Great investors often use mental models or frameworks for thinking about investing. Modelling their thought processes may help improve our own investment decision making, especially for beginners. The following list includes some of the frameworks that have influenced our thinking and are a good introduction to investing.
1. Charlie Munger
Charlie Munger is one of the great investors. He is the right-hand man of Warren Buffett and Vice Chairman of Berkshire Hathaway. Charlie is a big fan of mental models or frameworks for thinking.
While investing models are important, Charlie thinks it's good to start with the big ideas in key disciplines such as math, economics, psychology, engineering and biology. A psychologist will think in terms of incentives, a scientist in terms of hypothesis and experiments, and engineers in systems and redundancy. All disciplines analyse events from different angles, but it’s helpful to consider the overall perspective. This means we don’t just look at a company’s financials but also try to understand the ecosystem it operates in and different views or perspectives. It sounds difficult and requires wide reading but understanding that different views exist will better equip us to solve problems and understand what impacts a business.
High quality businesses
The quality of the business matters most over the long term. Quality means having first class management and products. Really good managers are able to see opportunities to create value that most cannot anticipate. But it's a bit like sport teams in that you have to pay up for the superstars. In Munger’s words: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
2. Ben Graham
Ben asks you to imagine that you are the owner of a business with a partner called Mr Market. This partner quotes you a price, every day, to buy his share or a price to sell your share. Mr Market’s quotes can vary from widely pessimistic to widely optimistic! You are free to decline his offer because you know he will always be back tomorrow with an entirely different one.
A stock is a piece of a business
Ben says, “Investment is most intelligent when it is most businesslike.”We think this is about having the mindset of a private business owner. Stocks aren’t just quotes on a screen or a piece of paper (share certificate), but a real business. If we owned the business 100% as a long-term owner, would we be as worried about negative news headlines or short-term stock market volatility? Most of the time the answer to that question would probably be no.
Margin of safety
A margin of safety is the difference between the price of a security and its estimated intrinsic value. Buying shares or other securities with a margin of safety allows an investment to be made while reducing downside risk. Anything can happen in markets, so it’s useful to buy at a significant discount as a cushion against market volatility or errors in judgement or calculation.
3. Warren Buffett
We all know Warren.
The moat framework is highly relevant to us at Spaceship, as it's part of our investment process. When selecting companies for our Spaceship Universe Portfolio, we look for companies with sustainable competitive advantages or moats that allow a company to differentiate its services and products from competitors, giving the company a competitive edge. Typical company moats include branding, scale benefits and network effects (where a service gains additional value as more people use it, such as at Facebook). Read more about network effect here.
4. George Soros
George Soros is one of the most successful hedge fund managers in the world, most famous for breaking the Bank of England.
George Soros has suggested that financial markets are affected by how participants think. In short, Soros thinks markets are reflexive i.e. our beliefs about the market or a company can directly affect the underlying fundamentals causing a positive or negative feedback loop. So, instead of the market reflecting what is happening in the economy, the market can directly impact what happens in the economy. An example of this is a share market crash. Share markets are supposed to reflect economic fundamentals, but a share market crash can affect the economy by reducing wealth and confidence, which helps to cause a recession. A more positive example is a company with a rising share price; it can more easily raise capital and attract new investors, thus increasing the company’s chance of success.
5. Peter Lynch
Famous portfolio manager of the Fidelity Magellan Fund and author of One Up on Wall Street.
Simple is best, invest in what you know
Speculative mining and biotech stocks may be an attractive investment in a bull market. But as Lynch says, “a share is not a lottery ticket … it’s part-ownership of a business.” Sometimes the best investments are right in front of you. While it was hard not to notice Microsoft, Apple or Google, investors seemed to always be drawn to riskier (and potentially more lucrative) "lottery ticket" scenarios. The best ideas often come from what you know and are simple. In fact, visits to the shopping mall were a source of many of Peter’s ideas.
6. Michael Steinhardt
Another famous hedge fund manager. His investments averaged returns of 24% per annum over a 28-year period.
One way to make money in the stock market is to have a view that is different to what everyone thinks will happen. Of course, you’ll only make money if that view turns out to be right! In other words, a differentiated or contrarian view of the market. One way that Michael has stood out from the rest of the industry is by identifying companies at key inflection points, ahead of institutional investors. In other words, he invested in companies while said companies were still underdogs. Again, though, the key is to be right. These situations don’t happen too often, as the market view is usually correct, but when the opportunity exists for the market to shift towards your non-consensus view, it typically pays.
7. Howard Marks
Famous credit investor and author of The Most Important Thing: Uncommon Sense for the Thoughtful Investor.
Second order thinking
First level thinking is simple: a company has a favourable outlook, so the stock will go up and it's a buy. If only investing was that simple. Second level thinking takes into account the second order effects of others’ expectations. Second level thinking understands that while a stock may be a great company, because everyone thinks it's a great company, it’s at risk of being overpriced or overrated. Thus, the stock is actually a sell.
If you’d like to read more about Spaceship’s investment process and how we apply some of these mental models, please head here.