In my previous article, I highlighted a few points from Alice Schroeder's speech at UVA about Warren Buffett (Trades, Portfolio). One of the points was how Buffett always identifies the one or two factors that will make a business succeed or fail. This ties back to the simplicity mental model that I mentioned in my Charlie Munger (Trades, Portfolio)'s mental models article. Simplicity is enormously important but it's missing in almost all the investment write-ups that I have ever read. In this article, I'd like to share with the readers my thoughts on the subject of simplification and the application of this mental model in the investment process.
"Everything should be made as simple as possible, but not simpler." Such are the wise words from Albert Einstein. The message is clear and powerful. Yet it is rarely adequatly applied in our daily lives. Understandably and ironically, in the world of investing, the word "simple" is often misconstrued as unrealible and inferior. Just take look at all those strategies the hedge fund industry utilitzes. There are macro, quant, event-driven, credit, absolute value, low volitility and etc. The selling point to investors is often the high degree of sophistication of the system being deployed, as opposed to the risk-adjusted performance information.
However, is performance postively correlated with the degree of complexity of the investment strategy? I doubt it. Look at all the failures. The most egregious example is Long Term Capital Management. The models were so complex that very few can understand what they are doing. The result? When genius failed.
I believe like everything else, an investment system has to be made simple, but not simpler. This means simpliying the investment process to the extent possible without missing important information. The best example of such a system is Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio)'s 4-filter system. Any person with a decent amount of education can understand those 4 filters. Yet most people don't believe it actually works. They think there are more.
What's misunderstood about those 4 filters, in my opinon, is that the 4 filters are really just one of the most important mental model applications in Buffett and Munger's investment process. It is not their whole system. The purpose of the 4 filters is to simplify the investment process by forcing them to focusing on the most important factors. If you don't understand the business, you can't evaluate it. If the business doesn't have a sustainable moat, you can't sleep well knowing someone may drive it out of business. If the management is shoddy, you worry about whether they are trying to squeeze the wealth of shareholders. And lastly, if the price does not make sense, your will not get a satisfactory return, which will render the other 3 filters worthless.
The beauty of the 4-filter system lies in its simplicity. It's simple and clear. Once you can clear all 4 filters, you are likely to have a very good investment ahead of you. The 4 filters force you to think about the things that matter the most so you can allocate your time and effort more efficiently.
The other common misunderstanding about the 4-filter system is related to the complexity of actual application. Although they are powerfully simple, they are, at the same time very hard to apply. As Charlie Munger (Trades, Portfolio) put it, "anyone who thinks it's easy is an idiot." It's hard to apply because under those 4 filters, there are many subsystems. For example, in order to apply filter 1 (is it a business I can understand), an investor has to come up with evidences that support the claim that he or she can understand the business. If you think you understand the oil and gas E&P industry, can you list the 3 most important factors that will make an oil and gas E&P company succeed or fail? Can you describe how the business model works? What operating metrics should be used? Similarly, if you think the business has a moat around it, can you describe the moat in details and support this by data and statistics? How do you know the moat is sustainable or not?
You can see that the 4 filters are just the starting point. You must ask and answer all those follow up questions under each filter to support your hypothesis. The hardest part is asking the right questions and coming up with answers to those questions with a high degree of confidnece. Then you make the investment decision based on your analysis. The end result should resemble what Warrren Buffett once told a group of students:
"I used to tell the stock exchange people that before a person bought 100 shares of General Motors they should have to write out on a piece of paper. I’m buying 100 shares of General Motors at X and multiply that by the number of shares and therefore General Motors is worth more than $32 billion or whatever it multiplies out to,because (fill in the reasons). And if they couldn’t answer that question, their order wouldn’t be accepted.
That test should be applied. I should never buy anything unless I can fill out that piece of paper. I may be wrong, but I would know the answer to that.I’m buying Coca Cola right now, 660 million shares of stock, a little under $50. The whole company costs me about $32 billion dollars.Before you buy 100 shares of stock at $48 you ought to be able to answer I’m paying $32 billion today for the Coca Cola Company because... If you can’t answer that question, you shouldn’t buy it. If you can answer that question, and you do it a few times, you’ll make a lot of money."
This approach is very sensible and I encourage the readers to try it. Before you are about to initiate an order, write down your investment thesis on a piece of paper and see if you have answered the question Buffett encourged us to think about before buying a stock. If you are buying Facebook for $150 billion, you better come out with a damn good reason why it is worth almost as much as Coca Cola. By focusing on the enterprise value, you have a better sense of the valuation,especially when you think about what other businesses you can buy at similar prices.
So to sum up. An intelligent investor should apply the simplicity mental model by automatically going through a system that is similar to Buffett and Mungers's 4-filter system. Then the investor should writedown the reasons why a business is worth X or Y on a piece of paper. By doing so, an investor will be force do focus on the most important factors that will make both a company, and your investment succeed or fail. And if you do it consistently and successfully, you will make a lot of money.