Vitaliy Katsenelson: My Investor Holiday Reading List

My Investor Holiday Reading List, Part 1

23 DEC 2013 – VITALIY KATSENELSON

The thing I love the most about investing is learning. Investing is a never-ending, open-ended, multidisciplinary learning endeavor. You can always get better. Just like a shark that has to keep moving to live (breathe), an investor has to keep learning and improving to survive. Books are one important learning tool. In this and my next two columns, I’ll share with you an abbreviated list of books that have helped me along the way and may do the same for you.The following books should help you think like an investor, forcing you to focus on what is under the hood of any stock: a company’s business and the people who run it. The first book is The Essays of Warren Buffett: Lessons for Corporate America, a compilation of the Berkshire Hathaway CEO’s annual letters to shareholders dating back to the 1970s. As you might expect, Buffett’s annual reports themselves are fairly repetitious; his wisdom doesn’t vary that much from year to year. This book organizes main concepts and removes annoying redundancies.

You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits by Joel Greenblatt is one of those books that should be read more than once. Greenblatt, the founder of hedge fund Gotham Capital, shares unique approaches to finding undervalued stocks. On top of being a very good investor, Greenblatt has a healthy sense of humor. He also has written The Little Book That Beats the Market . At the end of the book, he offers a “magic formula,” a screen that has beaten the market over a long period of time. The magic screen is very simple: Buy low-price-earnings stocks that have a high return on capital. Low P/E is an indication of cheapness, whereas high return on capital is an indication of competitive advantage and the possibility to grow earnings quickly. Here is the book’s web site, which provides a weekly list of stocks that score high on both measures.

Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Baupost Group’s Seth Klarman is another gem. Unfortunately, you won’t find this book in bookstores. It is out of print, and it occasionally sells on EBay and Amazon.com for thousands of dollars. This book lacks Greenblatt’s humor, but it is full of Buffett-like lucidity, and it is a must-read for anyone who is serious about value investing. In fact, even though Greenblatt receives the credit for identifying and popularizing spin-offs as an often-mispriced subset of stocks, Klarman dedicates a good portion of a chapter to spin-offs in his book, which was published eight years earlier than Greenblatt’s.

Klarman talks about how investors’ time horizon has shrunk over the years:

Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative-performance derby…. The short-term orientation of money managers may be exacerbated by the increasing popularity of pension fund consultants. These consultants evaluate numerous money managers, compare their performances, contrast their investment styles, and then make recommendations to their clients. Because their recommendations can have a significant influence on the health of a money management business, the need to impress pension fund consultants may add to the short-term performance pressures on money managers.

Another must-read is The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor by Howard Marks. This book is a compilation of investment letters written by Oaktree Capital Management chairman and co-founder Marks over the past two decades. If I were to judge a book solely by how much highlighting I did while I was reading it, this one would score at the top. Here are some of my Kindle highlights:

It’s hard to consistently do the right thing as an investor. But it’s impossible to consistently do the right thing at the right time. The most we value investors can hope for is to be right about an asset’s value and buy when it’s available for less.

Thus, it seems to me, the choice isn’t really between value and growth, but between value today and value tomorrow. Growth investing represents a bet on company performance that may or may not materialize in the future, while value investing is based primarily on analysis of a company’s current worth.

Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable ones do.

Experience is what you got when you didn’t get what you wanted.

Few people may have heard of The Super Analysts: Conversations with the World’s Leading Stock Market Investors and Analysts by Andrew Leeming, but it is a book well worth reading. The author interviews successful investors (not academics), who discuss their approach to investing and their analyses of common stocks and of some specific industries.

Secrets in Plain Sight: Business & Investing Secrets of Warren Buffett by Jeff Matthews is not another biography of the Oracle of Omaha but rather the most insightful, critical and balanced analysis of Buffett and Berkshire Hathaway I’ve ever read. I also encourage you to read Matthews’s musings on his blog; I’ve been reading it for years.

Finally, I also recommend The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments by Pat Dorsey. Michael Porter wrote Competitive Strategy a few decades ago, and it quite deservedly turned into a bible of industry analysis that is taught in all business schools and management programs. Dorsey, president of Sanibel Captiva Investment Advisers, adopted Harvard Business School professor Porter’s concepts into this little book and applied them directly to investing. To be honest, if this book had been out when I was teaching my investment class, I’d be using it instead of Porter’s — sorry, Michael!

The right temperament is crucial in investing. Being a critical thinker and knowing how to value stocks are important, but it is all a waste if your emotions get the better of you. The following books will help you recognize the shortcomings of your hard-wiring and help you devise strategies to deal with it.

Psychology of Investing by John Nofsinger is short and to the point. You’ll become an expert on behavioral investing in about an hour. Well, not quite, but close.

The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy by James Montier is another good read. This book is written for value investors by a value investor who happens to be a leading thinker in behavioral finance. This is the only behavioral investing book that I am aware of that quotes Ben Graham, Seth Klarman, John Templeton and Warren Buffett throughout the book and synthesizes their lessons with those of behavioral investing.

The two books above cover many of the topics in Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, written by Wall Street Journal columnist Jason Zweig. His Chapter 10 makes the book a must-read: It addresses happiness — yes, happiness. Even though, as most of us know, money doesn’t buy happiness (unless you are starving or living in a cardboard box), money spent on buying things brings a burst of happiness that quickly fades away. Think of how happy you were on the day you bought your first car. Now fast-forward a few weeks later: The rush almost certainly has faded. Money spent on experiences, on the other hand, brings a higher utility of happiness. Recollecting experience brings happiness (so take a lot of pictures and videos to remember things better). Zweig also provides a list of things you can do that will make you happy, and none of them require you to spend a penny, which is a big positive in today’s economy.

 

My Investor Holiday Reading List, Part 2

25 DEC 2013 – VITALIY KATSENELSON

Though traders and value investors fish in the same pond — the stock market — and may even catch the same fish at times, their approaches and analytical timeframes are quite different. Value investing and trading, however, share a common element: Both are done by humans and are thus affected by emotions. That’s why I recommend a work of fiction that provides a great look inside a trader’s mind and teaches many behavioral and common-sense lessons. Reminiscences of a Stock Operator , written in 1923 by Edwin Lefèvre, depicts from a first-person perspective the early years of the great trader Jesse Livermore. It is rumored that this book was actually written by Livermore and edited by Lefèvre. Here is a sampling of its insights:

Another lesson I learned early is that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market to-day has happened before and will happen again.

A man must believe in himself and his judgment if he expects to make a living at this game. That is why I don’t believe in tips. If I buy stocks on Smith’s tip I must sell those same stocks on Smith’s tip.

The recognition of our own mistakes should not benefit us any more than the study of our successes. But there is a natural tendency in all men to avoid punishment. When you associate certain mistakes with a licking, you do not hanker for a second dose, and, of course, all stock-market mistakes wound you in two tender spots — your pocketbook and your vanity.

One of the most helpful things that anybody can learn is to give up trying to catch the last eighth or the first. These two are the most expensive eighths in the world. They have cost stock traders, in the aggregate, enough millions of dollars to build a concrete highway across the continent.

A few years ago my friend Jon Markman took this wonderful book and made it better — he annotated it. His annotation is almost like a book within a book. He takes you behind the scenes of Lefèvre’s story and provides important insights into characters and the backdrop of that very interesting time period.

Another good book about Livermore is called Jesse Livermore: World’s Greatest Stock Trader , by Richard Smitten. Here’s one of its best passages:

After several months of despair, Livermore finally summoned up the courage to analyze his behavior and to isolate what he’d done wrong. He finally had to confront the human side of his personality, his emotions and his feelings. … Why had he thrown all his market principles, his trading theories, his hard-earned laws to the wind? His wild behavior had crashed him financially and spiritually. Why had he done it? He finally realized it was his vanity, his ego. … The outstanding success of making more than $1 million in one day had shaken him to his foundations. It was not that he could not deal with failure — he had been dealing with failure all his life — what he could not deal with was success.

I really enjoyed reading Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies by Wharton School finance professor Jeremy Siegel, but it took me a while to recognize how dangerous this book is. The book, currently in its fifth edition, is well written and provides a good overview of the performance of different asset classes over the past two centuries. But it needs a different title, maybe something like Stocks for the Really, Really, Really Long Run. That way, it would not lure investors into a false sense of security when it comes to equity returns.

Siegel’s book preaches that the stock market is always a buy, no matter what valuations are, and that a 7 percent real rate of return is a birthright for stock investors, no matter if the market is extremely cheap or ridiculously expensive. This is true if your time horizon is 30 years or if you plan to live forever. It is also true if you can tolerate seeing your portfolio go nowhere for a decade or longer. Unfortunately, most of us don’t have that idealized time horizon. We need to pay for our children’s educations, weddings, boats and other things. I don’t know anyone who has the patience to see a portfolio of stocks do nothing for decades.

That is why Siegel’s book should only be read alongside the following antidote: Unexpected Returns: Understanding Secular Stock Market Cycles , which is a truly terrific book by Ed Easterling. Unlike Siegel, Easterling shows that even though stocks are a great investment for the (really, really) long run, they have periods when their returns are unspectacular. Easterling calls these periods bear markets. I call them range-bound, or sideways, markets, which is just a difference in semantics. Those bear (sideways) markets take place after secular bull markets.

What is the appropriate way to look at risk? I suggest two books by Nassim Nicholas Taleb: Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets and The Black Swan: The Impact of the Highly Improbable . These books address the risk associated with rare events.

Fooled by Randomness is my favorite nonfiction book, period. I’ve read it at least five times. This book turns upside down the way we are taught to look at risk. Taleb rebels against the current Establishment of finance, which measures risk with elegant formulas that receive Nobel Prizes but lack common sense.

Any model that focuses solely on past observations and dismisses outcomes that lie outside of what happened in the past is worthless and dangerous, Taleb explains. One way of understanding how randomness works is by studying alternative historical paths, which requires more than just focusing on what took place in the past. Observed history is actually just one of many possible outcomes. One should focus on what could have taken place, what alternative paths might have existed. With that added insight, we can then predict and prepare for what might happen in the future.

The Black Swan is a follow-up to Fooled by Randomness. Taleb takes a lot of the concepts discussed in the earlier book and explains them in greater detail, providing new and unexpected insights. I have to warn you that The Black Swan is not an easy read. It has more insights per page than most books, but it’s not a beach read. If you’re looking for a CliffsNotes version, check out this 2008 lecture that Taleb gave at the Long Now Foundation in San Francisco, in which he covers major concepts described in both books in great detail.

In the second edition of The Black Swan, Taleb added a section that talks about how Mother Nature deals with black swans through redundancy. One way to avoid catastrophic failure is by having spare parts: We get two lungs, two eyes and two kidneys, and each has more capacity than we ordinarily need. Taleb writes,

An economist would find it inefficient to maintain two lungs and two kidneys: Consider the costs involved in transporting these heavy items across the savannah…. Also, consider if we gave Mother Nature to the economists, it would dispense with individual kidneys: since we don’t need them all the time, it would be more “efficient” if we sold ours and used a central kidney on a time-sharing basis.

This reconfirms why I’d like to own stocks with “suboptimized,” debt-light (cash rich) balance sheets. Or, as Taleb eloquently puts it, “Debt implies a strong statement about the future and a high degree of reliance on forecasts.”