Lemon Juice, Knights and Hybrids

Freestyle chess can teach a lot about the value of a hybrid approach to value investing

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Oct 18, 2016
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Being a hybrid maker off and on over the years, I'm very comfortable with the idea and have been the subject of quite a few pretty good mashups myself.” – David Bowie

A man does not show his greatness by being at one extremity but rather by touching both at once. Albert Camus

One of the more interesting aspects of value investing is how different the process can be for various investors.

For instance,

Warren Buffett (Trades, Portfolio) has migrated from the more traditional Graham-based model of cigar-butt investing to buying high quality businesses at fair prices. Mason Hawkins (Trades, Portfolio) at Southeastern Asset Management (co-manager at the Longleaf Partners Fund) says three things drive his investment criteria: good business, good people and a good price. Seth Klarman (Trades, Portfolio) looks at things quite differently, operating under three principles: bottom-up approach, absolute performance not relative performance and protecting the downside.

At Dorfman Value Investments, John Dorfman and I have two distinctly different approaches to value investing. John is a more traditional value investor focusing on companies with low price-earnings (P/E), low price-book (P/B) and low price-sales (P/S). I have to admit I never looked at a P/E ratio before I met John. My focus was – and still is on a significant discount to my estimated intrinsic value, rock solid balance sheet and high returns on equity, assets and capital.

This merging of methods has made me a better investor. I might not adopt all of John’s criteria, but they give me a vastly different view of my holdings. This hybrid approach can be a powerful tool in your investment approach. But investing isn’t the only area where a hybrid approach creates value.

Sometimes a hybrid is best: freestyle chess

In a great paper on Sept. 10, 2014[1], Michael Mauboussin and Dan Callahan wrote about the similarities between freestyle chess and value investing. Freestyle chess is where a team of humans and computers compete against another such team. They compete this way because experience has shown that a hybrid approach is more powerful than a single human or a single computer. Further on in the article they discuss the similarities between freestyle chess and investing. In regard to a team consisting of human and computers, they wrote:

Freestyle teams are currently better than the best machines, although the gap is likely to narrow over time. So for now, man plus machine beats man or machine. A recent estimate places the advantage of the freestyle players over the best programs at 100-150 rating points, which suggests they are expected to win about two-thirds of the points in a match. Freestyle teams appear to be melding the strengths of humans and computers while mitigating the weaknesses.”

Later on in the article, they cite the findings of Tyler Cowen in his book “Average is Over.[2] He cites four lessons from freestyle chess.

  1. Human-computer teams are the best teams.
  2. The person working the smart machine doesn’t have to be an expert in the task at hand.
  3. Below some critical level of skill, adding a man to the machine will make the team less effective than the machine working alone.
  4. Knowing one’s own limits is more important than it used to be.

Implications for value investors

The evolving debate about man or machine in the chess world tracks similarly to the human versus robo-advisor conversation in investing. One can also see similarities between active and index investing. While investors are certainly making their druthers known by piling into index funds, a reasonable question is whether a hybrid approach works in value investing. I would suggest it does. Two findings jumped out at me when I read the Mauboussin/Callahan paper.

Know your limits but seek to enlarge them

One of the mistakes many investors make is underestimating the difficulty in choosing winning stocks as well as overestimating their ability to choose them. As demonstrated in the Dunning Kruger effect[3], many investors have no idea what they don’t know. These investors have a form of illusory superiority where they believe their ability is much higher than it is in reality. The ability to accept the limits of one’s knowledge is the beginning of value investing wisdom.

That doesn't mean these boundaries are hard and fast. Great value investors are always looking to push their individual limits by learning about new methodologies, new industries, and new companies. Buffett’s acquisition of Burlington Northern Santa Fe demonstrates his ability to move his personal comfort zone and adapt to industry changes.

Multiple approaches give you multiple views

As mentioned at the outset of this article, my partnership with John Dorfman has certainly made me a better investor. When I first looked at John’s portfolio, my reaction was not entirely positive (John might say it was a little stronger than that). Over time, as John explained his methodology I found there were real attributes that could teach me a lot. More importantly, it forced me to take a vastly different look at my portfolio creating an entirely new perspective. I’m not suggesting an investor needs to – as William T. Sherman said – “forage liberally” on any stock-picking style generating a scattershot system. But always be open to learning new information on industries, companies and investment tools.


It is always a conflict for investors to stick with their investment process but at the same time be flexible to new knowledge. Sometimes we do ourselves an injustice by picking one or the other. Great investors – much like Camus said – show their greatness by combining both in their process. In the final analysis more knowledge makes us better investors.

As always, I look forward to your thoughts and comments.

[1] “Lessons from Freestyle Chess: Merging Fundamental and Quantitative Analysis,” Michael Mauboussin, Dan Callahan, Global Financial Strategies, Credit Suisse, Sept. 10, 2014.

[2] “Average Is Over: Powering America Beyond the Age of the Great Stagnation,” Tyler Cowen, Dutton Press, September 2013.

[3] The Dunning Kruger effect is named after David Dunning and Justin Kruger of Cornell. In their seminal work “Unskilled and Unaware of It” (1999), they discuss the story of McArthur Wheeling. Wheeling robbed two banks in Pittsburgh after rubbing lemon juice on his face absolutely certain it would be invisible to security cameras. He apparently got the idea from the fact lemon juice is mentioned as a core ingredient in invisible ink. Needless to say, Wheeler spent a considerable amount of time behind bars contemplating how it all went wrong.

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