🔑 Key Takeaways
- Dr. Graeme Forster's transition from academia to investing was influenced by disillusionment with academia's bureaucracy and politics. He believes that a bottoms-up approach is necessary to balance macro trends in uncertain markets, and good and cheap companies can outperform even in bear markets.
- Accepting uncertainty and making decisions based on probability, rather than outcome, is essential in both investing and poker. Leaders should recognize imperfect information and avoid projecting false confidence. Proper position sizing is crucial in investing, but the Kelly criterion's effectiveness is limited to binary bets.
- The Kelly criterion can help investors identify situations where they have a differentiated view and intrinsic value of a business higher than market price with a narrow range of outcomes to take a big position, but determining an edge relies on personal character and unique thinking.
- When valuing a business, consider how expenses like marketing are accounted for. Understanding a business's narrative and taking a long-term view are crucial during times of uncertainty. Modeling potential outcomes and analyzing relevant data can also inform investment decisions.
- Successful investing during the pandemic required understanding the resiliency of businesses and investing for the long-term, as the pandemic highlighted the importance of a diverse portfolio and the unpredictability of events.
- With a focus on intrinsic value, long-term thinking, and markets with massive opportunities, investors like Allan Gray can achieve extraordinary results even in times of volatility and uncertainty.
- Having an open, flexible mindset towards investments and being actively focused on intrinsic value is crucial for efficient capital allocation and creating a wide opportunity set. Being altruistic in investing helps prevent misallocation of capital and promotes societal good.
- Long-term success in investing is more likely when based on fundamental analysis rather than relying solely on signals and data. Short duration businesses with high dividends and free cash flow are better investments than long duration businesses with high expectations.
- The term premium is the reward for taking on time risk but has been negative in recent years, leading to market inefficiencies and potential misallocation of capital. It is crucial for investors to understand this concept in the bond world.
- Low term premium can lead to mispriced shares and perverse capital allocation decisions by management teams, which can create inflationary dynamics and shortages of raw materials in the economy. This can be remedied by being aware of the natural cycles and taking steps to mitigate the impact.
- Despite higher income, increasing wealth disparities have resulted in a feeling of being poorer than the 1950s. To succeed in investment outside the US, understanding global currency policies and labor policies is essential, along with a focus on discounted securities and improved capital allocation.
- Changes in the multiple on earnings streams due to the cost of money impact investment returns. Investors need to stay vigilant about potential structural changes that could compress margins. Focus on owning businesses with a margin of safety and intrinsic value for excess returns.
- Don't base valuations solely on the past decade. Look at previous decades for a more normal economic environment. Invest in good and cheap businesses in non-spotlight sectors with high free cash yield and high dividend yield for a potential asymmetric upside with low downside. Tiny edges in the portfolio can make a big difference.
- Living in a quieter environment like Bermuda can help with productivity and independent thinking. Allan Gray believes in democratizing investment and providing direct access to clients. Visit Orbis website for more information on excess return strategies.
📝 Podcast Summary
From Mathematics to Investing: Dr. Graeme Forster's Journey
Dr. Graeme Forster, Director and Portfolio Manager of Orbis explains his journey from mathematics to value investing. Through exploring legendary quant investors like Jim Simons, Graeme learnt how playing poker taught him the art of making decisions under uncertainty using mathematical ability and psychology. His transition from academia to investment came from being disillusioned with academia's bureaucracy and politics and he saw investing as a more professional and reputable career option. Graeme believes that the world is inherently uncertain, even in a closed system; hence his thesis of the great misallocation emphasizes balancing macro trends with a bottoms-up approach. Good and cheap companies can outperform, especially during bear markets. Orbis, a global investment management firm, manages around 30 billion and owes its success to founder Allan Gray's investing flexibility.
Embracing Uncertainty in Decision Making: Lessons from Investing and Poker
The world is inherently stochastic, and living in a stochastic world means accepting that there is always a degree of uncertainty in every decision we make. Investment decision making is similar to poker since both are probabilistic, and it's essential to base decisions on their probability rather than the outcome. Leaders and directors should recognize that perfect information is not possible, and they need to make the best decisions based on imperfect information available. CEOs tend to project strength, certainty, and conviction, but it may not be effective in running the business. Position sizing in investing is crucial since it determines the edge over odds ratio, but the Kelly criterion used in gambling works well only in binary bets.
The Kelly Criterion for Investing and Portfolio Management
The Kelly criterion can help determine how much of total wealth to put into a single position if you have a differentiated view of the odds that differ from the given price. It works well with binary outcomes but investing and portfolio management represent multiple outcomes with a probability distribution. The principle of the Kelly criterion is to identify situations where you have a tangible differentiated view and intrinsic value of a business that is higher than the market price with a narrow range of outcomes to take a big position. Determining your edge in investing is based on your character, strengths, and unique way of thinking. It's essential to be pointy and leverage on what you do well to identify situations where you can think differently.
Valuation and Investing Strategies in Uncertain Times
When valuing businesses, it's important to consider how certain expenses like marketing are accounted for. A company like Amazon, for example, may capitalize marketing expenses as investments rather than expenses, leading to higher earnings than previously thought. Looking at a business's pieces and understanding the news flow are mechanical ways to value them, but understanding how you personally think about the business and its narrative can provide an edge in finding discounted businesses. During the pandemic, investing strategies had to take the long-term view and model potential outcomes. One useful piece of data early on was studying the demographics and mortality rates of a cruise ship with a known number of infected individuals.
Understanding the Impact of COVID-19 on the Economy and Investing
The key to modeling the impact of COVID-19 was not just the rate of spread, but also the deadliness of the virus, which was significantly higher than seasonal flu. However, predicting government responses proved difficult and led to economic destruction as bad as the disease itself. The pandemic caused a meaningful dislocation in the economy that led to a perfect storm for old economy businesses, which were already very discounted. Successful investing during this period required understanding the resiliency of businesses and their potential for recovery after the lockdown. The pandemic showed the importance of a diverse portfolio and the unpredictability of events, highlighting the need to underwrite businesses and take a long-term approach to investing.
Investing in Volatility: How Allan Gray Found Value in Negative Oil Prices
During the period of negative oil prices, companies like Glencore were primed to make a lot of money out of the volatility of commodities. They could store oil on ships they had hired, which was getting expensive, but their share prices were down. This is a positive development for certain companies but their share prices were not reflecting it. Allan Gray, the founder of Orbis and sister company Allan Gray, was an intrinsic value focused investor and achieved success by taking his skillset and style to markets with massive opportunities for a value investor. Longevity is key to delivering excess returns over very long periods of time and achieving extraordinary results.
The Importance of Flexible Investment Thinking for Maximizing Opportunities and Societal Good.
Flexibility in investment thinking is critical for a wide opportunity set. Having a narrow mindset limits potential ideas, leading to inefficiencies. Having a flexible, open mindset creates a big opportunity set. Active, intrinsic value focused investors are critical for societal good to prevent huge misallocation of capital. It's important to have an altruistic element to investing. Buffet himself was not a value investor, he's just an investor. Jim Simon's quant driven approach did not appeal to Graeme Forster as it's essential to have an active management scene. Being very active in markets is a societal good. The narrative of just investing in great management teams or companies with a net balance sheet can limit opportunities.
The Case for Fundamental Investing Over Quantitative Investing
Investing based on fundamentals proves to be a better approach than quantitative investing, as the latter is signal-driven and lacks a fundamental basis. Even though quant investors claim to improve efficiency, it is difficult to invest a large sum of money without understanding the underlying business. The cyclical nature of investing and the fear and greed of human beings also drive market inefficiencies, highlighted by the lack of highly successful quantitative funds. The author believes value investors should focus on short duration businesses, which pay high dividends and generate free cash flow rather than reinvesting it, as they offer higher intrinsic value compared to long duration businesses with high free cash flow expectations.
Understanding the Term Premium in Investing
The term premium is the extra bit that investors get compensated for taking on time risk. It's been positive throughout history but has been negative for the past five years, creating a real inefficiency in markets. This negative term premium means that a dollar in ten years may be worth more than a dollar today, which drives money into new economy stocks. The low term premium in the sixties also contributed to a massive misallocation of capital in the late sixties. Understanding the term premium is important for investors in the bond world and can provide insight into market inefficiencies and potential misallocations of capital.
The Negative Impact of Low Term Premium on Economy and Capital Allocation.
When the term premium is low, it drives a big gap between the new economy and the old economy, leading to mispriced shares and perverse capital allocation decisions by management teams. This is seen during times of negative term premium, like during the tech bubble and currently. Such decisions are bad for the economy, as they create inflationary dynamics and shortages of raw materials, leading to dislocations that eventually close. Hedge funds were born out of the inefficiencies during such periods, but as the inefficiencies close, they wane. This natural cycle takes time, and we are quite early in the cycle of the current unwinding of low term premiums.
Understanding Labor Policies, Wealth Disparities, and Currency Type Policies in Investment Strategies.
In the 1950s, due to high tax rates and few wealth disparities, people's circumstances were more in line with their expectations, resulting in a more positive perception of the era. Since then, income has tripled, but wealth disparities have increased, leading to a feeling of being poorer than the 1950s. Labor policies are becoming increasingly important, as people demand real wage increases in line with inflation. Orbis's bottom-up approach focuses on finding discounted securities and working with management teams to improve capital allocation, which has been successful in markets like Japan with niche opportunities. The global phenomenon of currency type policies means that US Fed's policies affect the rest of the world, and understanding these dynamics is critical to investment strategies outside the US.
The Impact of Cost of Money on Investment Returns
According to Graeme Forster, investment returns are generated either through earnings growth or changes in the multiple on those earnings. The cost of money impacts the multiple you pay for an earning or cash flow stream. In 2022, the fall in equity markets can be attributed to higher bond yields affecting the multiple on earnings streams. Going forward, investors need to worry about structural changes which could compress margins, such as higher labor or interest costs. The low term premium leaves a shadow of doubt and mindsets take time to reset to a more normal world. With markets still quite expensive, it is important to generate excess returns by owning businesses with a sufficient margin of safety and intrinsic value.
Why Valuations Shouldn't Be Anchored in the Past Decade
Investors should not anchor their valuations on the past decade as it was a period of abnormal monetary, labor and tax environment. They should look at the previous decades where the economy was more normal. Good and cheap businesses in sectors not in the spotlight and with high free cash yields performed well in bear markets like the 70s and early 2000s. These businesses, with a good valuation underpinning and high dividend yield, are a good bet even now. If these businesses have massive optionality on top, with potential 40-50% upside, it creates an asymmetric situation with very low downside. Tiny little edges in the portfolio can make a big difference and represents today's opportunities.
The Benefits of Living in Bermuda and Allan Gray's Investment Philosophy.
Living in a library-like atmosphere instead of a noisy big city like New York or London helps Graeme Forster to think and develop an independent view. Being located in Bermuda, which is a solid financial center, is hugely efficient and convenient for him. Graeme appreciates his time with his family and every minute of his life, either he is doing something productive or enjoying with his family. Additionally, democratizing investment is important to Allan Gray, where investors could go directly to a firm instead of paying layers of fees. People can go to the Orbis website to obtain information on excess return strategies for institutional and retail clients.