PICK STOCKS LIKE WARREN BUFFETT PART 5 pptx

.This was a case of sloppy analysis, a lapse that may have beencaused by the fact that we were buying a senior security [owners of preferred stock must be paid dividends before owners of

CHAPTER 17

Admit Your Mistakes

and Learn from Them

Agonizing over errors is a mistake But acknowledging and analyzing them can be useful, though the practice is rare in corporate boardrooms There, Charlie and I have almost never witnessed a candid post-mortem of a failed decision, particularly one involving an acquisition The financial consequences of these boners are regularly dumped into massive restructuring charges or write-offs that are casually waved off as

“nonrecurring.” Managements just love these Indeed, in recent years it has seemed that no earnings statement is complete without them The origins of these charges, though, are never explored When it comes to corporate blunders, CEOs invoke the concept of the Virgin Birth.

In the reports, the litany of mistakes tends to come right upfront The 1999 report discusses “just how poor our 1999 recordwas Even Inspector Clouseau could find last year’s guiltyparty: your Chairman.” He describes the mistakes; he tries to fig-ure out why he made them; and he assesses the consequences ofthose mistakes

Admitting mistakes and trying to learn from them seems to be

an attribute of gifted investors—and of gifted people in general.Let’s look at how Buffett has discussed some of his mistakes in thepast:

• In the 2000 annual report he confesses, “I told you last yearthat we would get our money’s worth from stepped up advertising

at GEICO in 2000, but I was wrong The extra money we spentdid not produce a commensurate increase in inquiries Additionally,

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the percentage of inquiries that we converted into sales fell for thefirst time in many years These negative developments combined toproduce a sharp increase in our per-policy acquisition cost.” (Hegives more details about the problem, pointing out that a key com-petitor, State Farm, has resisted raising its prices.)

• Why didn’t he repurchase shares of Berkshire Hathaway whenthey were cheap?

“You should be aware,” he has said, “that, at certain times in thepast, I have erred in not making repurchases My appraisal of Berk-shire’s value was then too conservative or I was too enthused aboutsome alternative use of funds We have therefore missed some op-portunities .” Granted, he continued, he did not miss out on mak-ing a great deal of money

• “I clearly made a mistake in paying what I did for Dexter [a shoecompany] in 1993 Furthermore, I compounded that mistake in ahuge way by using Berkshire shares in payment .”

• (Talking about Berkshire Hathaway textiles): “We also made amajor acquisition, Waumbec Mills, with the expectation of importantsynergy But in the end nothing worked and I should be faultedfor not quitting sooner.”

• “Shortly after purchasing Berkshire, I acquired a Baltimore partment store, Hochschild, Kohn, buying through a company calledDiversified Retailing that later merged with Berkshire I bought at asubstantial discount from book value, the people were first class,and the deal included some extras—unrecorded real estate valuesand a significant LIFO cushion [potential tax deduction] How could

de-I miss? So-o-o—three years later de-I was lucky to sell the business forabout what I paid .”

• “Late in 1993 I sold 10 million shares of Cap Cities at $63; atyear-end 1994, the price was $851/4 (The difference is $222.5 millionfor those of you who wish to avoid the pain of calculating the dam-age yourself.)”

“Egregious as it is, the Cap Cities decision earns only a silvermedal Top honors go to a mistake I made five years ago that fullyripened in 1994: Our $358 million purchase of USAir preferredstock, on which the dividend was suspended in September .This was a case of sloppy analysis, a lapse that may have beencaused by the fact that we were buying a senior security [owners

of preferred stock must be paid dividends before owners of mon stock] or by hubris Whatever the reason, the mistake waslarge.”

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• Another mistake: Buying Gillette preferred instead of Gillettecommon “But I was far too clever to do that If I had negotiatedfor common rather than preferred, we would have been better off atyear end 1995 by $625 million, minus the ‘excess’ dividends of about

$70 million.”

Learning from Mistakes

Not learning from your mistakes, of course, may mean that you mayrepeat those mistakes or make similar mistakes

Learning means: recognizing that it was a mistake, despite any cuses that you might have been tempted to make, and pledging torecognize such a situation in the future and to avoid making thesame or a similar mistake

ex-One of the worst investors of our time was the late CharlesSteadman, whose Steadman funds year after year lost money.Steadman Oceanographic lost around 10 percent of its value everyyear for 10 years Such consistency, even among poor-performingmutual funds, is rare What Steadman, a lawyer who was not unin-telligent, did wrong was: (1) buy story stocks, those that had excit-ing tales to tell, such as a company that claimed to breeddisease-free pigs; (2) buy stocks with no persuasive numbers be-hind them; and (3) make the same mistake again and again Hemust have had a powerful need to impress people by reaping extra-ordinary profits from colorful companies Or he was simply unable

to resist the allure of story stocks Perhaps he had once made akilling on a story stock, and yearned to feel once again the ecstasy

of that experience, the giddy sensation of far greater wealth, ofsoaring self-confidence and self-satisfaction

People who can confront and analyze their mistakes seem to havedeep-seated self-confidence They know that, despite their lapses,they are still worthwhile, talented individuals—and perhaps evengifted in whatever line of activity they made their mistakes (Or theyhave just trained themselves, or been trained, to endure the pain ofself-criticism, recognizing the benefits.)

Charles Bosk, a sociologist at the University of Pennsylvania, hasconducted a series of interviews with young physicians who had leftneurosurgery-training programs Either they had been let go, or theyhad resigned What, he wondered, separated these young doctorswho went on to become surgeons from those who had faltered andstumbled along the way?

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It wasn’t so much a resident’s intelligence or dexterity, Bosk cided, as much as the person’s ability to confront the possibility, thecauses, and the consequences of his or her mistakes, and to take

de-steps to keep them from recurring Quoted in The New Yorker

maga-zine (Aug 2, 1997), Bosk said:

When I interviewed the surgeons who were fired, I used to leave the view shaking I would hear these horrible stories about what they did

inter-wrong, but the thing was that they didn’t know that what they did was

wrong.

In my interviewing, I began to develop what I thought was an indicator

of whether someone was going to be a good surgeon or not It was a ple of simple questions Have you ever made a mistake? And, if so, what was your worst mistake?

The people who said, ‘Gee, I really haven’t had one,’ or ‘I’ve had a ple of bad outcomes, but they were due to things outside my control’—in- variably those were the worst candidates.

cou-And the residents who said, ‘I make mistakes all the time There was this horrible thing that happened just yesterday and here’s what it was.’ They were the best They had the ability to rethink everything they’d done and imagine how they might have done it differently.

Possibly these surgeons had not made mistakes, in the sense thatthey had done something that they should not have done—or notdone something they should have Just as you can buy a stock thatgoes down without your making a mistake—you couldn’t haveknown about, say, a new lawsuit—a surgeon can have a bad out-come that is not his or her fault Perhaps the patient had health con-ditions the surgeon and hospital weren’t aware of But assiduouslychecking into the causes of mishaps in general—stocks of yours thatplummet, patients who have bad results—even if the mishaps aren’tyour mistakes, can be as beneficial as trying not to repeat mistakesthat result from a failure on your part

Peter Lynch has admitted that he would sometimes buy a stock at

$40, sell it at $50, then buy it again at $60 He didn’t fear the pain ofhumiliation, of experiencing a decline in his self-esteem, by his pub-licly acknowledging that he had done something he should nothave—sold that stock at $40 (If I had seen that the stock rosebriskly after I sold it, I would out of shame never have looked at itsprice again.) By the same token, Gentleman Jim Corbett, the heavy-weight champion boxer, was said to have been very polite to othermen No one would suspect him of being afraid of them No one

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would think Peter Lynch was not a gifted investor, despite sional lapses And, of course, no one thinks less of Warren Buffettfor his compulsively studying his so-called mistakes.

occa-He plays bridge the same way “When he makes a stupid take,” Carol Loomis has written, “he tends to be hard on himself ‘Ican’t believe that I did that,’ he said recently after one hand ‘Thatwas incredible.’ ”

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Not long ago, I sold $20,000 shares of SBC and bought two $10,000positions in Berkshire Hathaway and Pfizer I still had $20,000 left inSBC But when I look at my stocks now, I’m delighted that Berkshireand Pfizer have risen—and even pleased that SBC has fallen—be-cause all of these steps confirm how clever I am I have to remindmyself that I’m still behind because I have lost more money in SBCthan I have gained in Berkshire and Pfizer.

Psychologists have devised a term for behavior like mine, where

I try to fool myself into thinking what I did was very clever: pidity.” Another term they use is “recency”: People tend tooveremphasize things that have happened recently If there’s aflood nearby, people will buy more homeowners’ insurance; if astock has been going up and up, people are likely to jump on thebandwagon

“stu-Like all other psychological mistakes, recency can serve a useful

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purpose Maybe floods are getting more common these days;maybe that stock will continue going up because (1) some profes-sional investors are gradually buying big positions and (2) new in-vestors keep discovering it But focusing on recent purchases, andoverlooking the stocks that have been in a portfolio for years, can

be a costly mistake

Related to recency is “extrapolation,” the human tendency tothink that whatever has been happening will continue to happen; thenumber that comes after 1, 3, 5, and 7 is 9 Extrapolation is a usefulguide in life A good restaurant deserves a return visit; a friend whogives useful advice is worth consulting again But it doesn’t alwayswork in the stock market, where a stock or the market itself can be-come excessively expensive, where the number that comes after 1,

3, 5, and 7 may be minus 12

A recent and striking event can have a far greater impact on our

psyches A recent airplane crash may lead us to buy more airplaneinsurance; a recent decline in the stock market can cause us to panicand sell

Obviously, we investors are a neurotic lot Just consider howmany investors think that they don’t really have a loss unless they sell a losing stock; and how many other investors believe that an individual bond is better than a bond fund because youcan’t lose money on an individual bond if you don’t sell it beforematurity (assuming that it doesn’t default) It’s the same fallacy:

An individual bond that’s worth less is a loser even if you don’t sell it

Yet, ironically, a popular theory for many years has been the cient market hypothesis, the notion that stock prices are reason-able because all information is distributed quickly and equally,and all investors are intelligent and logical The evidence seems to

effi-fit better with the Nutty Investor Theory, the notion that stockprices are frequently too high or too low because a great many in-vestors are illogical

To do well in the stock market, as Buffett has, it helps enormouslyjust to resist the common psychological mistakes that other in-vestors make

Perhaps the single most important mistake is trapolation, which drives markets up too high and drives them downtoo low “The major thesis of this book,” writes a noted value in-

recency/saliency/ex-vestor, David Dreman, in Contrarian Investment Strategies: The

Next Generation (New York: Simon & Shuster, 1998), “is that

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vestors overreact to events Overreaction occurs in most areas

of our behavior, from the booing and catcalling of hometown fans

if the Chicago Bulls or any other good team loses a few tive games, to the loss of China and the subsequent outbreak ofMcCarthyism But nowhere can it be demonstrated as clearly as inthe marketplace.”

consecu-Other common psychological mistakes include:

LOSS AVERSION. People seem to hate losses twice as much as theylove winners They will accept a bet where the odds may be 2 to 1 intheir favor, but no less Many experiments have confirmed this I my-self presented this case to a group of investors: In your companycafeteria you overhear the president and chairman talking abouthow wonderful things are Earnings are going up; a new product isflying off the shelves; a big competitor is in big trouble Do you buymore shares? About half would, half wouldn’t Again, you’re in yourcompany cafeteria You already own the stock You overhear thepresident and chairman lamenting how lousy things are Earningsare down; a new product has bombed; a big company is beating you

up big-time Do you sell? Everyone would sell.

I once asked Richard Thaler, a leader in behavioral economics, toexplain the origin of loss aversion: It’s an inheritance from our prim-itive days, he said, when losses—of food, shelter, safety—imperiledyour very life

LOVE OF GAINS. Investors are also prone to selling too quickly; instead

of selling their losers and letting their winners ride, they hold ontotheir losers and sell their winners Perhaps they are afraid that theirgains will vanish if they wait too long A bird in the hand

THE PATHETIC FALLACY. A term coined by art critic John Ruskin, it tails endowing inanimate objects with human qualities For instance:not selling a stock because when you were an employee the com-pany treated you generously, or because a favorite relative be-queathed it to you, or because the stock once blessed you withprincely returns and you don’t want to be an ingrate by selling it Astock, as the saying goes, doesn’t know that you own it (Also called

en-“personalization.”)

SEPARATING MONEY INTO DIFFERENT CATEGORIES. This can occur when, forexample, you’ve doubled your money on American Antimacassar,

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and that prompts you to invest your profits more aggressively because it was easy money rather than money you worked hardfor.

COGNITIVE DISSONANCE. It can be painful to change your mind, to stitute one set of beliefs for another That may be why analysts tend

sub-to be slow in upgrading a ssub-tock that has a positive earnings surprise,and to be slow in downgrading a stock with a negative earnings sur-prise Related to this is the “endowment effect”: People tend to ac-cept evidence that supports whatever they already believe (a stockthat they own is a good buy) and reject evidence that conflicts withwhat they believe (a stock they own is a dog)

AVOIDANCE OF PAINFUL MEMORIES. I would never consider buying Intelbecause the very name reminds me that I foolishly sold the stock 20years ago I have trouble buying any stock or mutual fund that cost

me money in the past

CONTAMINATION. Some stocks get hurt because others in the same dustry have been hurt But a company in one industry could proveimmune from the epidemic, and even benefit later on if its competi-tors lose their shares of the business Shrewd investors like to zero

in-in on companies in-in a sufferin-ing in-industry that seem to be immune, theway Buffett bought Wells Fargo during a period of bank troubles andhas been glomming onto companies with asbestos problems re-cently (Sometimes called “false parallels.”) By the same token, somestocks take off because they’re in a favored industry, such as Inter-net stocks, even though they may be exceptions This is called theHalo Effect

COMPLEXITY. In some situations, even sophisticated investors aren’tsure what to do There are lots of good reasons to buy, lots of goodreasons not to buy One money manager, Brian Posner, told me thatthat’s what he looks for—complicated situations, where by intensestudy he can gain an edge over other investors

TOP-OF-THE-HEAD THINKING. I once got a solid tip from a friend in themedical arena that Pfizer, the pharmaceutical company, was in alot of trouble It had manufactured a heart valve that was defec-tive, and everyone with such a valve might sue I sold my 100shares of the stock at $79 and smugly watched as the news got out

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and the price starting dropping—$78, $76, $74, $72 Then, over thecourse of the next year, Pfizer went to $144 You’ve heard that hap-piness is a stock that doubles in a year? I have a neat definition ofthe word “misery.”

A year after I sold my Pfizer, I asked Ed Owens, portfolio manager

of Vanguard Health Care Portfolio, to tell me about something hewas proud of having done recently He mentioned buying all theshares of Pfizer that he could lay his hands on Didn’t he know aboutthe defective heart valve? Yes, of course, but he and his analysts fig-ured that if everyone with a defective heart valve sued, it wouldknock just one point off Pfizer’s price Meanwhile, the company hadall sorts of promising drugs in its pipeline, including one with afunny name: Viagra

THINKING INSIDE THE BOX. So many investors, having lost money on ternet stocks, for example, feel that they must regain their money byholding onto their Internet stocks But, as Buffett has said, you don’thave to make it back the same way you lost it

In-ANCHORING. People seem hungry for any sort of guidance Tell themthe date when Attila the Hun invaded Europe, and they will use thatoff-the-wall number to guide them in estimating the population ofSeattle or Timbuktu In the stock market, people will anchor on astock’s yearly high, or the price at which they bought it If the highwas $50, they will think it must be cheap at $25 (especially if theyare adherents of the efficient market hypothesis) If they bought it

at $50, then it declined, they may wait until it reaches $50, then load it

un-THE HERD INSTINCT. Many people will go with the flow—even good vestors, one of whom once told me that he will buy only on anuptick Often the voice of the people is indeed the voice of God; if Iwas in a theater and everyone began running madly for the exits, Iwould try to beat them out the door Often, though, especially in thestock market, the voice of the people is plain wrong Of course, peo-ple also have a tendency to be stubborn, to ignore the crowd There’s

in-a fine line between courin-age in-and stubbornness

OVERCONFIDENCE. Lawyers, drivers, physicians all think that they arebetter than they are—in winning cases, in avoiding accidents, in di-agnosing illnesses Positive thinking can be beneficial You apply for

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jobs for which you don’t have the requisite experience; you astically undertake projects where you may be over your head Butoverconfidence can also lead investors in particular to take toomuch risk, to overestimate their knowledge and skill, to trade toomuch, to stubbornly refuse to sell.

enthusi-THE SUNK COST FALLACY. People will send good money after bad Ifyou’ve spent $500 getting an auto repaired, it’s very painful to junk the car and buy a new one but somewhat less painful to putmore money into the car By the same token, some people aretempted to buy more shares of a stock that has gone down—perhaps also to prove to themselves that they weren’t dopes forbuying it high

OVERLOOKING SMALL EXPENSES, ESPECIALLY IF THEY ARE REPEATED. Smallleaks, as Munger likes to say, sink great battleships Gary Belsky

and Thomas Gilovich, in their book Why Smart People Make Big

Mistakes—And How to Correct Them (New York: Simon & ter, 1999), call this “Bigness Bias.” Or, as Harold J Laski, the polit-ical analyst, once pithily observed, Americans tend to confusebigness with grandeur

Schus-THE STATUS QUO BIAS. People apparently would rather do nothingrather than do something that would be a mistake They are hap-pier holding onto a stock that loses half its value than they areselling stock one and buying stock two, which also loses half itsvalue This is reinforced by folk wisdom: out of the frying pan intothe fire

CONFUSING THE CASE RATE WITH THE BASE RATE. If you look at one case,the answer may seem to be X; but if you look at many cases simi-lar to that case, you may see that the usual answer is Y A well-known example: In college, Jane was interested in books Is shemore likely to be a librarian now or a salesperson? Answer: Sales-person, because there are far more salespeople in the UnitedStates than librarians In the stock market, investors may thinkthat a particular Internet stock is bound to succeed, paying scantattention to how many other similar Internet stocks have fallen bythe wayside

NOT DISTINGUISHING BETWEEN WHAT’S IMPORTANT AND WHAT’S TRIVIAL. chological tests indicate that when investors are given far more in-

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