The Punch Card Mindset
“I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches–representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you would do so much better.”- Warren Buffett
Many Buffett and Munger pupils preach following the “punch card mindset,” yet very few actually do. I really think applying this filter has made all the difference for me in my evolutionary process as an investor, and I’m quite confident it will dramatically improve your results as well; especially if you are striving to be a focused investor like Geoff and myself. What does following the punch card mindset mean to me? It means doing the due-diligence required to get to a level of certainty that you are willing to put 20%+ of your net worth in a single idea. It means not succumbing to the daily irrational swings of Mr. Market, and being able to stick to your original thesis if nothing fundamentally has materially changed within the business. It means not laying out capital unless you feel like the odds are so heavily in your favor that heads, you’ll make money, or tails, you can at least break even or not lose that much. It is easy to talk the talk, but actually putting it into practice can be much more challenging, as It should be. After all, why should It be easy to become rich? You need to be okay with the fact that not every stock you look at will be a punch card worthy investment. Logically speaking there would be no such thing as the punch card mindset if so. Success in investing to me is saying no a lot more than you say yes. The best part about investing though is even if you say “no” to an idea, the amount of work you did to get to that decision can be extremely useful to you. Everything in investing is all cumulative. All knowledge stores up like compound interest. So even if you feel like you are not getting anywhere because you are not finding any actionable ideas, trust me, you are. Just keep your head down and keep chugging along.
“The most important three words in investing may be: “I don’t know.” Having strong viewpoints on a lot of securities, and acting on them, is a sure-fire way to poor returns in my opinion. In my view, it’s easier to adopt this “I don’t know” ethos by focusing on the business first and valuation second, as opposed to the other way around. I’ve found that when valuation is the overriding driver of interest, I’m prone to get involved in challenging businesses or complicated ideas and liable to confuse a statistically cheap price with a margin of safety.” — Allan Mecham
Ever since I came across this quote in Allan’s interview with Manual of Ideas it has really stood out to me. I actually have this quote framed on my office wall so I see It every day and have it imprinted on my brain. I truly think it may be the best investing advice I have ever read, and it coincides directly with the punch card mindset. Everyone in the investing industry likes to act like they know everything about everything (is smart beta, smart?) and you really need to understand that you must not fool yourself, and that you are the easiest person to fool. The first step to understanding something is simply understanding that you do not know something about the particular subject, and then taking the steps forward to learning about it. Intellectual honesty can take you far in investing (and life for that matter). Saying “I don’t know” keeps you out of businesses that you do not fully understand. Saying “I don’t know” doesn’t let the daily noise creep in. Saying “I don’t know” allows you to focus more on the true business fundamentals instead of the daily price movements of the stock. Always remember that markets move faster than real businesses do. The stock market in the short term is a voting machine; voting on emotions, traders trading, headline news, politics, etc. But in the long-term It’s a weighing machine; weighing to the true fundamental facts of the business. Therein between lies opportunity for you and I. Below are some steps to assist you in developing the punch card mindset.
- Use an investing / mental model checklist — Airline pilots fly hundreds of times in their career, yet they go through the same routine checklist on every flight. Why? Because the brain has blind spots. Using checklists will help guard against this and ensure you have thought about an investment from all angles. Be sure to check ours out, and understand that it’s constantly being added to because we are all constantly still learning.
- Change your research process from starting at companies that may be “statistically cheap” to studying businesses that are incredible businesses that you would like to own at a future lower price. Build a watchlist of these companies and wait for Mr. Market to give you your fat pitch. Every smart investor I know does this.
- Always invert and look at your investment ideas from different angles. Ask yourself: why is this investment idea available? Why are people selling? What could kill this business? How did this business do in 2008 or other crisis situations?
- Keep it simple. An investing idea should hit you on the head and be a complete no brainer. You shouldn’t need a 30 tab excel file to justify making an investment. Stay away from complex formulas, always use back of the envelope math.
The obvious question that you may be thinking about is how do you know when you are wrong and your thesis is broken? Do you double down or sell out? There are a lot of smart investors that doubled down on Valeant thinking the long-term thesis was intact and they ended up losing their shirt. Of course, this really is more of an art than a science, but from my experience I would say be careful when doubling down on companies if they are highly levered. Valeant was a prime example. Warren Buffett doubled down on Coca Cola safely and successfully, but he didn’t double down when he lost his whole investment in Irish Banks. So, I really think it becomes tricky if you are dealing with companies that are levered. Bill Miller took some huge hits on: Wachovia, Citigroup, Countrywide Financial, Washington Mutual, and AIG. All companies that had levered business models. At the Daily Journal investor meeting this year in California Charlie Munger was asked “So if you had a foundation today with let’s say a billion dollars, would you be comfortable with it being invested in just three stocks?” His response is as follows:
“Am I comfortable with a non-diversified portfolio? Of course…if you take the Munger’s, I care about the Munger’s. The Munger’s have three stocks. We have a block of Berkshire, we have a block of Costco, we have a block of Li Lu’s fund, and the rest is dribs and drabs. So am I comfortable? Am I securely rich? You’re damn right I am. Could other people be just as comfortable as I who didn’t have a vast portfolio with a lot of names in it? Many of whom neither they or their advisors understand? Of course they’d be better off if they did what I did. And is three stocks enough? What are the chances that Costco’s going to fail? What are the chances that Berkshire Hathaway’s going to fail? What are the chances that Li Lu’s portfolio in China’s going to fail? The chances that any one of those things happening is almost zero. And the chances that all three of them are going to fail…”
The three businesses Charlie is involved with for majority of the Munger’s net worth all employ little to no leverage. So, if you are going to follow the punch card mindset and create a concentrated focused portfolio, I think it’s best to stay away for companies that have levered business models. He continued by saying:
“That’s one of the good ideas I had when I was young. When I started investing my little piddly savings as a lawyer, I tried to figure out how much diversification I would need if I had a 10% advantage every year over stocks generally. I just worked it out. I didn’t have any formula, I just worked it out with my high school algebra. And I realized that if I was going to be there for thirty or forty years, I’d be about 99% sure to do just fine if I never owned more than three stocks and my average holding period is 3 or 4 years. Once I’d done that with my little pencil, I just…I never for a moment believed this balderdash they keep…why diversification…diversification is a rule for those who don’t know anything. Warren calls them ‘know-nothing investors’. If you’re a ‘know-nothing investor’ of course you’re going to own the average. But if you’re not a know-nothing investor, if you’re actually capable of figuring out something that will work better, you’re just hurting yourselves looking for fifty when three will suffice. Hell one will suffice if you do it right. One. If you have one cinch, what else do you need in life?”
To demonstrate an idea that I thought was a punch card worthy investment that Geoff and myself both profited from, you can study the company: Breeze-Eastern. Geoff’s original write up on the company is a great read and is right here. The high-level overview was we were buying a company that pretty much owned the market it was in, had staying power, had a very strong moat, incredible margins, could earn a 20+% return on equity without using debt, all for 7x’s EV/EBIT. At the time, I really viewed it as a no-brainer investment. I backed the truck up at around $12.00 per share, and they ended up getting acquired by TransDigm for $19.61 per share a little less than a year later; a price that I thought was under their true worth.
Key Takeaways
- Working to develop the punch card minset will greatly help your odds in investing
- Success in investing is saying no a lot more than saying yes
- If you develop the “I don’t know” ethos, it will keep you guarded from fooling yourself
- Build a watchlist of companies that you would like to own at a future lower price is Mr. Market gave you a chance,
- Keep it simple – an idea should be a complete no brainer and make all the sense in the world
- Create a checklist to help guard against blind spots
- Invert
- Wait for your fat pitch