Warren Buffett likes to say: “I don’t try to jump over seven-foot hurdles; I look for one-foot hurdles I can step over.” Sounds simple, but as Steve Jobs pointed out: “Simple can be harder than complex.” This letter discusses what we think is the right investment approach for 2022. Briefly stated, we believe that the best results can be achieved by boosting the “signal-to-noise” ratio, amplifying useful information (the “signals”) and subtracting unproductive data (the “noise”) as much as possible. We address these twin challenges in reverse order and then discuss why boosting the signal-to-noise ratio is simple, but not easy.
Financial news and the popular press bombard us with an enormous amount of information, much of which is not very useful. On any given day there is talk both of a stock market crash and a market boom. Speculation about the damaging effects of sustained inflation compete with assurances that the inflation we’re seeing today is just a temporary (if dramatic) side effect of an economy awakening from a long Covid slumber.
Adding social media to this mix makes things even noisier and fuels rampant speculation in meme stocks, cryptocurrencies, unprofitable companies and businesses with too much debt. When the herd gets loud enough, reason often goes out the window. Warren Buffett once illustrated this phenomenon in an amusing anecdote about an oil prospector who died and went to heaven, where he met St. Peter:
St. Peter said, ‘Well, I checked you out, and you
meet all of the qualifications. But there’s one
problem.’ He said, ‘We have some tough zoning laws
up here, and we keep all of the oil prospectors over
in that pen. As you can see, it is absolutely
chock-full. There is no room for you.’
And the prospector said, ‘Do you mind if I just say four words?’
St. Peter said, ‘No harm in that.’
So the prospector cupped his hands and yells out, ‘Oil discovered in hell!’
And of course, the lock comes off the cage and all of the oil prospectors start heading right straight down.
St. Peter said, ‘That’s a pretty slick trick. So,’ he says, ‘go on in, make yourself at home. All the room in the world.’
The prospector paused for a minute, then said, ‘No, I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.’
Well, that’s the way people feel with stocks. It’s very easy to believe that there’s some truth to that rumor after all. 1
The relentless drum beat of the news media
and the “Twitterverse” has, we believe, created an
extended “silly season” in which people will pay up
for companies whose value proposition is dubious at
best. A perfect example is the electric vehicle
company that recently went public with a $130
billion peak valuation despite never having sold a
vehicle.2 “Fake it until you make it” may be a good
way to line the pockets of a handful of Silicon
Valley unicorns, but for the investing public, it is
nothing more than risk-laden noise.
Noise may emanate from the natural fluctuation of the markets as well. As Peter Lynch wrote in his book Beating the Street:
A decline in stocks is not a surprising event, it’s a recurring event – as normal as frigid air in Minnesota. If you live in a cold climate, you expect freezing temperatures, so when your outdoor thermometer drops below zero, you don’t think of this as the beginning of the next Ice Age. You put on your parka, throw salt on the walk, and remind yourself that by summertime it will be warm outside. A successful stock-picker has the same relationship with a drop in the market as a Minnesotan has with freezing weather. 3
The intelligent investor knows how to identify the “noise” in the market and realizes that subtracting that noise from the investment decision-making process can be difficult, for the reasons discussed below. On the other hand, the intelligent investor also knows how to spot the signals that point to a sustainable investment strategy.
Being able to spot decision-useful investment information should never be confused with being able to “predict” or “time” the market. A favorite saying of ours comes from that inimitable wag, Yogi Berra: “Predictions are difficult, especially those about the future.”
One of the hardest things to predict these days is the potential for sustained, wealth-destroying inflation. Although some say it is already here, since the U.S. inflation rate hit a 39-year high in November of last year4, the majority view seems to be that that this is a temporary after-effect of the pandemic. Those who hold this view believe that lasting inflation is not a valid concern since so much money creation has gone on for many years now without inflationary consequences. While I’ve been wrong before in my now thirty-year investment career (and while I’m occasionally outwitted by my two-year-old son), I firmly believe that consequential inflation will show up in the foreseeable future. It might be in six months, one year, or ten years, but it is headed our way.
The likely effect of meaningful inflation on fixed-income investment portfolios is one signal that we heed. Although investors continue to pour their assets into low- and negative-yielding debt thinking they can simply reverse course if inflation gets too serious, we are mindful of the Wall Street trading proverb that “the Hoover Dam cannot empty through a garden hose.” Tens of trillions of dollars in bond investments globally fleeing inflation at about the same time will, we think, lead to very large losses for fixed-income investors.
trying to predict when consequential inflation will
land on our shores, paying attention to the likely
consequences of such an event leads us to ask, for
every investment we consider, “How will it do if all
this money creation does cause sustained inflation?”
We want to own businesses
that will do well whether we have inflation or not.5
In the search for top-notch businesses, we focus on safety and try to step over one-foot hurdles by reading a number of signals. First, we look for businesses that own real assets that increase in value ahead of inflation or have the ability to increase cash flows faster than inflation.
As a large railroad’s CEO recently said: “We are definitely getting more price than we are experiencing in inflation” – that’s what we hope for with the businesses we own. We think companies like Costco, Berkshire Hathaway, Amazon, and many others may not benefit a lot from inflation, but neither do we expect them to be hurt by inflation over time.
In our search for resilient businesses, we do not get distracted by the buzz (noise) of exotic or complex ideas, preferring to follow Peter Lynch’s advice to “Never invest in any idea you can’t illustrate with a crayon.” We also look for sustainability signals. Taking a lesson from nature, we think of businesses as trees. They do not last forever, but they thrive for vastly longer than you’d think watching all the frenetic noise-driven trading that goes on. When trees do die, they are replaced by saplings that often out-grow the trees that came before them. We search the forest for trees with hopefully decades of robust growth ahead of them.6
Another important signal we heed is the human element. One of our favorite reads about the intersection of human nature and business is Business Adventures by John Brooks, published in 1967. This collection of business case studies first published as New Yorker magazine articles in the 1960s is also a favorite of both Bill Gates and Warren Buffett. Gates wrote that: “Brooks’ work is a great reminder that the rules for running a strong business and creating value haven’t changed. For one thing, there’s an essential human factor in every business endeavor. It doesn’t matter if you have a perfect product, production plan, and marketing pitch, you’ll still need the right people to lead and implement those plans.” 7
We strive to own businesses that have the right human elements – great managements with foresight and a demonstrated ability to make and implement rational decisions. This is what creates value for customers and rewards for investors.
In addition to focusing on company-specific signals, we also look at macro signals, including the cultural and political environment in which a business operates. In general, we prefer to invest in American businesses, believing, as Warren Buffett has said, that “Being short America has been a loser’s game and will continue to be a loser’s game.” We believe that the American economic ecosystem encourages human productivity and innovation and operates in an environment designed to respect the rule of law, which provides a critical measure of stability. Furthermore, although there is certainly room for improvement, we find that America recognizes the value of human capital. In particular, providing more opportunities for women expands our productive capacity enormously.
U.S. corporate profits in the quarter ended September 2021 were at an all-time high.8 Although all markets go through business cycles, and future profitability is never guaranteed, on the whole, we remain bullish on American businesses.
When we do invest internationally, we look for the same signals that inspire our confidence in the United States. To begin with, we strongly favor businesses in countries that respect the rule of law. (A good litmus test for this is whether a country’s citizenry feels safe criticizing the government.) We also look for countries that respect human capital and foster entrepreneurs. Of course, sometimes the signals in these areas are strong, but extremely negative. A recent Financial Times article discussed a report by the Chinese Communist Party’s China Daily to the effect that 72 of the country’s billionaires had died premature deaths between 2003 and 2011.9 According to this report (which also was the subject of a 2011 Forbes article),10 “Among the 72 billionaires, 15 were murdered, 17 committed suicide, seven died from accidents, 14 were executed according to the law and 19 died from disease.”11 Signals like these are hardly confidence builders. The same is true of signals indicating that a country’s citizens are busily moving their own money elsewhere. We believe it’s best to keep our distance from markets like these!
As we see it, the stock market today is oddly bifurcated between companies we don’t want to “touch with a ten-foot pole” and businesses we think are compelling to own. Although we have to dig through a lot of mediocrity, we have been finding a number of investment opportunities that excite us. And we have been doing this by tuning out the noise and focusing on the signals.
The question remains, why do so many investors find it hard to boost their signal-to-noise ratio? Blame it on human nature.
Human Nature’s Attraction to Noise
There are many different motivations that drive human beings, but two of the major motivations for investors are fear and desire. These are the emotions that Daniel Kahneman (whose work we have written about in the past) considers when he describes various forms of “fast thinking” that are not really thinking at all but emotional responses that generate faulty decision-making and inappropriate solutions to problems. The buy-high/sell-low model that represents fear and the get-rich-quick/risk-be-damned model that represents desire are both stoked by news- and social media-generated noise. In addition, a lot of the investment foolishness that is going on— or what the famous businessman and investor Greg Maffei calls the “hype train” — is exacerbated by things like online shopping that give people dopamine stimuli for quick rewards. And folks want more and more of these dopamine “hits.” Then, as Mr. Maffei put it: “This inundation of dopamine desensitizes our brains’ risk-reward calibration and heightens a gambling mindset.”12 We believe this is another reason investors find it hard to tune out the noise in the markets.
Keep Things Simple and Safe
People have an almost overwhelming desire to add analysis and variables to their decision making, instead of aggressively subtracting extraneous data (noise) to find the key decision-useful information (signals). We feel too many moving parts create almost a fog in which wise thinking becomes difficult. (That said, we are fascinated by irrationality and the investment opportunities it creates for those who resist it!)
investors who make a conscious effort to fight human
nature, subtract noise and identify signals will see
that inflation can diminish, if not destroy, their
purchasing power unless they own businesses that can
navigate an inflationary environment. Boosting the
signal-to-noise ratio also shows that since all
dollars are created equal, stepping over an easy and
safe hurdle to gain a dollar is far preferable to
trying to leap over a high bar.
As always, please let us know if you have any questions or want to discuss any parts of this letter in more detail.
We wish you good health, much joy and great investment returns in the new year!
With Warmest Regards,
2. In a November 18, 2021 CNBC interview, the famous businessman and investor John Malone used the IPO for this company (Rivian Automotive, Inc.) as an example of how the “equity markets right now are … interested in growth above all other criteria.”
5. Potential inflation is a wonderful example of the importance of inverting your thinking – asking what if you are wrong? If you own shares of excellent businesses and are wrong about the potential for sustained meaningful inflation, you still own investments that should do well even though you miscalculated regarding inflation. Conversely, if you own bonds expecting a benign outlook for inflation and the inflationary outlook darkens, your mistake is likely to make you very unhappy.
6.Scale: The Universal Laws of Growth, Innovation, Sustainability, and the Pace of Life, in Organisms, Cities, Economies, and Countries by Geoffrey West (2018). This book (by a physicist, but without a single equation in it) is a wonderful read about applying biology to other disciplines.
11.“72 super rich dead before their time since 2003,” China Daily (Updated, July 22, 2011).
12.At the Liberty Media investor meeting on November 18, 2021. A superb book on how our modern world affects dopamine levels and thus human behavior is “Dopamine Nation: Finding Balance in an Age of Indulgence” by Anna Lembke (2021).