One of the most famous problems in popular statistics is the monty hall 3 door problem. Monty presents you with 3 doors. Behind one random door is a new car and behind the other 2 doors are goats.
Being averse to goats you select a door hoping for a car. Monty selects a door with a goat. You are given the option of changing doors or staying with the door you choose first.
You should change doors as it shifts your odds from 1:3 to 2:3. Wikipedia solution.
Being an excel geek, I created a spreadsheet tool to simulate the game 1,000 times. Warning it does have a macro. Download MontyHall.xls
One of the things I learned in writing up the visual basic was that Monty does 2 layers of information processing before revealing his answer.
This has a lot to do with investing, as perceptions and behaviours while new information reveals itself are some of the biggest factors to success.
Many firms operate in mature markets with known market shares and similar inputs to their competitors. So maybe you are looking at 6-10 doors.
The dynamics of earnings margins are more about the competitive environment and or some structural edge to the respective firm.
The largest piece of information missed by "value" investors is competitive dynamics and the direction of the moat relative to them over time. Munger hints at this in his excellent book Poor Charlie's Almanack.
A firm that has a geographic, regulatory, behavioural or structural moats may grow or shrink that moat over time. As an allocator, having a process to invest and allocate risk/positions is more important than each individual choice.
The Moat=the Margin=Earnings edge=extra ROE=Equity price appreciation relative to peers.
Take a look at that relationship above and think about it. This only works for firms in stable competitive dynamics i.e. mature stable industries. Most technology lead firms have black swans flying at them out of garages in silicon valley everyday and may not be suitable as classic value investments. It is my belief that Buffett understood microsofts and many technology businesses. I think he just didn't know how they could keep an edge over time.
You have 25 years and can make 1 investment among 3 choices: Coke, Apple or Google?
So how do you figure out what Monty Hall is telling you, skip the goat and get the car?
The car is a high ROE at fair price over time with a moat that expands as the firm grows leading to share price appreciation assuming you bought it at a reasonable value.
This is the proverbial snowball rolling downhill. Coke in the 1950-90's was like that with a single simple product, and ever better distribution and purchasing power. Eventually the behavioral moat "taste"triggered by marketing and lemming consumers watching each other guzzle the stuff meant a widening moat. Also recognize the Mungerian (sic) lalapalooza effect of multiple feedback loops.
- increasing sales lead to better input margins
- increasing sales lead to more efficient advertising buys
- increasing sales lead to more points of presence
- increasing sales lead to more cultural behavioral visual cues triggers other to consume
Monty Hall is the historical margins earned by a firm relative to its peers gleaned from 10Q's and 10K's. Watch firms with better operational margins or efficiencies. Understand their moats and substitute products. As a hedgie, anthropologist with a deep technology background it is fairly easy for me to see behavioral moats and the limited lives of most technology moats.
Coke as a product will most likely be here with stable margins in 20 years, Abercrombie & Fitch less likely. The half life of a fashion firm is limited and in its death throes, it will most likely spend any retained earnings away on marketing and other new forms of "coolness" that allowed it capture large margins in the first place.
The "problem" of asset allocation in mature business sectors isn't purely closed form like Buffett & Munger's pari-mutual betting analogies, but in some industries it is close enough that trends seen in expanding ROE over time may be indicative of sustainable advantage.
If one treats the sustainable comparable ROEs as indicator of competitive edge and longevity then there might be an investing edge assuming the price is right.
It is critical to understand what drives the edge. If it is a one off or something that doesn't scale with the business then think again. Monty can be tricky and most likely 2008 was goatish enough.
Where did value investing go wrong in 2008?
One could argue value investing didn't go wrong, the economy did. Value investing just tagged along with the market. Value investing isn't market timing or macro analysis per se, it occurs at the security level. Portfolio exposures at the economic level are another matter.
The diagram above explains why. The grey circle represents a firm at some fair value operating in a mature competitive dynamic.
The investor is looking for the car behind door number one over time. It is important to realize that relative to its peers the firm may well have delivered #1 results, but occasionally the larger economic environment overwhelms that success. The background represents the ups and downs of the larger economy green is positive and red is negative. The GDP and credit, normally limited factors in returns loomed large as the acute credit crunch became chronic.
The loose credit from 2004 on created a false economy probably 20% larger than the "real sustainable one" due to the wealth effect of perceived house values and easy credit.
When the macro economy credit crunch hit a "value" investment, the investment went down like everything else. Equity appreciation will most likely return faster to those value firms that truly possessed the attributes of value.
A few weeks back a colleague in my office asked, "When do you think the economy will get back to normal", I replied, "I think it's on its way there now."
I wasn't trying to be funny. The statement was meant to indicate that spending levels based on false credit meant an economy as measured by GDP that was 10-15% ahead of itself in terms of spending was reverting to its longer term growth rate.
A contracting real GDP may overshoot the long term growth rate on the downside but will eventually find equilibrium with a better current account balance and savings rate in the years to come. Yes it will take years. Fear doesn't dissipate quickly and the greed built up for a long time as shown in the savings rate.
The major issues now are how the economy ebbs and flows relative to the latest acronym dreamed up in DC. The new "normal" economy looks more like a big spending program perched dangerously on top of a massive t-bond bubble trading at a fear premium of 3% for 10 yr government bonds. Dollars anyone?
