We try to buy these businesses carefully, taking advantage of occasional periods when their stocks seem to be mispriced. Though it contradicts academic theory, we believe a concentrated portfolio of businesses that has been intensively researched and carefully purchased will generate higher returns with less risk over time than a diverse basket of stocks chosen with less care. However, a concentrated portfolio may deliver results in an individual year that do not correspond closely to the returns generated by the broader market.

Declining holding periods, for who?!

          We have now owned TJX for 12 years and Mohawk for 10 years.

Signs of an expensive market:

In the fourth quarter of 2012, we were modest net sellers of equities for the first time since 2008, in response to specific situations at several of our portfolio holdings. In particular, we exited Target Corp., the discount retailer we’d owned since 2006, as we became increasingly concerned by its lackluster sales growth and vulnerability to competition from online retailers.

Given the huge run up in equities since early 2009, we are no longer finding compelling valuations, either for our existing holdings or for new ideas we are researching. Our current portfolio seems fairly valued today. That said, anyone who has paid attention over the past 15 years knows equities can trade at extreme levels, both of overvaluation and undervaluation.

Top down thoughts:

Valuations for stocks are heavily influenced by interest rates, and particularly by the risk-free rate of return on 10-year and 30-year United States Treasury bonds. Relative to the current return on Treasury Bonds, stocks continue to be quite attractive. However, the current risk-free rate of return is not a product of market forces. Rather, it is an instrument of Federal Reserve policy. As long as these policies remain in place, and stocks trade at higher levels of valuation, it will be more difficult for us to find individual stocks that meet our criteria for returns on a risk basis that incorporates substantially higher interest rates than exist currently. Just as we think it would be a mistake for investors to buy bonds at current levels, we believe it would be a mistake for us to buy stocks on the assumption that interest rates remain anywhere near current levels.

A Junior’s Thoughts on Investing

One thing I have come to realize by myself is that investing is much more of an art than what I thought before while trying to figure out exact calcs to reach a conclusion. Thus developing your framework – as Munger would say, wordily wisdom or mental models – is key to becoming a great investor. Perspective and curiosity are another two relevant characteristics. Naturally, perseverance must reign in your life so you can develop your mind.

Having read a book of the greatest CEOs of all time – if you are interested, just contact me, it made it easier for me to contemplate how they allocated capital: back of the envelope calculations, having a great knowledge of the specific market/segment they were investing in and knowing the two or three key issues on that topic. Therefore one reaches the conclusion that no complex DCF model is sharp enough predicting the future. Deep knowledge is the path to clarity and wise decision making.

Moreover elaborating on the above topic, portfolio turnover should be really low or none since your knowledge is so thorough you wouldn’t change your mind frequently.By the way, if you have any good books to recommend, please do not hesitate to share.