[00:02:14] Kyle Grieve: I’ve always really enjoyed learning things about why people think and act the way they do. So I spent a lot of time reading books on psychology. I just, I found that to be very, very riveting. And then also I loved learning more about the history of just humankind and biology. So I read a lot of, you know, just books on history and books on biology and evolution and things like that. So it just led me down a bunch of different rabbit holes and on different domains that I want to learn more and more about. But I will admit that when I was reading this book beforehand, I didn’t have the framework that Charlie Munger has laid out that we’re going to be sharing with you guys today.

[00:02:50] Kyle Grieve: So, I knew these things at a very base level, but I wasn’t really trying to connect what I was learning cementing them in my brain and being able to use them on other areas of my life, which is what, Robert Hagstrom from goes over in this book. So I was really excited once I found Charlie and Robert, and especially after reading this book, it just really helped me understand the power of trying to learn these models, but also trying to implement them and array them so that I could use them at the right time in the right place.

[00:03:17] Kyle Grieve: So yeah, I’m just excited to share all the interesting things that we learned from this book with the audience today.

[00:03:23] Clay Finck: Yeah, so Hagstrom, he pulled together all these ideas that Munger talks about. He has chapters on physics, biology, philosophy, mathematics, and a whole lot more that we’ll be getting into.

[00:03:35] Clay Finck: And just to be up front here, you don’t have to be an expert. In all of these fields, Munger talks about how you just need a few key ideas from each field and then learn to really recognize them and apply them to other disciplines when it’s necessary to do so. So that’s what Hagstrom did in this book is he went through all these different disciplines and pulled what he thought were some of the key ideas from all these fields that we’ll be touching on here.

[00:03:59] Clay Finck: One interesting point that Hagstrom made in the beginning is that we’re all told to sort of specialize and get really good at one thing. So we go to school, we get a specific skill set, and then we use that skill set for really the rest of our lives. You know, I know a lot of people that have just done one thing for 40, 50, 60 years, and we’ve become really a society full of specialists, which capitalism to some extent really incentivizes us to do.

[00:04:25] Clay Finck: And this book really encourages us to do the opposite. To get a broad understanding of these different disciplines and the best way to approach this is that Hagstrom encourages us to first understand the basic disciplines from which we’re going to draw knowledge from. And then second, be aware of the use and the benefit of metaphors.

[00:04:43] Clay Finck: So metaphors are a way for us to easily remember these mental models and make us more equipped to apply them to other disciplines.

[00:04:52] Kyle Grieve: That’s right. And so just going a little bit over the backstory of the book, it was derived from Charlie Munger’s 1994 chat with students at USC, which was a really iconic discussion that was featured in Poor Charlie’s Almanack.

[00:05:03] Kyle Grieve: So in that speech, Charlie discussed a variety of important investing topics that are seemingly non investing related. But Charlie said, quote, quote, You’ve got to have models in your head, and you’ve got to array your experiences, both vicarious and direct, on this latticework of mental models. So, since this book is on acquiring worldly wisdom, I thought it would be good for us to cover exactly what worldly wisdom is.

[00:05:24] Kyle Grieve: So, Robert defines it as, quote, It is an ongoing process of first acquiring significant concepts, the models from many areas of knowledge, and then, second, learning to recognize the patterns of similarity among them. The first is a matter of educating yourself, and the second is a matter of learning to think and see differently, unquote.

[00:05:43] Kyle Grieve: So there’s really only two parts to the process. You know, number one, clay kind of already outlined this acquire the concepts, the different mental models, and just learn what they are. And like Clay said, you know, you don’t have to have a PhD in these things. You just need to understand them to some degree.

[00:05:57] Kyle Grieve: And then the second part is just learn to connect them with the world around you. And obviously we’re going to be pushing this towards investing related things, but you can literally connect it to anything you want. So when you look at mental models this way, it just seems really simple, but if it’s so simple Why is it that so few people think in this manner?

[00:06:14] Kyle Grieve: So I think that was the question that Robert Hagstrom wanted to address when he named the book Investing: The Last Liberal Art. So like you just mentioned, Clay, society sort of pushes us to specialize because, you know, we can live an entire life specializing in just one subject and be incredibly successful while doing it.

[00:06:31] Kyle Grieve: So the notion of learning concepts from many areas of knowledge is very foreign to most people. Let’s say you’re a chemist, then doing your job successfully doesn’t require you to think about concepts from biology, psychology, physics, and economics, for instance. But, this is where Charlie Munger would definitely disagree.

[00:06:48] Kyle Grieve: Charlie concluded that solving problems is often hindered by specialization. So, one of Charlie’s most famous quotes is, To a man with a hammer, everything looks like a nail. Meaning, if you only really have one tool to fix a problem, that is going to be the one tool that you’re going to use. But what if the problem you are solving requires a drill, a saw, a screwdriver, a pencil, or a tape measurer?

[00:07:09] Kyle Grieve: You can’t solve all problems with the one tool, which is why Charlie thought the way he did. But Charlie mentioned in the USC speech that if you only have one mental model in which you see the world, that you will warp reality to fit your models.

[00:07:22] Kyle Grieve: That

[00:07:22] Clay Finck: Munger quote I think is so, so powerful because when you’re able to apply the right mental models to a problem.

[00:07:29] Clay Finck: You’re able to see things that other people literally can’t see because they’re viewing the way through just like a totally different reality. The best opportunities in the markets is going to be opportunities that other people misunderstand. They can’t see it because they’re applying the wrong mental models.

[00:07:46] Clay Finck: And when you look at many of the best businesses, I think they also have a way of just looking at the problem differently. In order to come up with a new solution.

[00:07:56] Kyle Grieve: That’s right. And I just want to jump back into one other thing that you were talking about with metaphors there, Clay. So, I really liked how Robert illustrated the importance of metaphors in helping us understand the world and connect one idea to another.

[00:08:09] Kyle Grieve: So through the use of metaphors, we can more easily understand concepts by relating them to other, more widely known concepts. If we do this enough, we can really super charge our ability to connect one concept with another. So I spent a lot of time thinking about how to improve my own way of thinking like this, and it’s been a pretty uphill battle.

[00:08:27] Kyle Grieve: So I will be going over some methods that I’ve been using to help myself think in a multidisciplinary way in the second part of this conversation.

[00:08:34] Clay Finck: And one other shortcoming that comes to mind of the schooling system is, I mean, this just really hits home for me. We’re just like, Just told to memorize facts, memorize dates, statistics, and all this stuff that you essentially just forget once you’re done with your classes and, but simply memorizing something is really have little use if you don’t know when to apply that information and knowledge.

[00:08:56] Clay Finck: So what Munger referred to as worldly wisdom was having the ability to recall these facts in the right situation, or in other words, using the appropriate tool for when the situation calls for that tool.

[00:09:09] Kyle Grieve: Yeah, absolutely. And I think this ties in really well with what Buffett was just talking about in Omaha a couple weeks ago.

[00:09:15] Kyle Grieve: He said that basically Warren wanted to know just whether things worked or not, but Charlie thought so much deeper. He wanted to know how things work. So, you know, Charlie would be constantly asking himself why to just to get to the essence of the situation. And, you know, Warren and Charlie deferred on this because Charlie just, he really dove into why things worked and more importantly, why things didn’t work.

[00:09:38] Clay Finck: And one more point I wanted to highlight here before we get to the meat of the book, I also can’t help but think about what Munger calls the Lollapalooza effect. Oftentimes the best businesses, they aren’t obvious because they don’t just have one thing going for them. I think the most powerful forces in the markets and within businesses is when you combine many of these concepts together at once, it creates a situation where you have one plus one equals five because the combination of forces creates an exponential force.

[00:10:12] Clay Finck: All in the same direction. I wanted to share the Munger quote that, uh, Hagstrom had in the book here. Worldly wisdom is mostly very simple. There are a relatively small number of disciplines and a relatively small number of truly big ideas, and it’s a lot of fun to figure out. Even better, the fun never stops.

[00:10:31] Clay Finck: Furthermore, there’s a lot of money in it, as I can testify from my own personal experience. What I am urging you is not that it’s hard to do, and the rewards are awesome. It’ll help you in business, law, life, and love. It makes you better able to serve others. It makes you better able to serve yourself. And it makes life a lot more fun.

[00:10:49] Clay Finck: So with that, let’s dive right into the first discipline that Hagstrom covers here, which is physics. And I sense that with physics, many listeners hear that and just want to skip the show or go to another episode. But I believe Hagstrom intentionally included this topic first because by definition, it’s a study of how the universe works.

[00:11:08] Clay Finck: But like we mentioned earlier, you don’t have to be an expert in physics to benefit from some of the key mental models that can be picked up from the discipline.

[00:11:16] Kyle Grieve: So I had so many great takeaways from Robert’s chapter here on physics. So I studied some areas of physics that weren’t highlighted in this book that I think will have some value.

[00:11:24] Kyle Grieve: So I’ll cover those a little bit later, but let’s just stick with some of the main principles that Robert covered for now. So for listening, the first physics related model that Robert discussed was equilibrium. So equilibrium is a great introduction to the wide field of physics, because I think it is widely understandable by everybody.

[00:11:39] Kyle Grieve: So Robert wrote, Equilibrium may indeed be the natural state of the world, and restoring it when it is disturbed may be nature’s goal, but it is not the constant condition that Newtonian physics would suggest. At any given moment, both equilibrium and disequilibrium may be found in the market. So equilibrium is this super crucial concept to consider when looking at the market.

[00:12:00] Kyle Grieve: So if we, let’s say we zoom out, look at the S&P 500, we can see that it’s got about 7.4% inflation adjusted returns over the last a hundred years. So from this stat, we can see that the market will go through phases of equilibrium and disequilibrium. Some years the market might go up 20%. Other years it might go down 20%, but at equilibrium, the market is gently compounding at that 7.4%.

[00:12:23] Kyle Grieve: So I like to look at this when trying to determine where we are in the market cycle. I’ve asked other people where we think we are in the market, and they usually assume I’m asking them where I think or where they think the market is going to be headed. But if you know my investing style, then you probably know that trying to time the market is the furthest thing away from what I’m trying to do.

[00:12:41] Kyle Grieve: And instead, I like the Howard Marks approach of getting a temperature of the market. If you have a general awareness of where we are in the cycle, you can have a better understanding of how much risk is embedded in today’s prices. So when the market is in disequilibrium, you could argue that the prices are swinging widely up or widely down.

[00:12:58] Kyle Grieve: If prices swing widely up, they’re most likely to eventually swing back to equilibrium. And the same for when prices are depressed. As a long term investor who is a net buyer of stocks, I would love to see depressed prices for many of the stocks that I own. It means that I can buy even more great businesses on sale.

[00:13:14] Clay Finck: So I think equilibrium can be a really powerful mental model because there are always opposing forces at play within the market. And I’m personally fascinated by businesses and how they price their products. For example, And how pricing impacts a business’s performance and their sales and whatnot. So just look at my local coffee shop, for example, let’s say they started pricing their lattes at 15 for a cup.

[00:13:41] Clay Finck: Then many customers are going to go into the shop and just walk out the door and just go out to another coffee shop. So the business sees these market forces at play. And recognizes that there’s some sort of disequilibrium because their profits all of a sudden have plummeted due to this pricing strategy.

[00:14:00] Clay Finck: And that same mental model, I think, applies to stocks. So when a stock goes way up and it gets to an egregious valuation, Fundamental investors, they look at their opportunity costs. They’re not dumb. And they adjust to that disequilibrium in the market. So if they’re holding shares in that company, they likely see better opportunities elsewhere in the market.

[00:14:21] Clay Finck: And it goes back to the Benjamin Graham principle that the market’s a voting machine in the short run and a weighing machine in the long run. And And in the long run, the market naturally tends to reach an equilibrium, or in other words, it naturally gravitates towards that intrinsic value. What also fascinates me is when I can find a business that sort of defies the laws of physics.

[00:14:44] Clay Finck: So you see some luxury companies that sell handbags for 10, 000 or more and customers are fighting to get their handbag or a company that’s maybe in an unattractive industry, but their returns on capital are consistently 25 percent per year. It’s like, huh, this company’s doing something different than a lot of other players.

[00:15:04] Clay Finck: And they’ve found some sort of equilibrium that other businesses aren’t able to strike. And the fundamental law of capitalism is that most companies are doomed for failure. The equilibrium or the natural state of the market. Is that others are going to go out and try and eat your lunch. And because of that, companies always have to adapt or they’re just going to fall prey to this gravitational force of capitalism.

[00:15:30] Clay Finck: I’m also reminded of the buffet point that turn around seldom turn. And it reminds me of this, the physics example that an object in motion tends to stay in motion. And so businesses that’s in a decline. It’s much more difficult than you might think for things to turn things around, uh, especially within large organizations with, uh, you know, many people and so many different factors at play.

[00:15:54] Kyle Grieve: So another use case for equilibrium in markets is to use when the market has swung upward in price. So this is obviously just a great signal that the market is becoming much less risk averse. And this means that as risk goes up, I won’t say whether you should stay on the sidelines or not, but I think it’s a very powerful thing to understand when people are deploying money into a market with very little attention to risk.

[00:16:15] Kyle Grieve: So if you know this, it can help you avoid taking unnecessary risks like buying overpriced stocks. If we want to focus on equilibrium at the business level, it fits in very nicely as well. So, you know, businesses rarely follow a linear line upwards, but instead go through some forms of cyclicals swings going up and cyclical swings going down.

[00:16:35] Kyle Grieve: So, you know, obviously there’s extremes at this when we’re talking about cyclicality. So, you know, if we go to one extreme, let’s look at, you know, precious metals, for instance. So when the prices of tin, gold or silver, etc. increase, then these businesses that are engaged in mining that specific commodity often see these massive booms and outputs and therefore in profits.

[00:16:54] Kyle Grieve: But since he’s commodity prices are highly volatile, these profits are unlikely to consistently grow at these previously astronomical rates. And once the commodity price comes down closer to historical averages or even lower, many commodity businesses see rapid decreases in profits in their cash flows.

[00:17:11] Kyle Grieve: So this is why I personally stay away from these types of investments. I just, I don’t like those massive swings. And then if we go to a less severe level, all businesses are still somewhat cyclical. So one of the members of our TIP mastermind community just did a wonderful presentation on MasterCard.

[00:17:26] Kyle Grieve: And in his chat, he discussed how both Visa and MasterCard have outpaced global inflation since 2008, other than in 2020 due to COVID. So Visa and MasterCard are among the best businesses out there, and even they can be exposed to disequilibrium. But the best part, I think, about equilibrium is how long term investors can just take advantage of it.

[00:17:45] Kyle Grieve: One of Benjamin’s greatest contributions to value investing was the Mr. Market analogy. You can argue that Mr. Market is just a manifestation of equilibrium in investor psychology. When Mr. Market is acting normal, he is in equilibrium. And as an investor, there probably isn’t much activity needed when he’s acting that way.

[00:18:01] Kyle Grieve: But when Mr. Market decides to act out and offer silly prices and is in disequilibrium, that’s when we should be paying the most attention. If we know there are four sellers or some sort of macro event that is causing stock prices to go down, We should be jumping for joy as it means we can add to our current positions at depressed prices, or run down our watch list to add companies that maybe we wanted to buy previously, but just couldn’t pull the trigger on because they were so expensive.

[00:18:26] Clay Finck: I’m reminded of a mental model I’ve added over the past couple of years, and that’s realizing sort of what was happening in March 2020. You know, ever since I learned that there was just so much forced selling by so many institutions at play. I hadn’t thought about how really that was a state of disequilibrium in the markets and such an opportunity for long term investors.

[00:18:50] Clay Finck: And Hagstrom also gets into the debate of the efficiency of markets. To achieve outsized performance you’re going to want to look for areas where we can find that disequilibrium. And Howard Marks, he shared on our show that finding great companies is not enough. You’re going to need to find great companies that the market doesn’t view it as great as you do.

[00:19:14] Clay Finck: And you also have to be right in your assessment. So Costco, for example, is a classic example that is priced to perfection because the market realizes it’s an incredible business. There’s no debate about that, but it’s hard for me to see how investors can earn outsized returns at this sort of valuation level for Costco.

[00:19:33] Clay Finck: And the best part is. That it doesn’t matter if my opinion is right or wrong as long as I haven’t taken a position in it. What matters is that a disequilibrium exists in the companies that I do take a position in.

[00:19:46] Kyle Grieve: Yeah. So I love that example you just gave on Costco. Cause I, I see the exact same thing. I think Costco is a tremendous business, but Whenever I just look at it and I run the numbers and try to see what kind of returns I can get, I’m just like, the price just doesn’t make sense to me.

[00:19:58] Kyle Grieve: I don’t know, either I’m missing something or who knows. But yeah, I completely agree with you on that. So another physics related mental model that I want to cover that Robert doesn’t cover in this book is just critical mass, which I think it is super powerful. So critical mass is basically the smallest sum of something like an ingredient, an idea, wealth, anything really that can create a self sustaining entity.

[00:20:19] Kyle Grieve: So when I think of critical mass, I think a lot about a business’s self sustaining abilities. As Warren has repeatedly shown, businesses that don’t require capital to run are an investor’s best friend. So I think if we look at businesses as these self sustaining entities, then the ability to be self sustaining relies on a number of different factors.

[00:20:38] Kyle Grieve: For instance, a business that will die without a constant influx of capital would be viewed as a bad business by Warren Buffett. I think a really good example of this is just, you know, the original Berkshire Hathaway textile mill. In order for the business to reach a critical mass and do what it needs to do, it must constantly be fed new capital, whether that’s new machines, new buildings, new factories, et cetera.

[00:20:57] Kyle Grieve: If it’s not Fed capital, it just simply dies as a business. But a wonderful business often does not require new capital. It may require very little capital to run, have latent pricing power, or be run by an incredibly talented management team. In that case, very little capital is needed for that business to reach critical mass.

[00:21:14] Kyle Grieve: So a very good example everyone on here probably knows is See’s Candies. You just, they barely put any money back into that business and they’ve taken so much money out. So in these types of businesses, no debt is required and the business can just keep growing or, you know, maintain some sort of level of operation.

[00:21:29] Kyle Grieve: But there are very few businesses that can do that. So if you find one, make sure you hold on for dear life.

[00:21:35] Clay Finck: So turning here to the section on biology, I couldn’t help but thinking about Pulak Prasad’s book, what I learned about investing from Darwin, which covers so much on biology. The core idea that Hagstrom focuses on is evolution.

[00:21:50] Clay Finck: So the process of evolution is one of natural selection, and it can help us view the market through a lens of economic selection. So, similar to Prasad’s book, Hagstrom outlined how Charles Darwin, he figured out that species evolved over time and that each species was not static. It was very dynamic. So species with favorable traits would tend to outlive species with unfavorable traits.

[00:22:19] Clay Finck: So we can look at companies in a similar light, Joseph Schumpeter, who was a 20th century economist, he believed that capitalism can be understood as an evolutionary process of continuous innovation. And just like how species, you know, maybe small incremental steps of improvement or decline even companies.

[00:22:38] Clay Finck: I think we can do in the same light as well.

[00:22:41] Kyle Grieve: Yes, I just want to touch real quick on your point there about pool ox point on the pace specifically of evolution. So he summed it up so well in his book. So he said, there is a lovely fractal like property to this phenomenon. It does not seem to matter if the measurement period is thousands of years, in the case of the bears that he uses in the example, or just a few decades, which he uses finches as an example.

[00:23:03] Kyle Grieve: The pace of evolution speeds up over short periods and slows down over extended periods. So his points above here just speak to the fact that when we look at very short periods of time, we can see changes occurring. The market obviously is the best example of this. Every single day we can see daily fluctuations of market prices and what direction our businesses or the market is trending in because we have this information.

[00:23:27] Kyle Grieve: We feel that we, we have to act on it. But at the same token, when we look out, like I just said about the S&P 500 making, you know, constant steady gains over these long periods of time, right? The market, it just, you know, it’s continuing to just do what it does on its historical basis. It’s just climbing upwards, nice and steady.

[00:23:44] Kyle Grieve: So sure, there’s going to be spurts of high growth during a few four periods and heavy losses during recessions and other shocks. But over the long period, the market just continues to go up. So my main takeaway from this is to be very wary of short term signals. These signals can very easily lead us astray, and often the best course of action is just to stay the course and focus on the long term.

[00:24:06] Clay Finck: I think it’s also important here to explain the importance of a complex adaptive system. And this is another topic that Hagstrom covers in this chapter on biology. So the Santa Fe group, they shared four distinct features of markets that make them just extremely complex. And these features all interrelate with biology.

[00:24:28] Clay Finck: So the first feature is dispersed interaction. So you have a number of actors acting within a system and they’re acting in parallel to each other. So this could be out in the jungle, all these animals and plants interacting with each other or in a economy, you go out and people are shopping for coffee, they’re going in order and lunch and they’re doing all these things.

[00:24:47] Clay Finck: The second feature is there’s no global controller. So although we have rules and laws, no one entity controls the economy. So it’s controlled by really competition and then coordination between agents within that system. So the third feature is continual adaptation. And I think this one is pretty Probably one of the most important ones.

[00:25:08] Clay Finck: The reality is that the system is just always changing. Businesses are adjusting their products, they’re adjusting their prices, they’re making decisions based on new information constantly. And then consumer tastes, consumer preferences change. Just the reality is that everything always has and is always going to keep changing.

[00:25:26] Clay Finck: The only constant is changed and we have to adapt to what the market is telling us. So the fourth feature here that make markets so complex is out of equilibrium dynamics. So because the agents within a system are constantly changing their behavior and how they’re acting within a system, This leads to many parts of the economy acting in disequilibrium.

[00:25:49] Clay Finck: If you think about it, if things are in equilibrium, then there would be really no need to change. So there seems to almost always be some sort of disequilibrium that leads to people constantly changing the behaviors. Just think about how the Fed, for example, they’re just constantly changing interest rates every quarter.

[00:26:08] Clay Finck: They’re adjusting it up, adjusting it down there. Their forecast is constantly changing and they’re changing their behavior along with it. So each economic actor is really the same way, how we’re always changing our actions based on our environment. And we can’t predict how our actions are going to change going forward.

[00:26:24] Clay Finck: So it’s just a dynamic system that’s always fluctuating so. After interviewing so many smart people here on the show, you sort of realize how ridiculous it is to predict what the stock market’s going to do over the next year, because the market is a complex adaptive system and people oftentimes create this sort of model in their head where, because X is happening, then the market’s going to do Y, but if X is happening, people’s behaviors are going to change.

[00:26:52] Clay Finck: They’re going to adapt in ways you really can’t foresee. And that’s going to have unforeseen downstream consequences related to this. I’m reminded of the, in the interview I did last year, it was with John Jennings, who wrote this great book called the uncertainty solution in the book. He explained how we all just have this innate, intense desire to know what’s going to happen.

[00:27:15] Clay Finck: You know, humans just hate uncertainty. It’s something that’s hardwired into us. So that’s why everyone just wants to know what’s going to happen over the next year. I’m sure 50 years ago, people are still asking if they’re investors in the market, they’re still wondering what’s the stock market going to do over the next year.

[00:27:30] Clay Finck: And that just is something within us that just is not going to change in my opinion. And since that desire is always going to be there, there’s always going to be people out there that try and tell you what the market’s going to do. And even if we innately know that the direction of the market is uncertain, we still find comfort in listening to people that sound smart because it gives us, you know, that sense of certainty.

[00:27:54] Clay Finck: It helps that uncertain feeling within us sort of wither away a little bit. So I just love that point from John’s book, how, you know, uncertainty is just really a part of markets and we just need to learn to embrace that.

[00:28:07] Kyle Grieve: Yes, that’s a great point. And it’s funny because market forecasting, you know, there’s so much data out there, like you just pointed out that it’s, it just doesn’t work that well.

[00:28:16] Kyle Grieve: And it’s probably not the best use of our time. So this kind of just reminded me of one of my favorite Peter Lynch quotes, which is, If you spend more than 13 minutes per year on economics, you’ve wasted 10 minutes. I found that really amusing. And I think a lot of investors see this quote and probably get a good laugh out of it, but then end up spending inordinate amounts of time trying to guess what is still going to happen.

[00:28:35] Kyle Grieve: So Lynch further elaborates that nobody can predict interest rates, the future direction of the economy or the stock market dismiss all such forecasts and concentrate on what is actually happening in the companies in which you have invested. So I’ve really take this idea seriously, and I try to spend as much time thinking about the 10 individual businesses in my portfolio as close as possible and spend as little time as possible thinking about macro events, interest rates, bond yields or whatever direction the stock market is most likely going to go.

[00:29:03] Kyle Grieve: So Robert does a really good job in this chapter on biology discussing the El Farol problem. So this is a problem that is found out by Brian Arthur, who’s a big part of the Santa Fe Institute, and so El Farol was a bar in Santa Fe. So basically, the way he looked at it was that there’s this bar called the alpha role and it’s really fun bar to go to, especially when it’s not packed full of people and when it’s really packed when you’re shoulder to shoulder with everyone else.

[00:29:30] Kyle Grieve: Not so fun. So Arthur says, imagine that there’s, let’s say 100 people. Is the kind of the upper limit. So that’s where it’s not going to be very enjoyable. 60 people is that lower limit when it’s a lot more enjoyable. Now he says, okay, let’s assume L4Role releases attendance of the amount of people that are coming in to the establishment each day.

[00:29:50] Kyle Grieve: So now people who like the alpha role bar can create their own models off of the attendance to figure out when the bar is going to be less crowded. So given how many people are interested in optimizing their experience at alpha role, there’s going to be a number of different ways and different models that people use to really figure out when they should go to alpha role.

[00:30:08] Kyle Grieve: Some people might correlate attendance to the weather patterns. Others might look at, you know, the previous week’s attendance and others might take daily averages over the last several weeks. Who knows? There’s tons and tons of different models that you could use. But the problem here is that there’s going to be certain days that everyone knows are less attended.

[00:30:26] Kyle Grieve: And obviously if everyone knows that they’re less attended, then that means that the next week everyone’s going to show up that day and it’s no longer going to be a less attended day. The point is that, you know, these models are going to just be incredibly volatile and the L4L is just going to adapt.

[00:30:42] Kyle Grieve: So you’re never going to actually be able to get a constant steady answer. It’s just, so that’s why he uses this problem as kind of a really good representation of complex adaptive systems.

[00:30:52] Clay Finck: I’m also reminded that if there’s something so basic in the market that can be recognized as a disequilibrium, I thought about what our member said in the mastercard presentation that he spends the vast majority of his time on the qualitative aspects of the market.

[00:31:09] Clay Finck: You know, these algorithms and these really smart people on wall street can pick up disequilibriums that are very quantitative, you know, a multiple. High returns on capital or whatnot. If you’re just looking at those metrics, just using that as your investment basis, then oftentimes you’re probably missing something in your assessment.

[00:31:27] Clay Finck: If that’s your basis for investing, really it’s the things that can’t be picked up by an algorithm or can’t be picked up by these types of technologies that offer, I think, individual investors an advantage.

[00:31:39] Kyle Grieve: Yeah, absolutely. And the other thing also to think about is that a lot of these algorithmic businesses, they have a lot of money behind them and they can pay money specifically to have these very small advantages.

[00:31:50] Kyle Grieve: And that’s why it makes sense for them. But for the average person, you’re going to have a very hard time competing with them.

[00:31:56] Clay Finck: So turning to sociology here, sociology is essentially the study of human and group behavior. Markets are essentially the result of groups of people and how those people within groups behave.

[00:32:08] Clay Finck: Which can make this study useful for investors. Hagstrom opens up this chapter with a quote from Sir Isaac Newton. He said, I can calculate the movement of heavenly bodies, but not the madness of men. So for those not familiar with the story of the South sea bubble, Sir Isaac Newton, he got in early on the hype, made a ton of money, saw his friends making even more money and he regretted selling.

[00:32:32] Clay Finck: So he bought back in near the top only to Essentially lose so much of his investment in the crash that followed. What I found interesting about this chapter was the discussion around what makes a market efficient. Because as someone who’s an active investor, I talked about how we’re looking for those states of disequilibrium and those states where the market is in at an inefficiency.

[00:32:53] Clay Finck: So essentially things I think the market is getting wrong. Haxor outlines that there are really two key variables that make the wisdom of the crowd accurate. The first is. The diversity of participants, which can be somewhat counterintuitive. And then the second is independence of thought. So he argues that having a wide diversity actually makes the overall market even smarter than the smartest participant.

[00:33:21] Clay Finck: So a diversity of investors, you’d say a day traders, speculators, smart investors, novice investors, all of these different types of people, which, you know, it seems counterintuitive. If you add a bunch of people that really don’t know what they’re doing, you’d think it would make things more inefficient, but, uh, there’s some data and studies done that show that it actually makes the overall market smarter.

[00:33:41] Clay Finck: So the more diversity you have, the more efficient the market tends to be. And independence of thought essentially means that one person’s decision on a stock isn’t reliant on another person’s decision. So this isn’t necessarily always true when it comes to the stock market. Oftentimes people will Buy a stock because their neighbor, uh, bought it as well and got rich off it.

[00:34:04] Clay Finck: A large amount of independence in the markets, for example, was removed during the tech bubble because, you know, a lot of money was just chasing the same types of companies, which led to this massive disequilibrium because everybody was thinking the same way.

[00:34:19] Kyle Grieve: One of the people who’s influenced me is Michael J. Mobison, and he’s written a ton about diversity breakdown. It’s such an interesting concept because it relates so well to what I mentioned about market forecasting. So, as Clay pointed out, independence of thinking is a key variable to making the wisdom of the crowd accurate. So Mobison has run some really interesting experiments in his classroom that help illustrate just how accurate the crowd can be compared to just one expert.

[00:34:45] Kyle Grieve: So he ran one test, just a jelly bean test. Name how many jelly beans there are in a jar. So the answer was 1116 and the average guess was actually 1151. So very close. So the collective. was very accurate, but the average individual was off by 700 beads. So, you know, they had just wide ranges of answers. So, Mobison writes, the diversity prediction theorem tells us that a diverse crowd will always predict more accurate than the average person.

[00:35:13] Kyle Grieve: Not sometimes, always. So, Mobison further goes on to mention that you can improve the collective accuracy in two ways. One, you can increase the ability or two, you can increase the diversity. So as investors, we have no control over the diversity of the market. It’s just going to do whatever it’s going to do, but we have some control to some extent of our abilities.

[00:35:36] Kyle Grieve: So this can be a bit of a slippery slope because as Mobison would point out, most people like to overestimate their abilities. So But by definition, 50 percent of people will be above average and 50 percent of people will be below average. So the most usable part here, I think, is that if we can observe a breakdown in diversity, then we can better spot opportunities in the market.

[00:35:55] Kyle Grieve: So Clay mentioned events like the tech bubble, there was this huge breakdown of independence of thought. And so when everyone is thinking the same thing due to greed or fear or whatever, when you witness these types of events, this is where the largest mispricings will happen. But because the market will eventually have more independence of thought, these mispricings will close very quickly.

[00:36:14] Kyle Grieve: So if you find the right opportunity, you, you might not have very much time to act on it. So another interesting point about bubbles and this notion of diversity breakdown is the relationship between what Robert Hanks from calls fundamentalists versus trend followers. Most of the time, there is an equilibrium between fundamental focus investors and trend followers.

[00:36:33] Kyle Grieve: When they are in equilibrium, prices are most likely going to be closer to intrinsic value. But as we know from history, bubbles happen pretty regularly. To break down how this happens, we can see that during these events, the equilibrium between fundamentalists and trend followers changes. So let’s say there’s a stock that fundamentalists like very much.

[00:36:53] Kyle Grieve: The stock has been moving up somewhere around the increases in the intrinsic value of that business. But then as that stock price goes up, we get more and more trend followers observing the exact same thing. They’re liking the fact that the stock price is going up. So they begin to buy the stock and they drive the price upwards.

[00:37:11] Kyle Grieve: Now the fundamentalists, they start exiting the stock because they’re like, okay, well, this stock is good, but the price is getting to a point now where just, it doesn’t make any sense. So a lot of these fundamentalists are going to start exiting the stock and selling it. They have willing buyers. These momentum people are just going to keep on buying the stock.

[00:37:29] Kyle Grieve: So this basically results in the fact that you have less fundamentalists and more momentum traders and the equilibrium goes way out of whack. And this can go on for very long periods of time until the momentum eventually stops. And once the momentum stops and the trend followers decide to all exit, you have these massive, Bubbles that pop and it’s not very good to be a holder during that time.

[00:37:52] Kyle Grieve: So this is just a good example and kind of, you know, clay is going to go over some stuff happening with GameStop that’s alive really well with us.

[00:38:00] Clay Finck: Yeah. So I absolutely love this framework of trend followers and fundamentalists. I’m reminded of my recent conversation with Chris Mayer. And he talked about how he really likes to look at each business in his portfolio and then look at how the stock price moved throughout the year.

[00:38:18] Clay Finck: And oftentimes you’ll find a few names that just presented some great opportunities, even over the span of one year. So in a lot of cases, it’s not like you have to wait, you know, five plus years to get into some of these businesses that you like. For example, let’s say a company increases their earnings by 20 percent over the year.

[00:38:35] Clay Finck: You know, say it’s a, just a gradual step up quarter after quarter, their earnings are up into the right, but the stock price doesn’t directly follow the intrinsic value because of this pendulum between the trend followers and the fundamentalists. And I think, you know, that’s really at what’s at play. So the sort of mental model you can use is you see this intrinsic value increase, but then the stock price sort of oscillates.

[00:38:58] Clay Finck: A lot of times above and below the intrinsic value of how the market’s sort of viewing the company. And that’s how you can see these swings between the trend followers and the fundamentalists and people getting excited about it and not getting so excited about it. And Hagstrom also equated stock market bubbles as a social phenomenon, similar to something like an avalanche.

[00:39:19] Clay Finck: Kind of reminds me of the market forecasting stuff. One can never predict what’s going to spark an avalanche and how big the avalanche is going to be because there’s just so much randomness, so many downstream effects that are just unpredictable. And I can’t help but think of talking about the GameStop and AMC stuff that went up 10 X after COVID.

[00:39:38] Clay Finck: And ironically enough, they’re up crazy today here in Mid Bay. The fundamentalists were shorting the stock because they looked at the business and they just thought this thing’s going to become bankrupt essentially. But there was a social phenomena where you had these group of people on Reddit. They all bought into the stock.

[00:39:57] Clay Finck: They all bought into the story. The stock goes way up and then the fundamentalists that were short, they get these margin calls that pushed up the price even more, which encouraged even more of these trend followers to jump on board. And just this irony to this, where things become mispriced to the upside and for short sellers are forced to buy back in.

[00:40:16] Clay Finck: And then these trend followers pile back on. But eventually you run out of trend followers. And if enough people are up five X or 10 X, then they’re going to start taking profits and the cycle reverses. And then the shorts pile back on. And it goes back towards its equilibrium. So I guess that’s my way of saying buyer beware.

[00:40:34] Clay Finck: I think the major takeaway from this chapter though, is that since we have all these different actors, you know, within a system living within their own reality of the right way to invest, then you’re going to get these temporary periods of instability. Transcripts provided by Transcription Outsourcing, LLC.

[00:41:09] Clay Finck: And then things got pretty bubbly in 2021. And then even today there’s certain pockets of the market that are pretty hot. And I think another takeaway is that some stocks are going to be dominated by people that are just operating within a different reality of what many other, types of investors deemed to not really be rational.

[00:41:29] Clay Finck: So for example, maybe I’m crazy, but Kyle and I may never buy a company like NVIDIA. And if NVIDIA is the hottest stock on the market, then that doesn’t mean that we have to hop on board or that we have to try and make sense of it. We may even like the company itself, but if the stock is dominated by trend followers, then it may never get to a price that we can really make sense of.

[00:41:51] Clay Finck: So you want to focus on stocks where hopefully there’s less of those trend followers, hopefully less in the headlines. And in the news that, you know, it’s out of the limelight of where these trend followers are looking for companies that might be big movers.

[00:42:06] Kyle Grieve: Yeah. So those are great case studies there and in GameStop and Nvidia.

[00:42:09] Kyle Grieve: And I agree with you. So I think it’s fair to say that I, like you have no interest in really either of those businesses, but it’s interesting when I talk to people about GameStop, which I did actually look at pretty in depth many months before the original run up. So people always assume that I was upset with myself for not taking part.

[00:42:26] Kyle Grieve: And honestly, I wasn’t. So, you know, the business just, it didn’t make sense to me and it was not a high quality business. And I still don’t think it’s a high quality business today. And you know, yes, there was this short angle squeeze, but that was a game that I just had zero interest in playing. And therefore I just didn’t take part.

[00:42:43] Kyle Grieve: So I’m totally fine with that decision. And, you know, even though I could have made many multiples on my initial investment and I missed it perfectly fine, you don’t need to be part of literally everything that goes on in the market. Another point you made there was about the feeling or the need to hop on board of a stock when the price has run up.

[00:43:00] Kyle Grieve: So I actually prefer taking, and I think Clay would probably agree with me. He like prefers taking the opposite stance where maybe we’re looking for a business that are currently unloved by the market and everyone’s maybe trying to hop off. So this gives me the ability to buy them at a very good price and de risks the investment due to the lower purchase price.

[00:43:17] Kyle Grieve: So yeah, that’s a good point. This might seem very obvious to many listeners. We study billionaires because we have a lot of value investors out there, but trend following is just a dangerous game to play. You have no idea when the trend will end. And when it ends, it usually ends with a bang, not a whimpers, meaning you expose yourself to large amounts of downside risk.

[00:43:33] Kyle Grieve: The power of greed also just pulls us into making investments into something that has been trending up. That’s why a lot of people are end up being trend followers. But I would suggest that you try to be as robotic as possible in your analysis and stay away from investments where the price just doesn’t make any sense.

[00:43:51] Kyle Grieve: If you’re patient, long term investor, you can wait for trend followers to leave, in which case buying can often be a really good option because now you’re going to have that disequilibrium in the direction that makes sense for people who are buying. So lastly, I just wanted to mention an important point about quality shareholders that Lawrence Cunningham has done a brilliant job writing about.

[00:44:07] Kyle Grieve: So if you could find a business with a high concentration of quality shareholders, which in the, in Robert Hagstrom’s lingo would just think about fundamentalists who are long term oriented, you’ll probably find that holding the stock is going to be even easier. So if you look at businesses like say Berkshire Hathaway or Constellation Software, do they have some volatility?

[00:44:27] Kyle Grieve: Yeah, they do. But both Warren and Mark Leonard have mentioned that they don’t really want the stock to go super high above or super high below the intrinsic value of the business. They said this like publicly. So they feel that if this happens, they know they have a lot of quality shareholders and that it will benefit these shareholders because holding the stock is much easier when the price isn’t violently swinging, which can cause overtrading.

[00:44:49] Kyle Grieve: So, you know, if you look at some of these high quality businesses, they’re just easier to hold as an owner because you know, they don’t attract that many trend followers. So just another thing to think about.

[00:44:59] Clay Finck: It’s funny too, when the managers talk down a stock that can also keep some trend followers away too, because people are less likely to get excited about it, especially when the CEO isn’t as promotional.

[00:45:11] Clay Finck: And I had mentioned there to potentially avoid companies that are sort of in the limelight, but I think meta can be a caveat to that where it’s in the limelight, but it’s not getting the positive press. It’s getting the negative press and it really just sort of feeds on itself. On the downside and you know, so many people obviously cover that stock, watch that stock, but it’s still like a lot of people just missed the massive opportunity in hindsight, at least that was there.

[00:45:35] Clay Finck: Yeah. It’s just as interesting case study. I continue to visit over and over again. The last section we’re going to be covering today is psychology. Psychology is really the study of how the human mind works, which in my opinion is one of the most interesting parts about being a host of the show and studying the game of investing.

[00:45:55] Clay Finck: So Daniel Kahneman, he’s done a ton of research related to behavioral finance. A lot of the terms we talk about on the show really originated from him. You think about anchoring, framing, overconfidence, loss aversion, the list goes on. We always like to tell ourselves we behave and we think rationally, and we always do what’s best for us.

[00:46:15] Clay Finck: But every single one of us is irrational to some degree because of these behavioral biases. So look at loss aversion. For example, Kahneman was able to prove that individuals are loss averse. So it’s really just hardwired into us. Again, mathematically Kahneman proved that people regret a loss more than they welcome a gain by up to two and a half times.

[00:46:38] Clay Finck: So in other words, if I were to have a 5, 000 loss, that would hurt twice as much as the pleasure I would get from a 5, 000 gain. So one of the parts I found interesting on this was the discussion around the equity risk premium in particular. This is a topic we hardly ever talk about on the show. So I’ll give a brief definition here.

[00:46:58] Clay Finck: The equity risk premium, it’s essentially the additional return that investors demand for investing in stocks. relative to bonds. So let’s say bonds right now, government bonds, pretty close to risk free relative to other investment options out in the market. Let’s say they pay 5%. And that’s essentially the risk free rate.

[00:47:19] Clay Finck: If the stock market is priced at say a 10 percent return, or maybe some of the companies in your portfolio are priced at a 10 percent expected return, then your equity risk premium would be the difference between the two. So 10 minus five is a 5 percent equity risk premium. So Kahneman was really interested in this because the difference seemed particularly high given that historically equities have outperformed bonds.

[00:47:43] Clay Finck: When you look out over a long enough time horizons, you know, I think a lot of people would think that it. It would be priced a bit closer. So it also brings a question like, why would anyone own bonds? If you know, you’re going to get a 5 percent return instead of 10%. So Kahneman, he reasoned that because investors, they commonly check their portfolios and they know there’s a risk that stocks might drop 10, 20, 30, 40 percent in a year.

[00:48:08] Clay Finck: Then they’re much more hesitant to invest in stocks because of that potential loss in the short run. And humans also, I talked about certainty and uncertainty earlier. Humans value a certain outcome over an uncertain one. And stocks are much more uncertain than bonds over shorter time horizons.

[00:48:27] Kyle Grieve: That’s right.

[00:48:28] Kyle Grieve: And so there’s another concept that Robert Hagstrom mentions here, which was myopic loss aversion. So Hex wrote the following in my 28 years in the investment business. I have observed firsthand the difficulty of investors, portfolio managers, consultants, and committee members of large institutional funds have with internalizing losses, loss aversion.

[00:48:46] Kyle Grieve: Made all the more painful by tabulating losses on a frequent basis, myopic loss aversion. And overcoming this emotional burden penalizes all but a very few select individuals. So, can you guess the one person who has most brilliantly overcome myopic loss aversion? If you guessed Warren Buffett, then well done.

[00:49:05] Kyle Grieve: So, Warren has overcome the common psychological tendency from his vast experiences in his understanding of thinking of stocks And businesses in the same light. So because Buffett has this vast experience of both fully owning businesses and partially owning businesses. He thinks of businesses in terms of their operating fundamentals and not in terms of the fluctuations in the stock price.

[00:49:29] Kyle Grieve: So the other thing he does that, you know, most fund managers do is he looks at performance over many years, not over many quarters. So Robert gave a very good example of how Warren has succeeded, even though loss aversion would have made the average investor feel nauseous taking the same action. So like Clay just mentioned about, you know, how we feel losses worse than we feel gains.

[00:49:49] Kyle Grieve: So let’s just take a look at Berkshire’s investment into Coke between 1988 and 1998. So over that time horizon, it worked out great. Coke was a 10 bagger while the S& P 500 was only a three bagger. But when we look at this investment through the lens of loss aversion, it’s the investment is just seen in a different light.

[00:50:07] Kyle Grieve: So during the 10 years that Warren held Coke, Coke actually underperformed the market four times and outperformed six times. So yeah, that’s great. But if we look at it from an emotional unit, we know that like, oh, performance, we give it one unit. So that’s six total units and underperformance is four, but that’s doubled, right?

[00:50:23] Kyle Grieve: So that’s eight. So you get a net negative experience from owning cocoa or that 10 year period, despite it being a 10 bagger, which. You know, it’s just kind of mind blowing, but since Warren Buffett doesn’t concern himself with a short term, he’s able to just withstand these drops in the share prices because he’s just, once again, he’s looking at the fundamentals of the business.

[00:50:41] Kyle Grieve: So if you can clone this decision that Buffett does to try to look long term, you can see how much upside there is, even though in the short term, there’s going to be times where the stock market is just telling you sell, sell, sell, you know, stop the pain. I also wanted to touch on Clay’s point here about how the stock market has outperformed bonds.

[00:51:00] Kyle Grieve: Clay made a great point. You know, the stock market has historically outperformed bonds and all other asset classes, but I just wanted to go on, go and talk about why this is a little bit. So. My favorite reasoning from this was from we lose wonderful article, the prospect of value investing in China. So in it, he looks at stocks as an asset versus other assets, such as bonds and cash and some other things.

[00:51:21] Kyle Grieve: And his explanation is really simple for why stocks have outperformed. Essentially, net profits over the last 200 years have grown at about six to seven percent per annum. And that is tends to be the historical return of the stock market during that time period as well. So the other way he looked at it as well was if you invert the historical price to earnings ratio of the index, which is 15, you get 6. 7 percent earnings yield, which again is pretty similar to the long term gains of the stock market. Just to compare that bonds have historically returned just three and a half percent. So just kind of piggybacking on what Clay was saying about bonds is that, you know, obviously you get these coupons that bonds pay and you know, there’s a very high certainty that you’re going to get it. So people who are more risk averse are going to like bonds. So, you know, you’re basically guaranteed to get these coupons and the chances of you not getting them or the chance of your principal going down are very slim. So my dad actually fits this mold exactly. He absolutely hates seeing when his savings go down.

[00:52:19] Kyle Grieve: So he’s basically just taking the strategy of investing almost all of his savings into bond ETFs that way he doesn’t have to deal with those losses.

[00:52:28] Clay Finck: And I think within the stock market, even there’s a lot of investors who don’t like holding volatile stocks. So that can also present opportunities for investors who seem to find pleasure in volatility, volatility.

[00:52:42] Clay Finck: So Charlie Munger, he’s well known for highlighting this type of faulty thinking that we can have in his well known speech on the psychology of human misjudgment. And this is also covered in Peter Bevlin’s book titled Seeking Wisdom, which is a wonderful read. And I constantly have to remind myself that we all think that we think rationally, but it’s nothing of the sort.

[00:53:03] Clay Finck: We’re highly influenced by our emotions and our emotions can blind us to rationality. I really can’t help, but also highlight the importance of understanding incentives when you have the right incentive structure in place, and you have incentives that give you the result that you want, then the desired result tends to give you a much greater chance of happening.

[00:53:24] Clay Finck: Whereas when you look at a business where it feels like the company is constantly trying to push a boulder uphill, the entire incentive structure is just totally messed up. And then, you know, Charlie’s favorite business outside Berkshire is Costco. You can think about how each party in the Costco business model And you know how they sort of interact with each other.

[00:53:47] Clay Finck: So the main parties that come to mind is the shareholders, the managers, the employees, the customers, and the suppliers. So as Costco grows, each party is really better off. So shareholders get strong returns on capital, managers get compensated fairly, and they’re aligned with shareholders. Employees are well compensated and to my knowledge have a fairly good work environment.

[00:54:11] Clay Finck: Customers get a superior value proposition, and then the suppliers just get bigger and bigger orders from Costco to stock their stores. And I think of this as almost a business working in harmony. And then you look at other businesses. It just isn’t structured the same way. Maybe the business is dependent on low wage workers.

[00:54:29] Clay Finck: Maybe they have poor working conditions, high amount of turnover. Or maybe the management team is incentivized based on revenue growth or EBITDA, which isn’t optimal for shareholders. So the parties are at odds with each other and you know, one party’s win is another party’s loss. Another lesson from Munger’s psychology of human misjudgment is that most of us tend to be overconfident in our abilities, but Mobison reminded us by definition, 50 percent of us are going to be below average.

[00:54:58] Clay Finck: So with this overconfidence, we assume that bad things aren’t going to happen to us or happen to companies that we happen to own. And I have to constantly remind myself of my own limits and what I think I know. So when things are going well, it’s easy to be overconfident, think we’re smarter than everyone else.

[00:55:15] Clay Finck: And then, you know, it’s so easy to lie to ourselves and make ourselves believe we’re so smart when things are going well. And then when things aren’t going so well, it’s easy to tell ourselves that we just didn’t get lucky. So whether things are going well, whether they’re going poorly, we always need to be open to the possibility of being wrong and open to other people’s viewpoints and how they’re seeing things.

[00:55:36] Kyle Grieve: I love how you mentioned incentives are clay. So one of my favorite Charlie Meyer quotes is, I think I’ve been in the top 5 percent of my age cohort all my life in understanding the power of incentives and all my life I’ve underestimated it and a year never passes, but I get some surprise that pushes my limit a little bit farther.

[00:55:52] Kyle Grieve: So, you know, incentives are so crucial for understanding if you want to invest well and invest in really good companies. We always need to remember that management teams will chase the incentives that the board has designated to them. If they have incentives that upon a shareholder value, you should take that as a major red flag and just skip the investment entirely.

[00:56:12] Kyle Grieve: But Charlie understood this so well. And that’s why he paid very close attention to making sure that the incentives of the people he trusted at the company level to manage his businesses were incentivized to create alignment with shareholders, and more importantly, incentivize to create shareholder value.

[00:56:27] Kyle Grieve: So one of the evolutions of my investing analysis has also been towards really paying way more attention to incentives. So when I first started investing, just didn’t look too much at the incentive structure for management. And now, as I’ve learned, and as I’ve studied Charlie Munger and understood how much he, how much importance he puts on incentives.

[00:56:48] Kyle Grieve: I really spend a lot of time trying to understand it at a pretty deep level. So, you know, I want to know a few things. Does management have skin in the game? What key performance indicators are they incentivized to accomplish? Are there key performance indicators aligned with creating shareholder value?

[00:57:04] Kyle Grieve: Do managers think long term? The list really just goes on, but you want to make sure that you are in business with people that you are aligned with. And this matters both for private and public businesses. So I want to end this section just by mentioning how Stig has carefully constructed his incentive structure at TIP in the same light that Warren Buffett and Charlie did with Berkshire.

[00:57:24] Kyle Grieve: So Stig, understood very well that people working in an area of TIP would maybe have very little impact on other divisions of the business. So we are incentivized to create value in the specific segments that we work in. If one of the segments that we work in provides no value to TIP then, you know, we’re not incentivized and I think it’s a very fair way to do it.

[00:57:43] Clay Finck: You had mentioned constellation software earlier account from Twitter. It’s called seeking winners. They sent me this great write up on Lumine, which is a spinoff of constellation. One of the great points they made on what the constellation family has sort of figured out is that as headcounts grow within an organization, the complexity within the business just skyrockets.

[00:58:06] Clay Finck: So many of us know that as businesses grow, bureaucracies starts to creep in, you know, and, and employees, you know, they start having to operate within these guidelines within these principles. And this really stifles innovation because now everyone feels like they’re just walking on eggshells, trying not to break the rules.

[00:58:25] Clay Finck: So what Lumine did to counter this is they kept individual businesses units small to keep that entrepreneurial spirit intact. And essentially you have all these small companies within a larger holding company and all of them are essentially acting as if they were independent. And they may have also adopted this strategy from Illinois tool works, which is a company that Mark Leonard studied and this company under their CEO’s leadership, John Nichols, they grew revenue by acquiring and splitting businesses into these smaller independent units.

[00:58:57] Clay Finck: So I wanted to mention the incentive structure at Lumine that stood out to me and point to some of the items you talked about in that list there, just to use Lumine as an example. And Kyle and I don’t own shares in this company. So the board members, to my knowledge, they all own shares and they either came from the constellation family or they’re intimately familiar with the underlying business units within Lumines and they are required to invest 50 percent of their bonus into Lumines shares.

[00:59:25] Clay Finck: And then second, a significant portion of the managers bonuses are used to purchase shares of Lumine on the open market. So this incentivizes the managers to think like owners. And then there’s also a lockup period of three to five years. So they aren’t going to be, you know, making these acquisitions to try and boost the stock price over the next year.

[00:59:43] Clay Finck: Cause they know they have to hold it for. At least three or five years. And oftentimes I think you see these managers just hang onto their shares for a really long time. And then bonuses for managers are tied directly to the company’s performance. So it’s their bonuses are calculated based on some calculation between the difference between return on invested capital and the cost of capital.

[01:00:05] Clay Finck: So to put this in plain English, this means that managers only get a bonus if they’re creating shareholder value which is wonderful as a shareholder. Then what’s oftentimes overlooked is that there’s a lot of software companies that dilute shareholders through stock based compensation. And one of, uh, our previous episodes of TIP, I recall the typical company in the S&P 500 does something like one to 2 percent dilution through stock based compensation.

[01:00:34] Clay Finck: And it’s even more prevalent in software companies. So since Lumine and the other constellation companies won’t be doing any of this stock based comp, that alone adds two to 4 percent to the returns for investors relative to other software companies. And then all of these factors combines, I think really creates a strong alignment between the managers and shareholders to use this company Lumine as an example.

[01:00:57] Clay Finck: And then Joseph Sheposhnik and I a couple of months back on our episode, also discuss incentives. He’s targeting to own businesses that increase their free cashflow per share at a rate greater than the market. So ideally he wants some sort of incentive in place that encourages managers to do that. He used an example of Walter’s Clure, whose management team is incentivized based on sales growth, free cashflow growth.

[01:01:22] Clay Finck: And return on invested capital. So he explained how they have these guardrails in place where they’re incentivized to play offense, but also play defense as well, where they’re paid to compound free cashflow per share and a compound revenues as well. But at the same time, they have to do it while getting a good return on their capital.

[01:01:43] Clay Finck: And they have a really strong history of doing that. The free cashflow per share is up three X over the past 10 years. And then do you contrast that with the business that incentivizes based on EBITDA or EPS? And then you see managers act on what he calls their animal spirits and go make a bad acquisition, dilute shareholders as well in the process.

[01:02:05] Kyle Grieve: When I look at just the Constellation family of businesses, that’s part of the reason that I like the businesses so much that I look at a lot of incentive programs now, because I find it really interesting. And I still, I don’t think I’ve found one that’s better than Constellation or Topicus or Lumine, which they’re all similar, but it’s just, it’s such a tremendous way to create shareholder value and through, through the system, like clay was saying, a lot of these managers, they just end up holding their stock in the company. So I know Mark Leonard’s made it a goal to just generate a bunch of millionaires who are inside of constellation and inside of, you know, it’s umbrella businesses.

[01:02:37] Kyle Grieve: So, yeah. It’s just a tremendous way of adding shareholder value while also incentivizing managers and really aligning them together.

[01:02:45] Clay Finck: Yeah, I’d made a note to Kyle and I are going to be continuing this, the discussion on this book and the episode that goes out in a few days. But Chris Mayer shared this wonderful chart of what drives shareholder returns.

[01:02:58] Clay Finck: And I’ll briefly mention it here. So in the short run, it’s really driven by sentiment and the change in the multiple. But over the long run, it’s driven by people and culture. And to take the incentives one step further, I think Constellation Software with their business model and the way they operate and how they think very long term, you don’t go to Constellation to get like a giant pay grade and try and get rich, you know, really quickly.

[01:03:24] Clay Finck: Maybe like something like investment banking or something where you just kind of work to death and, you know, make your money and get out constellation. They want a culture where people are thinking longterm and there’s this culture that is brought about as a result of that. So the company, tracks the right people and then these people, you know, just grow and get better together.

[01:03:43] Clay Finck: So I think there’s something really powerful there within the incentive structure within that culture as well. That’s really powerful. So that wraps up today’s episode. Kyle and I are going to be continuing this chat here in a few days. So be sure to check out that episode as well. Thanks for tuning in.

[01:03:59] Clay Finck: And I hope to see you then.

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