World Global Strategy

16 June 2008

Mind Matters
Investment 201: a summer reading list
James Montier (44) 20 7762 5872

In the past I have put together a reading list of books that to my mind forms the core of what every investor should know. Every so often someone will ask me what I would add to that list today. This note seeks to answer that question by selecting 10 additions to my original list. The choices are personal and eclectic, as ever. My top two picks for summer reading are David Einhorn’s Fooling all of the people some of the time and Dan Ariely’s Predictably Irrational.

To give my selections some structure I have split them into three categories: Finance (5 books), Psychology (3 books) and Hidden Gems ( 2 books). In the Finance sections, my first choice was David Einhorn’s Fooling all of the people some of the time. Not only is it excellently written, but the lessons on just how far a corporate will go to hide the truth, and how to conduct fundamental analysis are salient to all of us. Rob Arnott et al’s The Fundamental index is a must-read – anything that provokes almost vitriolic responses from both active and passive managers must be good! Louis Lowenstein’s The Investors Dilemma will make uncomfortable reading for many in the fund management industry as it highlights the problems caused by the conflict of interest raised when management companies are separate from the funds themselves. My last two books in the finance section aren’t necessarily beach reading but they are a key part of the investor’s toolkit. Howard Schilit’s Financial Shenanigans, and Charles Mulford and Eugene Comiskey’s Creative Cash Flow Reporting both cover the topic of spotting companies that may be attempting to mislead investors. After a five-year earningsdriven bull run, these skills may well need some refreshing. In the psychology section, Dan Ariely’s Predictably Irrational is the must read of the year. It is a field guide to just how far our behaviour deviates from a ‘rational’ benchmark. The experiments that Ariely runs are ingenious, insightful and fun. Coming in a close second is Mistakes were made (but not by me) by Carol Tavris and Elliot Aronson. This book details the self justification that we indulge in when faced with situations where our actions and beliefs come into conflict. Carol Dweck’s Mindset is my third choice. This book concerns how we deal with failure, and how we can learn from our mistakes The two hidden gems for this year are Atul Gawande’s Better: A surgeon’s notes on performance and Sydney Finkelstein’s Why Smart Executive Fail. The former details the criteria required for success in medicine which seems to have a high degree of overlap with finance. The latter is the antithesis of all the management success books out there – case studies in failure help to highlight common areas of corporate disasters.


Albert and I wish to thank our readers for their continued support. The results of the 2008 Thomson Extel Survey of European Analysts were recently announced, and due to your votes, we were voted not only the top Global Strategy team, but also the top team across the entire survey (combining both macro and equity sectors). We really appreciate this level of support and hope we can continue the flow of stimulating ideas to justify it.

Mind Matters

Investment 201: a summer reading list
Back in March 2007 I wrote a note on the best books in investment (an investment reading list 101 if you like). For those who may not have seen the original note, the books I chose were split into four categories:

The Classics:
Security Analysis by Ben Graham and David Dodd (1934 Edition) Chapter 12 of the General Theory of Employment, Interest and Money by John Maynard Keynes Theory of Investment Value by John Burr Williams Manias, Panics and Crashes by Charles Kindelbeger Reminiscences of a Stock Operator by Edwin Lefévre

Modern Wonders:
The Little Book That Beats the Market by Joel Greenblatt The Little Book of Value Investing by Chris Browne Fooled by Randomness by Nassim Taleb Contrarian Investment Strategies by David Dreman Speculative Contagion by Frank Martin

Psychological Musts:
Robot’s Rebellion by Keith Stanovich Strangers to Ourselves by Tim Wilson How we know what isn’t so by Tom Gilovich Stumbling on Happiness by Daniel Gilbert The Psychology of Intelligence Analysis by Richard Heuer Jnr

Hidden Gems:
Halo Effect by Phil Rosenzweig Mindless Eating by Brian Wansink The Inefficient Stock Market by Robert Haugen The Margin of Safety by Seth Klarman Your Money and your Brain by Jason Zweig One of the most frequent questions I get is “what would you add to the list now?” So this note seeks to provide a guide to books that I would include as required reading in addition to those in the previous note. As ever my selection is eclectic and personal. However, to provide some structure I have separated the books into three groups: finance (5 books), psychology (3 books) and hidden gems (2 books).


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Mind Matters

Every so often a book comes along that seems to capture the hearts and minds of investors. When I started out in this business it was Michael Lewis’ Liars Pokers. Then When Genius Failed by Roger Lowenstein, Fooled by Randomness by Nassim Taleb was probably the last such book. I have a candidate for the book I think will be next in this mode. It is Fooling all of the people, some of the time by David Einhorn. The subtitle of this remarkable book is a long short story, and that is exactly what the book discusses. Einhorn went short Allied Capital, and then gave a ‘public’ speech on the subject. The book documents the lengths that Allied Capital have gone to avoid answering Einhorn’s criticisms, and the nefarious behaviour that they have been willing to engage in (such as stealing Einhorn’s phone records). The book should be required reading for all analysts. Why? For (at least) two reasons. Firstly, it documents just how far a company will go to maintain its illusion of respectability. All too often analysts seem to be little better than glorified PR departments for corporates, accepting what they are told as gospel truth (possibly an oxymoron in its own right). This book should serve as a wake up call to investors and analysts alike over the fact that corporates lie and cheat (when it suits them). After all, for a short seller, such a position amounts to one of many in a portfolio, but, to the company, it is everything. Secondly, the book is inspiring in terms of the portrait of fundamental analysis that it provides. Einhorn and his team went to great lengths to research their investment case. They provide a shining example of the way in which research should be done (and note not a single earnings forecast in sight!). Not only is the book a great read, thanks to Einhorn’s gifted writing style, but the profits made on the book go to a worthwhile charity (in fact, the same one that Einhorn originally gave the speech on Allied Capital for). This book is simply a must-read. My second choice in the finance section is Rob Arnott et al’s excellent The Fundamental Index. The concept of fundamental indexing has attracted much debate in finance. Rob and his colleagues have been attacked by the fans of passive and active investment alike. In the interests of full disclosure I am a fan of the fundamental indexing approach. Regardless of my personal views on the idea, anything that upsets quite so many people must surely be of interest. The basic idea is simple and powerful. If markets are inefficient then market cap weighting is no longer the outcome of theory. The CAPM leads to market cap weighting, if we break the assumptions underlying the model, then the conclusions change and market cap weighting is no longer efficient. A better index can be constructed. Rob and his colleagues have developed an alternative to CAPM inspired cap weighting. An index weighted by fundamentals such as earnings, dividends and cash flows. Some have attacked the idea for simply being a small cap/value bias. However, Rob presents some arguments that the index is more than this. It is effectively a way of contrarian indexing. By its very construction it will trade against whatever is doing particularly well in the market be it value, growth, large or small.

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Mind Matters

Moreover, products based on this approach are relatively cheap to run – they certainly don’t require 2/20 fee structures which may motivate some of those in active management to shun the idea! Of course, the fundamental index concept isn’t perfect. If a sector were to suffer a ‘fundamental’ bubble, that is to say its earnings were above trend for a long period of time then the fundamental index would likely suffer when the bubble burst. Of course, a cap weighted index would probably do much worse. The bottom line for me is that regardless of your placing on the active/passive debate or indeed your degree of keenness on the fundamental index concept, this book will provide you with fuel for thought. My penultimate choice in the financial context will be unpleasant reading for many engaged in fund management (especially at those large fund management houses with multi-style products). Louis Lowenstein’s The Investors Dilemma takes a long hard look at the mutual fund industry and finds that it has betrayed its fiduciary responsibility in favour of short-term profits – a position that I have espoused for many years (indeed on more than one occasion I have argued that we should all take an investment equivalent of the Hippocratic Oath – To do no harm - I know I am a hopeless idealist on this score, since in general caveat emptor is preferred in finance). At the heart of Lowenstein’s critique of the mutual fund industry is an attack on the clear conflict of interest that “the management companies are independently owned, separate from the funds themselves, and managers profit by maximizing the funds under management because their fees are based on assets, not performance”. This conflict seems to be at the heart of many fund supermarket structures. Lowenstein points out that the mutual fund industry offers some 11,000 different ‘asset classes’, ranging from high-tech to old economy stocks. Between 1980 and 2004, the assets of stock funds increased 90 times, from $45 billion to $4 trillion (today’s figure is closer to $6 trillion). During that same period, fees paid by investors and collected by fund managers via fund management companies soared from $288 million to $37 billion. The good news is that not all fund managers have fallen into this trap. Lowenstein details the select group of those managers who have the discipline and the integrity to do things differently. Strangely enough they are long-term orientated value investors. Lowenstein shows that this minority group illustrate that it is possible to combine good investment and good business by focusing on the long term. There is hope yet! My final selection is actually two books on the same topic. After a bull run and a period of truly impressive earnings growth, I recently found that the opportunities lie more on the short side than the long side (see Mind Matters, 13 May 2008). Given this kind of backdrop, a careful analysis of financial statements may well prove to be a particularly useful basis for analysis (as unpopular as that seems to be today).


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Mind Matters

Thus, my selections here are readable guides to looking for those firms who might just be trying to fool you into thinking their performance is still good. The first book is Howard Schilit’s Financial Shenanigans. This useful book sets out to explore seven common areas of what might be described as ‘earnings management with dubious intentions’. They are: i. Recording revenue too soon or of questionable quality

ii. Recording bogus revenue iii. Boosting income with one-time gains iv. Shifting expenses to a later or earlier period v. Failing to record or improperly reducing liabilities vi. Shifting current revenue to a later period vii. Shifting future expenses to the current period as a special charge

Each arena is explored and methods for detection are discussed. For those analysts wanting to improve their skills on the short side this book should become a very useful reference. The second book in this field is Charles Mulford and Eugene Comiskey’s Creative Cash Flow Reporting. In the past I have often cited Mulford and Comiskey’s previous book, The Financial Numbers Game, as it provides a great insight into the ways in which corporate managers fudge their numbers. Creative Cash Flow Reporting picks up where Schilit’s book leaves off. It concerns the manipulation of cash flows rather than earnings, and the use and abuse of free cash flow. As such is it a perfect compliment to the previous book. Both should be required reading by all analysts.

16 June 2008


Mind Matters

My prime pick from the field of psychology was an exceedingly easy call. I have referred to it in several of my notes, and used the author’s work in several more notes. It is Dan Ariely’s Predictably Irrational. This book is the freakonomics of behavioural economics. I often judge a book by how many of the corners of the pages I have turned down to remind me of something, Predictably Irrational is one of the few books that has almost every page marked. Dan is a gifted writer and clever designer of experiments to draw out people’s behaviour. His insights into the way we behave and why we behave in such a fashion are excellent. For anyone wanting an introduction to how being human affects our behaviour, this is the book for you. I simply can’t recommend this book highly enough. Next on my list is Mistakes Were Made (But Not by Me) by Carol Tavris and Elliot Aronson. This is a wonderful book on cognitive dissonance (the mental anguish we feel when we hold two contradictory views or when our actions conflict with our beliefs). Tavris and Aronson argue that cognitive dissonance is at the heart of pretty much all of the self justification that we tend to undertake. To my mind this book serves as a guide to guarding against our own worst behaviour. To illustrate their points Tavris and Aronson take the reader on a whirlwind tour from the Crusades to Holocaust, from recovered memories and the fallacies of clinical judgment to false confessions, and wrongful convictions. The range of topic covered show the universal nature of the biases of which I so often write. As a pedagogical device Tavris and Aronson deploy the image of two people standing at the top of an imaginary pyramid and undergoing the same dissonance-inducing experience. Person A processes the experience accurately, which leads him down one side of the pyramid. Person B engages in a series of defensive manoeuvres to reduce cognitive dissonance that eventually lands him at the opposite side of the pyramid. Once at these opposite poles, the two can no longer recognize their initial similarities, and see each other as unfathomable and even dangerous. One of my favourite examples of just how twisted our mental models can be is a true example of two men who experienced a terrifying episode of sleep paralysis in which they saw demons attacking them. One recognized it for what it was; the other became convinced that he had been abducted by aliens and had even fathered a set of twins with an alien partner! My third choice in the psychological field is Carol Dweck’s Mindset. I explored Dweck’s wonderful work in Mind Matters, 15 April 2008. She is an expert on how people deal with failure, and how cognitive coping styles can have a major influence on our behaviour. Dweck is a champion of what she has described as a flexible mindset – that is one that sees intelligence (broadly defined) as something that can be learnt and developed over time, rather than some fixed quantity we are simply allotted in life’s lottery. She has shown that those who view intelligence as a flexible concept are much better at learning from their mistakes than those with a fixed viewpoint who tend to see failure as severely ego threatening. The really good news is that mindsets are not themselves fixed. We can push ourselves to adopt a more flexible viewpoint. This book is the closest thing to a self help book that has ever appeared on my lists, but it is carefully grounded in empirical research that Dweck and her colleagues have undertaken over the last two decades.

16 June 2008

Mind Matters

Hidden Gems
My first choice in this section is Better: A surgeon’s notes on performance by Atul Gawande. This book was originally suggested to me by a client (thanks Hassan). Medicine and finance have many aspects in common. Obviously, the stakes are potentially far higher in medicine than in finance, but otherwise the fields have similarities. Foremost among them is that they are both classic examples of decision making under uncertainty. Gawande believes that success in medicine requires three core elements. Firstly, diligence (“the necessity of giving sufficient attention to detail to avoid error and prevail against obstacles”. Secondly, to do right “Human failings… like avarice, arrogance, insecurity and misunderstanding” are as common in medicine as they are in finance. Thirdly, ingenuity (“Thinking anew”). I would suggest that those who are most successful in finance possess all three of these traits in abundance. As regular readers will know, I advocate the use of simple rules to help in investment (see Mind Matters, 3 December 2007). Gawande provides an excellent example of a similar situation in medicine. Each year, according to the US Centres for Disease Control, two million Americans acquire an infection while they are in hospital…The hardest part of the infection-control team’s job… is not coping with variety of contagions they encounter, or the panic that sometimes occurs among patients and staff. Instead, their greatest difficulty is getting clinicians… to do the one thing that consistently halts the spread of infections: wash our hands. Of course, washing hands has been known to help prevent the spread of infection since the days of Ignac Semmelweis back in 1847. However, as Gawande notes even today doctors forget. He goes on to describe a series of ‘fixes’ or simple rules and procedures that helped massively cut the rate of secondary infections. Indeed, the broad topic of ‘choice architecture’ (of which hand washing is a excellent example) is covered in a another new book which is worth a peruse by Thaler and Sunstein, Nudge. My final choice for this year’s reading list is the antithesis of most management books which focus on success. This volume focuses on corporate failures, and seeks to uncover the root causes of these disasters. Why Smart Executives Fail by Sydney Finkelstein explores what was behind some of the most spectacular failures in recent times. Finkelstein uncovers the “seven habits of spectacularly unsuccessful people” as i. They seem themselves and their companies as dominating their environments, not simply responding to developments in those environments. ii. They identify so completely with the company that there is no clear boundary between their personal interests and corporate interests iii. They seem to have all the answers, often dazzling people with the speed and decisiveness with which they can deal with challenging issues. iv. They make sure that everyone is 100 percent behind them, ruthlessly eliminating anyone who might undermine their efforts. v. They are consummate company spokespersons, often devoting the largest proportion of their efforts to managing and developing the company image.

16 June 2008

Mind Matters

vi. They treat intimidatingly difficult obstacles as temporary impediments to be removed or overcome. vii. They never hesitate to return to the strategies and tactics that made them and their companies successful in the first place. Even better, Finkelstein gives a list of questions based on five elements to help serve as early warnings signs – to my mind these could be used profitably by analysts in their assessment of corporate management. For instance:

Unnecessary Complexity
• • Is the company’s organizational structure convoluted or complex? Is its accounting overly complicated, non-transparent or non-standard?

Speeding Out of Control
• Is the company so successful or so dominant that it’s no longer in touch with what it needs to do to remain on top? • Are there small, yet nontrivial, details or problems that seem to be getting overlooked by management?

Distracted CEO
• Is the CEO spending too much money to fulfil personal missions?

Excessive Hype
• • Is the excitement around the company’s prospects just unfulfilled hype? Is the latest missed milestone part of a pattern that could signify deeper problems?

Questions of Character
• Are the CEO and other senior executives too aggressive or massively overconfident?

Of course, just like the books on corporate success, hindsight bias and selection bias undoubtedly bedevil some of the analysis. However, looking for common traits among unsuccessful managers/corporates does strike me as a useful counterbalance to much of the corporate glorification which tends to border on deification. As ever, I am sure I have missed many excellent books. If you feel I have made a particularly egregious omission then please let me know.


16 June 2008

Mind Matters

16 June 2008


Mind Matters


16 June 2008

Mind Matters


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Mind Matters

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16 June 2008

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