The Manual of Ideas Interview with Guy Spier

Excerpts:

MOI: When it comes to stock selection, you have talked about the importance of checklists. Why are they so crucial, and what are some of the key items on your checklist?

Guy Spier: Those readers who have seen my two or three presentations know that I have talked about checklists. All of these ideas have emerged from conversations with Mohnish Pabrai, who noticed an article by Atul Gawande in The New Yorker with profound implications for investors. I'll share the basic insight that I have had as a result of these conversations: I think that we just have to acknowledge that there are some individuals out there — I think Warren Buffett in the investment world is one, Ajit Jain in the insurance world is another — who have a very particular ability to rationally analyze a situation in spite of crazy things going on in the world.

Most of us do not have that specific wiring. In spite of that, we can still improve our decision-making an awful lot by using checklists. The main way that I see it is that the investment world, either by design or by nature — and I think it is a combination of the two — throws up plenty of information that is designed to trigger one of two areas in the brain.

One is the threat detection fear mechanism, which throws up a very primeval response that has evolved within us for a very long time. It is one of the oldest parts of our brain — the fight-or-flight response. When we see something that makes us fearful, and we don’t have time to act, analyze and make weighted judgments, we have to decide either to run or to stay. We all know days in the market where that part of an investor’s brain is dominating and in which share prices can move around rather dramatically when compared to what appears to be very small amounts of news. So that is one sort of mode that the markets can be in, which is really the psychological mode of the majority of the participants in the market.

Then there is another side, which is irrational exuberance, as Alan Greenspan has described it, where the part of the brain that is being triggered is, as I’ve seen it described in various articles, the pleasure center of the brain. It turns out that the part of the brain we stimulate by the expectation of future profits is not that far away or dissimilar to the part of the brain that is stimulated, or lights up in CAT scans, when cocaine addicts either contemplate or are taking cocaine. These are very powerful centers.

Whether it is the fight-or-flight or the expectation of pleasure centers, the effect of both is to short-circuit rationally considered thoughts. They undermine the path of the brain that can make weighted, careful judgments about probabilities and about expectations. My perception is that it is the rational neocortex from which flow the very best investment decisions. Unfortunately, the world in which we operate is a minefield of opportunities to get caught up either by the fight-or-flight or by the pleasure center. So to the extent that somebody will talk about an investment being good when one is trembling with greed – I would not subscribe to that because trembling with greed implies that your greed and pleasure mechanisms in the brain are dominating the rational side.

I think that somebody like Warren Buffett is naturally wired not to be in either of those two extremes and spends his time in the happy middle. I think that what the rest of us human beings can do to train ourselves to be in that happy middle is use checklists. A checklist pulls us away from the kinds of actions that we would take if we were in either fight-or-flight or greed modes. So that is the basis for checklists.

The example I have given in talks is an airplane that is crashing. There is no question that checklists have been extremely helpful in reducing airplane accident rates. What it does is it brings the brain back to the place where one can make rational decisions.

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The real question is, as I look at the ideas, why am I discarding them and what personal biases am I engaging in as I discard them? I think something I have seen in a number of portfolios, including my own, is that the contents of the portfolio are a reflection of the particular biases of the person running the portfolio. To the extent that those biases or the model of the world that person has is faulty, it can lead to either phenomenal returns if the stars are aligned or it can lead to very bad returns if the stars do not align.

As I look at other people’s portfolios, I look to understand what their biases are and what particular chinks in their armor they may have. They may have a predilection for small-cap stocks or they may have a predilection for niche companies with niche ideas. Ultimately, what I can say for myself, I have had a bias towards low-capital invested, high-ROE businesses. In general, that is a bias that has probably been very productive. However, there are environments, particularly the one that we have just been through over the past 18 months, where that has probably hurt the portfolio more than it has helped the portfolio. So the way in which we go about generating ideas is obviously both important and critical and I think that ultimately it is a journey to explore our own personal biases.

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I think that the most profound pitfall and thing that one has to get over when investing beyond your borders is not to take the conditions that exist in the home investing country and assume that the same conditions exist in the country where the investment is being made. I have seen that going both ways. From the United States investing out, there are assumptions that investors have made about how the managers of the foreign company will allocate capital. There are also assumptions about what kind of standard managers hold themselves to. Not all managers of companies want to be remembered for being the best capital allocators. In some countries, being rapacious and greedy is considered a normal standard. Russia might be an example of that. At the same time, there are some countries such as Switzerland, where I would argue the ethics of drawing a modest salary and really acting for best interest of the shareholders are possibly even higher than the very high standards that already exist in the United States.

The reverse is also true. For example, Korean investors think that the United States is a very risky place to invest because they make assumptions about the way Americans act. I think that the key danger is that we make many assumptions that have to be checked and revised. One of the ways to do that is to spend some time in the country where the investments are being made. One of the rules that I have is that I want to be able to read the source documents in the language in which they are produced. I think there is a lot of subtlety that is missed when one reads a translation.