Previewing PRGX Global for Best Ideas 2018

December 15, 2017 in Best Ideas Conference, Diary, Equities, Ideas, Letters

This article is authored by MOI Global instructor Ben Terk, portfolio manager at Active Owners Fund, based in Toronto. Ben is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

At Active Owners Fund, we look for small cap “buy-out” quality companies that are in transition or open to a transaction, that have broken stocks, but are not broken companies.

We invest significant time and resources on due diligence to understand the industry, competitive set and near term opportunity for significant value creation. By focusing on the small cap sector that is under-covered, under-followed and for some companies, under-valued, we are always able to find opportunities where we can buy influence at a discount versus control at a premium. In the sub-billion-dollar market, there are always a whole host of companies going through different types of fundamental events that will unlock value and better reflect the true earnings power of their respective business models.

We have tracked PRGX Global (PRGX) for over five years and have spent time with previous and current PRGX management. As we all come out of private equity, we are constantly speaking with relationships there and exploring potential take private opportunities across our portfolio. We believed PRGX would make an interesting take private candidate given its cash flow potential, sticky customer base and ability to serve as a platform for further market consolidation

PRGX is the largest provider of recovery audit services to the retail industry in the world. The Company serves 75% of the top 20 global retailers, 32% of Fortune 50 companies and has a 99% customer retention rate. The Company recovers over-payments and under-deductions from a customer’s suppliers through data analytics and audit across millions of customer/supplier interactions. We began tracking the Company over five years ago when the prior CEO began his tenure. At the time, we were intrigued by the Company’s significant long-term customer relationships and its access to massive amounts of purchasing data that we thought could be monetized through incremental services and analytics. In addition, there appeared to be a large opportunity to lower costs by accelerating the offshoring of more of the recovery process to India, which was already underway.

We confirmed the scope of the cost reduction opportunity through numerous discussions with the former CEO and prior employees. Despite these near term opportunities, the former CEO had a more grandiose vision and chose to pursue a new business line focused on the healthcare sector. The Company made a couple of unsuccessful acquisitions and the former CEO was eventually pushed out. When the current CEO joined in late 2013, we began to spend time with him and re-started our diligence. We subsequently initiated a position in February, 2017. There are now two activist investors involved, one of which is on the Board and with whom we have a long term relationship.

Under the leadership of the new CEO, the Company exited the healthcare business and focused on automating and accelerating audit cycle times to differentiate itself in an increasingly commoditized business. As a result, the Company has been able to grow organically by adding new clients and increasing customer retention. The Company has had five consecutive quarters of organic revenue growth. The Company is also beginning to show success in leveraging its six petabytes of customer data to sell incremental services to its existing customers while also forging go-to market alliances with a number of consulting firms. The Company recently completed two small acquisitions to further accelerate its adjacent services offering and develop a software-as-a-service (SaaS) business model.

The combination of the heavy technology investment in the Company’s core platform and the buildout of the adjacent services business has masked the forward earnings power of the Company. If we adjust for these non-recurring items, the Company is trading for less than 7x 2017 EBITDA or approximately 50% less than its peer set. We believe the stock will rerate and liquidity will improve as the cash flow yield improve and the business starts to scale. Additionally a combination of a sticky customer base, renewed growth, a strong balance sheet, under-monetized data assets, and a shareholder-focused board will be attractive to both financial and strategic buyers.

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Investment Opportunities in Europe

December 15, 2017 in Featured, The Manual of Ideas

As we conclude another year, I am pleased to share with you the progress we’ve made building MOI Global into a unique membership community of intelligent investors.

The Manual of Ideas started out nearly a decade ago focused on content. As we went out to gather and generate uniquely differentiated content for value-oriented investors, we came to appreciate the tight-knit value investing community that had been developing for many years thanks to a strong nucleus formed by the Berkshire Hathaway annual meeting.

We realized this was not only a community of exceptionally gifted and successful investors, but that the vast majority of them were also willing to share with and learn from their peers. We were humbled to have the opportunity to bring the wisdom of investors like Tom Gayner, Howard Marks, Tom Russo, Mohnish Pabrai, Jean-Marie Eveillard, Guy Spier, and Ed Wachenheim to others in the community. We also saw an opportunity to leverage the internet to help broaden the appeal of value investing beyond its traditional U.S. base.

We now call this membership community MOI Global, with The Manual of Ideas constituting one component of the value we seek to bring to members. Other benefits include content shared on the new MOI Global website; curated idea presentations shared via online events such as the Best Ideas conference, Asian Investing Summit, Wide-Moat Investing Summit, and European Investing Summit; as well as offline experiences such as Latticework, The Zurich Project, Ideaweek, and member-run meetups in many cities globally.

All of the above benefits are now available to you as a member of MOI Global (at no incremental membership fee). In the past, our online events (formerly ValueConferences) generated revenue from ticket sales. Now they are not only complimentary to MOI Global members, but they are exclusive to members. The upcoming summit, Best Ideas 2018, is our largest online conference ever, with more than one hundred instructors from the community sharing their best ideas. Shai Dardashti and I have started recording some of the sessions, and we are thoroughly impressed by the quality of the presentations. The recordings will be released on January 11-13. The summit will also feature fourteen live sessions on those days (stay tuned for your access details).

As you probably know, we closed our doors to new members at the end of March 2017. We remain closed as we build up the internal resources needed to delight all of our members. We maintain a waitlist for those interested in membership, and we hope to invite selected high-caliber individuals to join MOI Global in the future. While new members may end up joining at a significantly higher annual membership fee, your rate will remain unchanged in recognition of your loyalty.

We strive for MOI Global to be a lifelong companion to our members, regardless of employment status, the market cycle, or other transient factors. If you are going through a tough period, it’s likely other members are either experiencing a similar phase or have done so at some point in the past. By facilitating the right kinds of introductions and interactions, we strive to support members on their personal growth path. Annual events like The Zurich Project and Ideaweek are near-ideal settings for fostering the kinds of exchanges and experiences that can have an enduring positive impact.

Thank you for allowing us to play a constructive role in your journey as an investor. Thank you also for being a part of the MOI Global journey as we pour our passion and resources into building a special kind of community.

In this issue, we focus on selected investment ideas presented at European Investing Summit 2017, the sixth annual online conference focused on uncovering ideas across Europe. More than thirty instructors participated in the event and shared their favorite ideas with MOI Global members.

David Marcus of Evermore Global Advisors made the case for dry bulk shippers in his characteristically witty, deeply knowledgeable way. David, a protégé of Michael Price, has focused on Europe for many years, getting to know some of the best owner-operators across the continent. David’s ability to identify great managers and to back them when the market ignores them has produced attractive returns, and it’s little surprise that Evermore’s AUM recently passed $1 billion.

David met Norwegian shipping magnate John Fredriksen a long time ago, setting the stage for revisiting the sector at a time of distress and despair. David tells the story of going to a dry bulk conference in 2016 and meeting an industry CEO:

“Before we even said hello, he saw my name tag and said, ‘Evermore!’ I said, ‘Yes?’ He said, ‘I bet you’ve never invested in this sector, and you probably didn’t even look at it until recently.’ I said, ‘You’re correct! What are you, a mind reader?’ He replied, ‘If you had invested any time before today, your name would actually be Nevermore.’ His point was this industry had crushed everybody.”

David shares his thesis on four dry bulk companies in which Evermore is a major shareholder: Scorpio Bulkers, Safe Bulkers, Navios Maritime Partners, and Songa. During the Q&A, David also explains why the container shipping industry may be at the same point dry bulk was eighteen months ago. Finally, David reveals he has started investing in Frontline, John Fredriksen’s tanker shipping firm.

Another highlight of European Investment Summit 2017 was Simon Caufield’s session on The Automobile Association, based in the UK. The AA is a market-leading roadside assistance business that enjoys the trust of its members and generates recurring revenue. It is a high return-on-capital business with strong cash flow. Formerly under private equity ownership, the company has been saddled with an uncomfortable amount of debt. In Simon’s view, as management continues to focus on debt reduction, value should accrete to shareholders at a swift pace. He likes the new CEO, with whom he has met recently:

“Simon Breakwell was a director for the previous four or five years and has an interesting, digital background. He worked at Microsoft to develop and launch the Expedia business. He also started the European operations of Uber. Simon doesn’t see any reason why the additional level of capex, beyond maintenance capex, should be required.”

Daniel Gladiš of Vltava Fund, an instructor whose focus on out-of-favor good businesses has produced one of the most impressive records at online conferences, unveiled his simple yet compelling thesis on a company well-known to everyone: BMW. A confluence of factors has caused BMW to trade at a market quotation that appears unjustified for a business of such quality. Daniel’s sum-of-the-parts valuation suggests attractive upside. His conclusion is straightforward:

“The market is offering us a top-class, financially strong, family-owned business at half of its value. How is this possible? It is difficult to say but investors or the market must either believe there is a hard recession just ahead, after which there will be no recovery, or Tesla will dominate the future and current car manufacturers will be marginalized. None of this will happen. BMW will probably end up with an even stronger position.”

Florian Schuhbauer’s session highlights the unique nature of MOI Global online conferences. Florian, formerly with major European private equity firm Triton Partners and now managing partner of Active Ownership Capital, has one of the strongest records of value creation in public companies, particularly in Germany. Despite this, he operates “below the radar” and does not generally discuss the activist situations in which he is deeply involved. Members of MOI Global enjoy a unique opportunity to benefit from Florian’s work.

At European Investing Summit 2017, Florian presented his case for two German companies in which his firm is one of the largest shareholders and actively involved in value creation, not through financial engineering but sustained profit improvement. Florian explains why franking machine (postage meter) manufacturer Francotyp-Postalia is a misunderstood business with the potential for organic and M&A-driven growth, and why wind farm developer PNE Wind has material underappreciated earning power.

According to Florian, Francotyp-Postalia’s “war chest” is a strategic asset in conjunction with the company’s under-appreciated expertise in encryption software:

“Francotyp has €100+ million in cash and financing lined up to acquire adjacent software businesses at the right valuation. The market quotations of document management and security software companies are completely insane at the moment. We have been looking to acquire software businesses that fit Francotyp for more than a year. Unfortunately, the asking prices are not what Francotyp should pay, so they will be patient. The money will be there when the next crisis hits and valuations come down.”

PNE Wind is a fairly typical neglected situation:

“For institutional investors PNE was uninvestable — a messy governance situation, bad track record, no value creation for shareholders, and the perceived share overhang. It led to an attractive valuation. On a pro forma basis, we bought shares at a negative enterprise value. PNE remains misunderstood and neglected. Most investors don’t look into it enough to also see the good side of it.”

Thomas Karlovits of Blackwall Capital is an MOI Global instructor whose knack for uncovering businesses that can compound value for long periods of time has made him a highly successful fund manager. Thomas is a regular participant of The Zurich Project, where he has shared his valuable insights into building a great investment firm.

At European Investing Summit 2017, Thomas unveiled his investment thesis on a software business that may be near a major growth inflection point due to new product adoption — RIB Software. Thomas sums up the case as follows:

“RIB offers the best BIM [building information modeling] software on the market, well ahead of peers. It benefits from IT spending increases in the construction industry and from regulatory changes. RIB has used technological leadership to smartly team up with Flex and Autodesk, big players in their industries. It is at the forefront throughout the construction industry via scale and economic share. Plus, we have long-term [new product] upside. The share price only discounts a good part of the core business, allowing for free options. I love free options. [RIB] has more angles than I’ve seen in a long time.”

Chris Rossbach of London-based family office J. Stern & Co. takes a multi-generational approach to investing, exploiting a “time arbitrage” advantage. Chris is an owner in the true sense of the word: When the founding family of Sika, a company Chris presented last year, agreed to sell their shares to Saint-Gobain without the same deal available to other shareholders, Chris teamed up with a fellow owner, the Bill and Melinda Gates Foundation Trust, to oppose the move. Chris’ efforts have borne fruit, as the original offer came at a share price of around CHF 3,000 and recently headed toward CHF 8,000 per share. MOI Global members have been uniquely positioned to benefit from Chris’s work.

At European Investing Summit 2017, Chris unveiled his thesis on Essilor, the leading prescription lens producer, which is merging with Luxottica, the leader in eyeglass frames and sunglasses. Chris lauds the complementary nature of the two scale-advantaged global businesses. He also points to the financial benefits of the merger:

“We view management’s €600 million synergies estimate as conservative. We estimate earnings growth of 8-9% over the next five years or, including growth synergies, 12-15%. It suggest that buying such a globally leading company at the recent market quotation may be a real opportunity.”

Jean-Pascal Rolandez of The L.T. Funds, a Geneva-based investment firm, is another MOI Global instructor who takes a long-term view. Jean-Pascal is not afraid to be contrarian in order to buy good businesses when they are shunned by the market. An example is his most recent European Investing Summit idea — DIA, the Spanish discount grocery retailer.

As a long-term investor, Jean-Pascal wants to get to know the “DNA” of companies, which is often shaped by their history. In DIA’s case, he describes the beginnings of the chain in the late 1970s, focusing on a single supermarket format with 600 square meters or less, no parking lot, but well-located in cities like Madrid. Jean-Pascal then takes us through a period during which DIA was owned by French giant Carrefour, illustrating how that episode derailed DIA but also set up the current opportunity as the company returns to its roots:

“Carrefour aimed for DIA to be its hard discounter across the globe, and it dragged DIA into places that were not natural for a Spanish company, such as Turkey and China. It was not natural for DIA to expand that way. Carrefour eventually realized the strategy was not working, and the Carrefour empire started to erode and even disintegrate. Carrefour decided to spin out DIA in 2011. As Carrefour was in need of cash, it took a huge dividend — about one billion euros — before spinning off DIA. DIA found itself with high gearing and a low valuation. It is when DIA’s own DNA took over. The Spanish company started to refocus on its natural turf — Iberia, Brazil, and Argentina. Carrefour realized it had made a mistake when it let its hard discount retail format in France go with DIA. Carrefour bought back the French operations of DIA, which helped DIA reduce gearing.”

Long-time MOI Global instructor Roshan Padamadan has added value to our community, not only through well-articulated ideas, but also through deep dives into industries with which our members may not be intimately familiar. Earlier in 2017, Roshan shared his long-term thesis on life insurance in India, a fascinating industry. At European Investing Summit 2017, Roshan assessed MiFID II, the regulatory framework that has implications for sell-side as well as buy-side firms. Roshan also presented his thesis on a company poised to benefit from those changes — Fidessa Group, a London-listed software firm:

“Fidessa has ‘efficient scale’, as Pat Dorsey calls it. Efficient scale keeps out new competition. Even for existing players, it’s hard to make clients switch from one system to another. A brand new player would find it daunting to come and compete. Fidessa’s core product is entrenched and has hidden pricing power. That will come through in an ability to keep raising prices by the rate of inflation or higher.”

Antonio Garufi of Decalia Asset Management was invited to become an MOI Global instructor two years ago due to the depth of his research. We were particularly impressed by his research into OraSure Technologies, which he articulated in early 2016. At European Investing Summit 2017, Antonio shared his view on Wizz Air, a leading low-cost carrier in Central and Eastern Europe. He sums up the investment case as follows:

“Wizz Air has outstanding management. It was founded by industry expert Bill Franke who manages PE firm Indigo Partners, which specializes in launching new airlines in the low-cost segment. The CEO, Jozsef Varadi, has strong credibility in the industry and has grown the company into one of the leaders. Wizz Air also has financial appeal due to low leverage and an affordable valuation [5x EV/EBIT, 12% FCF yield]. It generates cash at a strong pace and is a suitable takeover candidate.”

Investors with a penchant for “deep value” will appreciate the European Investing Summit presentation by Richard Simmons. While Richard shared two ideas, Daejan Holdings stands out as a steady, simple business trading at a discount. Daejan was founded in the 1940s and is a straightforward property-owning business in the UK, with most of the value coming from rents. Richard estimates liquidation value to be in line with net asset value of £102 per share:

“The good news is you don’t have to pay £102 per share. Recently, you could pay £58, a discount of 43%. The peers trade at much narrower discounts or even at premia. Daejan has often traded at a discount, ranging from 60% to as little as 0%. Presumably, because it’s a less liquid stock due to the family stake, Daejan shares have less marketability, and there is no likely takeover option. That doesn’t bother us. We’ve held Daejan for a long time, have done well with it, and it’s safer than the peers. It’s likely to continue to grow, and the deferred tax cushion provides downside protection and excess growth capital. If NAV continued to compound by 9% annually, it would reach £241 per share in a decade. If the share price went up to NAV during that period, an investor would compound at 15%.”

In addition to the sessions above, I encourage you to review other ideas presented at European Investing Summit 2017. To see a full list of ideas and listen to the session replays, visit https://moiglobal.com/eis (email [email protected] if you need help logging in).

This issue also includes selected interviews and articles featuring the wisdom of our global community. MOI Global instructor Richard Simmons delves into his investment approach, commenting on his favorite source of competitive advantage, how decades of investing have made him gravitate toward family-controlled businesses, and why “distraction” may be investors’ biggest mistake.
We also feature insights by Frank Martin, Gary Mishuris, Randall Abramson, and Matthew Sweeney.

Wishing you a joyful holiday season and
a year filled with good health, prosperity, and happiness,

JOHN MIHALJEVIC, CFA
Chairman, MOI Global

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Five Investing Mistakes to Avoid

December 14, 2017 in Best Ideas Conference, Diary

This article is authored by MOI Global instructor Glenn Surowiec, portfolio manager at GDS Investments. Glenn is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Glenn has written the following article primarily with 401(k) investments in mind. We believe the principles stated apply broadly to investors.

MISTAKE #1: You don’t know what your money is doing.

In other words, you’re investing your money with or through a service that denies you true transparency.

With typical mutual fund investments, for example, investors don’t know what’s happening day-to-day or in real-time. Instead, the fund might send a letter detailing all holdings 30 to 45 days after the end of the quarter. This lack of transparency can have numerous implications. You may not clearly understand how all fees are being assessed and/or charged, or you may not see serious conflicts of interest (where investment advisors steer clients into a small group of funds based on “pay to play” agreements with those companies).

Unfortunately, transparency best practices are lagging, according to a 2017 survey by Northern Trust, whose respondents named transparency as the #1 “very important” consideration for investments both traditional (63%) and alternative (62%).i If you don’t know what’s happening with your investments, how do you know if they can meet your needs?

MISTAKE #2: Your investments aren’t right for you.

Put simply, you must have the ability to customize your account to meet your unique situation. Many, many investments (e.g., mutual funds) don’t account for factors like age or time until retirement. That’s because mutual funds manage a single portfolio that treats every investor the same in terms of time horizon, risk tolerance, etc. Indeed, investment portfolios should be designed with some attention to individual needs rather than institutional practices. They should complement any other assets you have, support the kind of lifestyle you want to live, and otherwise incorporate all of your needs and where you are in your lifecycle.

When you leave an employer, you go overnight from something highly restrictive to something highly flexible. That’s a huge opportunity.

This mistake is an ironic one. When you leave an employer, and you can roll your 401(k) into another investment vehicle, you go overnight from something highly restrictive to something highly flexible. That’s a huge opportunity! Yet many investors choose something just as restrictive, or even let their 401(k) stand. Worse, they choose an investment vehicle that’s set on autopilot, with zero corporate accountability on how publicly traded companies are being allocated. Mutual funds are especially guilty because they own hundreds of companies and generally don’t have the resources to adequately vet every company in the portfolio.

MISTAKE #3: You’re too impatient.

I’d estimate that fewer than 5% of market participants think beyond next quarter, let alone next year. It’s no surprise: the entire system is built around a short-term, action-oriented approach to investing. From the minute you wake up, information flows nonstop across the computer and device screens in front of you. Prices are changing constantly, and you can buy and sell at any time.

Long-term thinking is key to successful investing, however.

In fact, patience is perhaps the single most important variable for success over time. The stocks you own will dip from time to time. Short-term under-performance flows into long-term over-performance, and vice versa; you cannot have one without the other.

In other words, while we all want our investments to do well 100% of the time, it’s more important to do well over a long period of time, and what works well over time doesn’t necessarily work all the time. Short-term dips must and should be endured, as long as the investment has been carefully studied and understood to possess the underlying investment characteristics that distinguish good value from bad.

MISTAKE #4: Your investment strategy isn’t value-driven.

Most investors act as though the market is perfectly efficient with information, instantly and accurately incorporating all information about a company and its market into price. Unfortunately, this unspoken assumption means that most investment vehicles are founded on buy-high, sell-low strategies.

That’s because stock prices discount the future; these ratios tell you more about the past. So, the investor’s job is to make judgments about the future that the market is discounting, while looking for things that are happening behind the scenes that the market hasn’t fully appreciated.

The market’s inefficiency with information can compound on itself. Most passive funds weight the indexes based on size. So, if a company gets bigger over time, the impact they have on the index goes up. If a company gets smaller, they have less of an impact. At its core, this is a momentum-based strategy, which penalizes the investor for past success rather than rewarding you for future success. The reality is that most of your best ideas do not come from companies that have done well from a price perspective.

Remember, there are just two kinds of companies: those that have problems, and those that will have problems. That’s business. No one will ride above everything all the time.

The key is to identify and deeply understand companies that are well-situated from a value perspective. It helps to spends a lot of time talking to management, going to presentations, reading filings, talking to people in the industry, discovering who’s gaining or losing share, etc. Then, once you’ve spotted a business you want to invest in, but you think it’s only worth X while it’s selling at 2X, you wait (see Mistake #3 again). Eventually, if you have enough of those companies that you’re patiently watching, that situation will reverse, and you’ll have an opportunity to pay X to get 2X value. You just need to have self-control. This is the essence of value investing: do the fundamental analysis today, with the expectation that the company can be bought at a discounted price sometime in the future.

MISTAKE #5: Your investments are too diversified.

Diversification has been overmarketed and overhyped. It’s important across asset classes but not within asset classes. Owning more and more equity mutual funds (which is very common) won’t protect you in a bear market (like what happened in 2008). In fact, it’s very easy to trick yourself into believing you’ve diversified when all you’ve done is concentrate.

The Wall Street Journal puts it perfectly: “In fact, regardless of the number of holdings, most traditionally allocated portfolios are saturated with equity risk. Over-diversification can create a false sense of confidence whereby we believe we are well diversified, but in reality, a large number of investments actually share a common risk.”ii

On any given day, the market just doesn’t present dozens and dozens of great investment opportunities, unfortunately. If you want to own 50 positions, the only way to do so is to lower your standards until you’re putting money into lower-value options. Instead, look for 15 to 20 different or uncorrelated positions. Owning such a number allows us to concentrate on our very best ideas without compromising the benefits of diversification.

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Value investing: Lecciones del campo de la Neuroeconomía

December 14, 2017 in Spanish

El siguiente artículo escrito por Luis García Álvarez, CFA, es parte del libro El Cerebro del Inversor, el cual tendrá una nueva versión ampliada y será publicado en 2018. La nueva versión de El Cerebro del Inversor es escrita por Pedro Bermejo, neurólogo, Doctor en Medicina y Presidente de la Asociación Española de Neuroeconomía; y Luis García Álvarez, CFA, gestor de cartera en MAPFRE Inversión.

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El cerebro humano es la estructura más compleja que conocemos. Sin embargo, debido a los años en los que se produjo la mayor parte de su desarrollo, nuestro cerebro está preparado para la supervivencia, no para tomar decisiones relacionadas con el dinero. En este sentido, la Neuroeconomía representa un campo con gran potencial de desarrollo y que puede ayudarnos a entender mejor cómo el funcionamiento de la mente humana afecta a los mercados financieros. El desarrollo de modernas técnicas, como la imagen por resonancia magnética funcional, está abriendo la puerta a nuevos descubrimientos sobre la manera en la que los seres humanos nos comportamos. Y estos avances están demostrando que, cuando nos enfrentamos a decisiones que tienen que ver con nuestro dinero, somos mucho más emocionales y menos racionales de lo que nos gustaría. En la actualidad, ya sabemos que en estas decisiones intervienen gran cantidad de factores que son inconscientes y que no controlamos.

El gran crecimiento experimentado por el campo de la economía de la conducta (behavioral economics) y el reconocimiento de los premios Nobel al trabajo de Daniel Kahneman (junto al fallecido Amos Tversky), Robert Shiller o Richard Thaler, parecen implicar un cambio de paradigma en la ciencia económica. Ésta se había basado recientemente en complejos modelos matemáticos heredados del campo de la física y en el supuesto de que los mercados financieros estaban formados por agentes racionales. Estos agentes pasarían por ser individuos fríos y sin emociones, pero capaces de completar complejos cálculos en un tiempo record, al estilo del Capitan Spock de la famosa serie de ficción Star Trek.

Las finanzas del comportamiento, que integran conceptos de la rama de la psicología, se desvían de este concepto irreal del ser humano y se centran, en su lugar, en investigar la manera en la que las personas verdaderamente tomamos decisiones. Este enfoque supone un importante refuerzo para mejorar el conocimiento y desarrollo de la filosofía de inversión en valor (value investing). Las estrategias básicas de value investing consisten en comprar acciones con un descuento significativo sobre su valor intrínseco en momentos de pesimismo (sobre la compañía o el mercado) y venderlas cuando coticen por encima de dicho valor como resultado de la euforia colectiva. Como explicó Warren Buffett, el inversor en valor debe “ser codicioso cuando los demás tienen miedo y temeroso cuando los demás sienten codicia”. Debe de ser además paciente y tener visión de largo plazo, ya que el mercado puede tardar tiempo en darle la razón sobre sus ideas.

En su proceso de análisis, los inversores en valor toman un enfoque empresarial, tratando de pensar como si fueran los dueños únicos de las compañías que analizan. Habitualmente, buscan empresas con negocios fáciles de entender, con flujos de caja sólidos y recurrentes, poca o ninguna deuda neta, buenos equipos gestores cuyos intereses estén alineados con los de los accionistas, altos retornos sobre el capital empleado y ventajas competitivas sostenibles (o fosos defensivos, como los llamó Buffett). Pero el punto determinante para decidir si compran una determinada acción suele ser la posibilidad de hacerlo con un descuento suficiente sobre su estimación del valor intrínseco del negocio. Este descuento o margen de seguridad les protege ante los errores que puedan cometerse en el análisis.

Sin embargo, comprar negocios de calidad (con las características descritas arriba) a precios de derribo es a menudo una tarea complicada. De hecho, suele resultar imposible bajo circunstancias normales. Cuando una acción cotiza barata esto se debe a que la comunidad inversora percibe que la compañía sufre algún defecto. Cuando existe incertidumbre sobre una empresa, esto provoca el rechazo generalizado de los inversores, cuyo cerebro está preparado para huir ante situaciones de peligro, tal y como hacían nuestros antepasados cuando, durante la caza, sospechaban que un animal peligroso se acercaba.

Por eso, un buen análisis es clave para poder encontrar valor donde otros sólo ven peligros. Nuestra tarea será distinguir entre compañías en las que los fundamentales del negocio se han deteriorado definitivamente y aquellas en las que el daño es simplemente pasajero o el impacto es mucho menor al que ha descontado el mercado. Este segundo grupo es el caladero preferido para los inversores en valor, que buscan en él compañías con una buena posición competitiva en su sector y un balance lo suficientemente sólido para aguantar hasta que pase el temporal. Las acciones de estas empresas representan oportunidades altamente atractivas para el inversor paciente, capaz de esperar a que los fundamentales del negocio se recuperen (o incluso mejoren tras el impacto, si encuentra empresas antifrágiles, como las definió Nassim Taleb). Sin embargo, un análisis profundo no será suficiente y el temperamento del gestor será determinante para esta tarea, ya que éste deberá mantenerse firme en sus convicciones frente a la corriente del mercado. En este sentido, dadas nuestras limitaciones como seres humanos para controlar el miedo, contar con un proceso de inversión sólido y fácil de repetir se convierte en una herramienta fundamental.

Nuestro cerebro no está preparado para comprar valores que presenten problemas (aunque estos sean pasajeros), por lo que habitualmente sentirá miedo o rechazo e intentará huir de ellos. Al enfrentarnos a situaciones de incertidumbre en una inversión, se produce en nuestro cerebro una reacción biológica consistente en la activación de la amígdala. Ésta actúa como centro de procesamiento de todo lo relativo a las reacciones emocionales, como la rabia o el miedo. En el ámbito de las inversiones, la amígdala es la causante de nuestra aversión al riesgo y provoca que los seres humanos puedan bloquearse frente a situaciones estresantes. Esto hará que, en numerosas ocasiones, prefiramos evitar las acciones de compañías que presenten cualquier tipo de incertidumbre, perdiendo oportunidades atractivas para el largo plazo. Por el contrario, los inversores se encuentran más cómodos comprando acciones percibidas como “de calidad”. Éstas no activarán la amígdala, sino las áreas del cerebro asociadas a la recompensa, liberando endorfinas y causando una sensación de bienestar.

Para el inversor de largo plazo, comprar acciones de compañías de calidad es sin duda una buena estrategia, ya que estos negocios tienen la capacidad de generar altas tasas de retorno sobre el capital empleado a lo largo del tiempo. Para estas compañías, incluso pagar un precio igual a su valor intrínseco puede ser suficiente para preservar nuestro capital, ya que el margen de seguridad puede venir de la propia calidad de su negocio. Por este motivo, el universo de inversión de un gran número inversores en valor abarca desde compañías decentes que cotizan con grandes descuentos, hasta negocios de alta calidad que cotizan cerca de su valor intrínseco. De esta manera, se mantienen alejados de compañías cuyos fundamentales son muy negativos aunque la acción cotice a niveles tentadoramente baratos, pero también de empresas fantásticas si todo el mundo tiene centrada su atención en ellas. El gran peligro con este segundo grupo de compañías radica en que, al gozar del beneplácito generalizado del mercado, las altas expectativas se incorporan al precio de la acción pudiendo éste llegar a ser demasiado elevado. Esto hace que el margen de seguridad (ya sea resultado del descuento en el precio o de la calidad del negocio) pueda llegar a desaparecer, aumentando las probabilidades de cometer un error de inversión.

Un claro ejemplo de este riesgo son las reacciones del mercado ante los resultados de las empresas. En su libro Contrarian Investment Strategies, el conocido inversor en valor David Dreman hace referencia a una serie de estudios que llevó a cabo junto a los profesores Eric Lufkin, Vladimira Ilieva, Nelson Woodard, Mitchell Stern y Michael Berry. Sus investigaciones demostraron que las sorpresas en las publicaciones de resultados a menudo impulsan el precio de las acciones de compañías poco favorecidas por el mercado (que cotizan a bajos múltiplos de valoración), mientras que perjudican a las acciones de las empresas que gozan de la admiración de inversores y analistas (múltiplos elevados). En una segunda fase, los autores diferenciaron entre noticias positivas y negativas. Así, observaron que, cuando aparece una sorpresa negativa en los resultados de una empresa favorecida por el mercado, los efectos para el precio de sus acciones son a menudo devastadores. Los inversores sólo esperan noticias positivas de sus compañías favoritas, ya que el exceso de confianza les hace creer que la evolución de sus negocios sólo puede ser favorable. No esperan, por tanto, que estas acciones puedan decepcionarles y por eso están dispuestos a pagar múltiplos muy elevados por ellas. Por el contrario, el estudio demostró que para las acciones repudiadas por el mercado, en las que las expectativas ya eran muy bajas, la llegada de una sorpresa negativa casi no tiene efecto en los doce meses posteriores al anuncio.

Dreman y sus coautores definieron dos tipos de sorpresas en los resultados empresariales: los llamados “eventos desencadenantes” y los “eventos de refuerzo”. Un “evento desencadenante” es una sorpresa negativa en una compañía que gozaba de la admiración del mercado o una sorpresa positiva en una acción sobre la que las expectativas eran mediocres. Este tipo de eventos cambia las perspectivas de los inversores sobre una acción, de positivas a negativas o viceversa. La segunda categoría de sorpresas son los llamados “eventos de refuerzo”: noticias positivas en compañías que gozaban de buenas expectativas o noticias negativas en empresas en las que se descontaba un oscuro futuro. En lugar de cambiar la percepción de los individuos, este tipo de eventos refuerzan las creencias anteriores. Los resultados del estudio demostraron que las reacciones del mercado ante sorpresas positivas o negativas son totalmente distintas en función de las expectativas previas. Mientras que los “eventos desencadenantes” tienen un efecto muy significativo sobre el precio de las acciones durante los doce meses siguientes a la publicación, el impacto de los “eventos de refuerzo” es prácticamente inapreciable.

Estos resultados refuerzan así la tesis de inversión en acciones de compañías rechazadas por el mercado y aparentemente tienen una explicación fisiológica proveniente del campo de la Neuroeconomía. En primer lugar, debemos entender el efecto que la dopamina tiene sobre nuestro organismo. Ésta es una sustancia química producida por nuestro propio cuerpo que provoca una sensación de placer en el cerebro, haciéndonos ser más proclives a realizar determinadas tareas. Las neuronas que tienen la capacidad de segregar dopamina se activan con eventos en los que el resultado final supera nuestras expectativas, permanecen inalteradas frente a resultados relativamente próximos a los esperados y son negativamente influenciadas por resultados inferiores a nuestras expectativas. La estructura de estos eventos es fácilmente asociable a los cuatro tipos de sorpresas definidos por Dreman y sus colaboradores.

Un estudio llevado a cabo por Pammi Chandrasekhar, Monica Capra, Sara Moore, Charles Noussair y Gregory Berns (NeuroImage, 2008) demuestra que recompensas superiores a las esperadas, como una sorpresa positiva en una compañía rechazada por los inversores (un “evento desencadenante”), provocan la segregación de dopamina en el cerebro. Por otro lado, las investigaciones llevadas a cabo por Schultz, Montague y Dayan (Science, 1997) muestran que las neuronas que pueden segregar dopamina comienzan a hacerlo si pensamos que una vamos a recibir una recompensa pero, si ésta finalmente no llega, detienen su actividad y dejan de liberarla. Esta situación es equivalente a una noticia negativa en los resultados de una compañía que gozaba de la admiración del mercado (un segundo tipo de “evento desencadenante”), lo que hará que el cerebro se sienta decepcionado al no producirse la liberación de dopamina que esperaba. Finalmente, los otros dos tipos de sorpresas, agrupados bajo la etiqueta de “eventos de refuerzo”, parecen no tener un impacto significativo sobre nuestra actividad neuronal. En estos casos, el resultado ya se percibía como altamente probable y, por tanto, estaba descontado.

Estos hallazgos son consistentes con las conclusiones que Dreman y sus colaboradores obtuvieron para los mercados financieros. En su análisis, estos encontraron que el impacto de un “evento desencadenante” sobre el precio de una acción fue cerca de cuatro veces superior (en términos absolutos) al de un “evento de refuerzo” en el trimestre siguiente a la noticia. Y hasta veinticuatro veces mayor una vez transcurridos doce meses. Las enseñanzas de la Neuroeconomía parecen reforzar, por tanto, los argumentos favorables a adoptar estrategias de inversión contrarias.

Como ya hemos comentado, desde nuestros orígenes el cerebro humano está preparado para sobrevivir y se siente cómodo actuando en manada. Sin embargo, el value investing, la única estrategia que ha demostrado ser capaz de batir a los mercados en el largo plazo, requiere a los gestores tomar actitudes contrarias. Esto es algo para lo que la gran mayoría de las personas no está preparada, bien sea por la imposibilidad de superar sus sesgos cognitivos o porque no deseen poner en riesgo sus empleos ante la posibilidad de obtener peores resultados que el mercado en el corto plazo. Este es el motivo por el que, a pesar de su fuerte crecimiento en los últimos, el value investing nunca será una corriente dominante. Por definición, implica hacer las cosas de manera distinta a los demás, comprando empresas infravaloradas de las que el resto no quiere oír hablar. Los inversores no deberían esperar obtener rendimientos extraordinarios haciendo lo mismo que los demás, ya que la información ya estará incorporada en el precio de las acciones. Para obtener resultados superiores, es necesario desviarse de la manada para tomar un camino diferente, a menudo incómodo y que nos demandará paciencia y fortaleza mental para esperar a que el largo plazo nos dé la razón, pero también humildad para revisar nuestra hipótesis de inversión cuando aparezca nueva información.

Además, incluso cuando el inversor que toma una estrategia contraria tiene razón, no es de esperar que haya mucha gente deseando festejarlo con él ya que, por definición, una gran mayoría de la gente estará perdiendo dinero en ese momento. Tomemos como ejemplo la película La Gran Apuesta (basada en el libro de Michael Lewis con el mismo título) y pensemos en las palabras del personaje de Ben Rickert, el gestor de inversiones retirado interpretado por Brad Pitt y basado en la historia real de Ben Hockett. Cuando sus dos jóvenes socios comienzan a celebrar su idea de vender en corto bonos hipotecarios para beneficiarse del probable desplome del mercado inmobiliario, Ben les pide que rebajen su alegría recordándoles que estaban “apostando contra la economía americana”. Si finalmente tenían razón, “millones de personas perderían sus empleos” y quedarían expuestas a un gran sufrimiento. Esta sensación de soledad al tomar una actitud contraria al mercado fue brillantemente descrita por Seth Klarman en su carta anual a clientes de 2005: “uno no se hace inversor en valor para recibir abrazos en grupo”. Sin embargo, la Neuroeconomía demuestra que nuestro cerebro disfruta de los abrazos en grupo y no está diseñado para recorrer plácidamente el camino que puede llevarnos a obtener resultados de inversión extraordinarios. Esto otorga una gran importancia a profundizar en el conocimiento de nuestra mente y a diseñar estrategias nos ayuden tanto a obtener beneficios cuando otros inversores se equivocan de manera sistemática, como a protegernos de nuestros propios sesgos.

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True Small-Cap Investing: An Institutional Blind Spot?

December 13, 2017 in Best Ideas Conference, Diary, Equities, Letters, Small Cap

This article is authored by MOI Global instructor Howard Punch, president and chief investment officer at Punch and Associates. Howard is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Investors are attracted to small caps because of the outsized performance historically achieved. However, based on how they typically allocate money, many investors often overlook the smallest companies which historically had the largest impact on the group’s outperformance. As of June 2017, approximately 3,600 companies traded on major U.S. exchanges.¹ Roughly 1,750 of those companies have a market cap of $1 billion or less, representing some $567 billion of market cap. Large, institutional investors pass over these smaller companies in favor of larger ones in which they can take more meaningful positions. We believe that this relative lack of attention and ownership of companies with a market cap of less than $1 billion creates an institutional “Blind Spot.”

In our experience, we’ve found that many of these companies are often profitable, conservatively capitalized, and self-financing, so they are often ignored by sell-side analysts who have no incentive to offer research coverage. As a result, these companies are less well-known and their shares may trade less frequently. Most small cap investors fail to realize (as shown in the chart below) that as a group, the smallest companies have historically generated the highest returns. However, those sized companies are generally excluded from the average “name-brand” small cap portfolio.

“As to methods, there may be a million and then some, but principles are few. The man who grasps principles can successfully select his own methods. The man who tries methods, ignoring principles, is sure to have trouble.”
– Ralph Waldo Emerson

Focusing On the Blind Spot is Worth the Effort

For the thoughtful investor willing to “take the blinders off” and gain exposure to “true small caps,” we believe a compelling opportunity persists. The performance of this largely ignored group of companies is often quite compelling. Over the past 90 years, the smallest decile of U.S. stocks has outperformed all other deciles – on both an absolute and a risk‐adjusted basis – providing an average annual return of 26% since 1927.

Today, the average size company in the first, second, and third deciles are $121 million, $522 million, and $1.0 billion, respectively.² This compares to $2.3 billion weighted average market cap for the Russell 2000 and $3.2 billion for the top 50 (by assets) actively managed small cap mutual funds.

It’s Becoming Harder to Access the Blind Spot

The most recognized small cap benchmark is the Russell 2000 Index. Yet, the benchmark and the ETFs that track it fail to provide investors significant ownership of the companies with the smallest market caps. Over time, that problem has increased, and investors are getting even less exposure to the smallest companies in the small cap universe.

Over the last five years, the weighted average and median market cap of the Russell 2000 grew by over 65% and, as of June 2017, the median market cap was $802 million. Notably, the number of companies in the sub-$500 million market cap segment (roughly the cutoff for the bottom 20% of companies by market cap) shrank by 34%, and the number of companies in the $2 billion and greater segment grew by 363%. Because the index is market cap weighted, the overall exposure is skewed to the larger companies in the index. As of June 2017, the weighted average market cap of the index was approximately $2 billion, meaning 50% of money invested in the “small cap” benchmark is actually a blend between a small and midcap (SMID cap) offering.

A Passive Approach Arguably Fails in the Objective and Increases Risk

The rotation of funds to passive investing is well-documented. We are not surprised that, in the ninth year of a bull market where passive investing has dominated (delivered the best results), the drum beats are growing louder for active managers to hand over their Bloomberg terminals. We believe that in the least efficient areas of the market, an active approach has a higher probability of generating better risk-adjusted returns (with acknowledgements to our obvious bias). We believe better risk-adjusted returns come from companies that can compound value at an above market rate but also can provide good downside protection for when things do not work out as expected.

For investors seeking exposure to small caps through a Russell 2000 tracking ETF, the decreased downside protection over the last five years is a hidden risk. Excluding the technology bubble in the late 1990’s and the Great Recession of 2008-2009, the percentage of loss-making companies in the Russell 2000 Index is at a record high. In addition, the index has also seen a declining dividend yield and current ratio and a rising debt-to-equity ratio. Simply put, the average company in the Russell 2000 Index today is of lower quality than only a few years ago.

One would think that, based on diminished fundamentals and higher uncertainty around future profits, these companies would be assigned a lower valuation. In reality, the average market cap of a company in the benchmark has risen by more than 65% since June 2012 and a variety of traditional valuation metrics (P/E, P/CF, P/B) have increased. Today, a passive portfolio consists of companies that, on average, have a lower margin of safety and a higher valuation in addition to having fewer of the smallest companies that historically have generated the outsized returns.

“The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”
– Seth Klarman

Most Active Managers are Not Focused on the Blind Spot

There is an often‐overlooked aspect of small cap offerings by active managers that does not receive much attention: despite the fact that many professional investors closely track the Russell 2000 benchmark, many do so with a heavy bias toward owning the largest, most liquid stocks in the index.

Half the stocks in the Russell 2000 Index have market caps under $800 million, and many of these stocks share these distinguishing characteristics:

  • under-owned by institutions
  • under-researched by professional analysts
  • unknown to most investors
  • relatively illiquid

Investing in small, illiquid, under‐researched stocks takes more time and effort to do well. Moreover, the absolute size of these companies becomes prohibitive when investing large amounts of capital.

As of June 30, 2017, according to Bloomberg, 405 actively managed small cap mutual funds with more than $25 million in assets exist in the U.S. On average, these funds have a median market cap of $2.0 billion (2.5 times that of the benchmark) and a weighted average market cap of $2.8 billion (121% of the benchmark). Only 23% of these funds have median market caps below the benchmark, which represents less than 14% of total assets invested in all small cap mutual funds.

The average “asset gathering” small cap manager would rather piggyback on the long-term track record of the asset class, in our opinion, than do the hard work of owning the very vehicles that contributed most to this historical outperformance. Investing in small companies is simply not as scalable—or lucrative—as managing money in larger, more liquid companies.

It is no surprise that small cap mutual funds with more assets also have portfolios with higher median market caps. For small cap mutual funds with more than $1 billion in assets, their average median and weighted average market cap are $2.5 billion and $3.3 billion, respectively. This is to say that half of the companies owned in these portfolios have a market cap that is greater than $2.5 billion, and half of the assets invested in these funds are in companies with a market cap greater than $3.3 billion.

A relatively small number of portfolio managers pay any attention to the smallest stocks in the index despite the fact that they represent a significant number of its constituents.

With the Russell 2000 benchmark having 50% of its capital tied to companies with a market cap of $2 billion or greater and the majority of small cap mutual funds with a similar weighting, it becomes easier to understand why we ask the question, “Is true small cap investing an institutional blind spot?” As seen below, one could conclude that indeed it is a challenge for institutions to capture exposure to what has historically been the best performing segment of the market, the companies in the bottom deciles in size as measured by market cap.

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Disclosures: Punch & Associates is registered as an investment adviser with the U.S. Securities and Exchange Commission. Registration as an investment adviser does not imply a certain level of skill or training. This material is for informational purposes only and is not and should not be construed as accounting, legal, or tax advice. Punch & Associates is not qualified to provide legal, accounting, or tax advice, and accordingly encourages clients and potential clients to consult their professional advisers with respect to such matters. The information is provided as of the date of delivery or such other date as stated herein, is condensed and is subject to change without notice. Information regarding market returns and market outlooks is based on the research, analysis and opinions of Punch & Associates, which are speculative in nature, may not come to pass, and are not intended to predict the future performance of any specific investment or any specific strategy. This document does not purport to discuss all of the risks associated with any specific investment or the use of any strategy employed by Punch & Associates. Certain information contained herein may constitute forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, it is not possible for any person or entity to accurately and consistently predict future market activities. While Punch & Associates makes reasonable efforts to ensure information contained herein is accurate, it cannot guarantee the accuracy of all such information. Further, some information contained in this report may have been provided by or compiled based on information provided by third party sources. Although Punch & Associates believes the sources are reliable, it has not independently verified any such information and makes no representations or warranties as to the accuracy, timeliness or completeness of such information. Past performance does not guarantee, and is not indicative of, future results. All investments in the market are subject to a risk of loss.

Bias from the Non-Mathematical Nature of the Human Brain

December 13, 2017 in Human Misjudgment Revisited

This article is part of a multi-part series on human misjudgment by Phil Ordway, managing principal of Anabatic Investment Partners.

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Bias from the non-mathematical nature of the human brain in its natural state as it deals with probabilities employing crude heuristics, and is often misled by mere contrast, a tendency to overweigh conveniently available information and other psychologically misrouted thinking tendencies on this list. When the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes.

“The right way to think is the way Zeckhauser plays bridge. And your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge.” –Charlie Munger

Availability

“Now, you notice I put in that availability thing, and there I’m mimicking some very eminent psychologists Kahneman, Tversky, who raised the idea of availability to a whole heuristic of misjudgment. And they are very substantially right. Nonetheless, even though I recognize that and applaud Tversky and Kahneman, I don’t like it for my personal system except as part of a greater sub-system, which is you’ve got to think the way Zeckhauser plays bridge. And it isn’t just the lack of availability that distorts your judgment. All the things on this list distort judgment. And I want to train myself to kind of mentally run down the list instead of just jumping on availability. So that’s why I state it the way I do. In a sense these psychological tendencies make things unavailable, because if you quickly jump to one thing, and then because you jumped to it the consistency and commitment tendency makes you lock in, boom, that’s error number one. Or if something is very vivid, which I’m going to come to next, that will really pound in. And the reason that the thing that really matters is now unavailable and what’s extra-vivid wins is, I mean, the extra vividness creates the unavailability. So I think it’s much better to have a whole list of things … than it is just to jump on one factor.”

Examples include:

  • Coke
  • John Gutfreund and Salomon Brothers (also: reciprocation, base rate, vengeance)
  • See’s Candy cashiers stealing from the till – consider the base rate (“what Tversky and Kahneman call baseline information”)
  • Serpico – allowing corruption and terrible behavior to spread is evil
  • Vengeance – don’t chase the last ounce of vengeance, or any vengeance (“I don’t think vengeance is much good.”)

Update

Munger added “Availability-Misweighing Tendency” as its own category in the update, along with his much expanded thoughts.

  • “When I’m not near the girl I love, I love the girl I’m near.”
  • “Man’s imperfect, limited-capacity brain easily drifts into working with what’s easily available to it. And the brain cant’ use what it can’t remember or what it is blocked from recognizing because it is heavily influenced by one or more psychological tendencies bearing strongly on it. ”
  • Antidotes: Darwin’s search for disconfirming evidence; “emphasize factors that don’t produce reams of easily available numbers”; “find some skeptical, articulate people with far-reaching minds”
  • Use vivid images and availability to your advantage in persuasion or improving your own memory.

“We tend to judge the probability of an event by the ease with which we can call it to mind.” — Danny Kahneman

There is now a treasure trove of behavioral economic work that is widely accessible, and Kahneman and Tversky were among the pioneers. Munger even cited their work in the mid-1990s before it had achieved such wide acclaim.

“Nothing in life is as important as you think it is when you are thinking about it.” — Danny Kahneman

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