Knowing What You Don’t Know is the title of Chapter 14 of Howard Marks (Trades, Portfolio)’ book, "The Most Important Thing."Â In his book, Marks mostly wrote about the unknowable, especially with regards to future forecasts. In practice, knowing what you don’t know also means that investors need to know what they don’t know about their blind spots regarding the business and the management team.
Li Lu and Charlie Munger (Trades, Portfolio) have both said many times that in order to have an opinion on something, you have to talk to the smartest people on the subject and prove that you know more than they do. This is a key aspect of doing fundamental research and making investment decisions. As Mark Twain once said, “It ain't what you don't know that gets you into trouble, it's what you know for sure that just ain't so.”
Li and Munger’s advice sounds so obvious, but in practice there are real and daunting challenges in achieving it.
Researching beyond public data
First of all, Li and Munger didn’t tell us how to find the smartest people on the subject. Even if you can find them, why would they want to talk to you? For instance, say you really wanted to know more about the subject of gene-culture coevolution for a newly-listed company. The smartest person on earth on this subject is Edward Wilson (at least in my opinion). Can you have a conversation with Wilson for a few hours? It’s not impossible, but it would require a lot of effort for most people.
I think we can safely assume that if people like Charlie Munger (Trades, Portfolio), Li Lu and Bill Gates (Trades, Portfolio) want to speak to Wilson on gene-culture coevolution, it would be an easier task. It’s the same thing with company research. In every industry, there are well-respected top experts. You know who they are, but how can you speak to them? And if you can’t, should you still form an opinion on the companies in that field?
Secondly, very often investors don’t know who the smartest people are, or they don’t know that they don’t know who the smartest people are. In fundamental research, this is what I call information asymmetry. It’s not easy to know how much you know, especially compared to other investors. In order for an investor to know what he doesn’t know, he needs to establish some sort of yardstick.
At Himalaya Capital, Li Lu asked his analysts to provide him with complete and accurate information. But what is complete and accurate information? You can verify the accuracy of some information, but there’s plenty of unverifiable information. Furthermore, how do you know whether the information is complete? Is your information 60% complete? 50%? 80%? It’s not that clear cut.
And thirdly, I think some investors may still have the impression that reading all the annual reports and public information is all that’s required to know everything about a business. Warren Buffett (Trades, Portfolio) may have made it beguilingly easy to do just that. For instance, he said the following during the 1994 annual meeting:
“I think you judge management by two yardsticks. One is how well they run the business and I think you can learn a lot about that by reading about both what they’ve accomplished and what their competitors have accomplished, and seeing how they have allocated capital over time.
And then the second thing you want to figure out is how well that they treat their owners. And I think you can get a handle on that, oftentimes. A lot of times you can’t. I mean it — they’re many companies that obviously fall in — somewhere — in that 20th to 80th percentile and it’s a little hard to pick out where they do fall. But, I think you can usually figure out — I mean, it’s not hard to figure out that, say, Bill Gates (Trades, Portfolio), or Tom Murphy, or Don Keough, or people like that, are really outstanding managers. And it’s not hard to figure out who they’re working for. And I can give you some cases on the other end of the spectrum, too. It’s interesting how often the ones that, in my view, are the poor managers also turn out to be the ones that really don’t think that much about the shareholders, too. The two often go hand in hand.
But, I think reading of reports — reading of competitors’ reports — I think you’ll get a fix on that in some cases. You don’t have to — you know, you don’t have to make a hundred correct judgments in this business or 50 correct judgments. You only have to make a few. And that’s all we try to do.
And, generally speaking, the conclusions I’ve come to about managers have really come about the same way you can make yours. I mean they come about by reading reports rather than any intimate personal knowledge or — and knowing them personally at all.
So it — you know, read the proxy statements, see what they think of — see how they treat themselves versus how they treat the shareholders, look at what they have accomplished, considering what the hand was that they were dealt when they took over compared to what is going on in the industry.”
To some extent, I think Buffett’s statement is misleading. We know he has an incredible amount of knowledge about the management team that Berkshire’s invested in, and a lot of knowledge comes from background checks and other investigative results. Li Lu also does a lot of investigative works for management teams. He spoke about how when he invested in Timberland, he got to know the founder and his family personally. You simply can’t get unbiased and complete information on management teams by just reading the publicly-available information.
You also can’t get complete and accurate information on the business by reading alone. That’s why expert networks such as GLG and Capvision are so profitable. It’s not uncommon for an institutional investor to make a few dozens of calls and spend a million dollars on a single company by utilizing GLG and Capvision’s expert network. The amount of information you can gather by calling many industry experts is astounding. However, many non-professional investors simply don’t know how much information professional investors have. It’s not a fair game.
Overcoming the information gap
Given all of this, what can non-professional investor do to cope with the information asymmetry?
My old boss Arnold Van Den Berg (Trades, Portfolio) has offered some great advice on this topic. He always held that it was impossible to know everything about a company, so what he did was develop a system of requiring different levels of margin of safety.
For instance, for a small cap industrial company, he might need a 75% discount to intrinsic value, regardless of how much he knows. For a large cap well-known and predictable company, he might still need a 30% discount to intrinsic value. It’s often necessary to just acknowledge what you don’t know and insist on a large enough margin of safety to protect you. You may miss some great investments this way, but the most important thing is the safety of avoiding going in blindly.
Read more here:
- Notes From Li Lu's Recent Interview - Part III
- Notes From Li Lu's Recent Interview - Part II
- Notes From Li Lu's Recent Interview - Part I
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