The Value of Being Approximately Right

Aug.18.08 | About: American Express (AXP)

Buffett said something to the effect of: “I would rather be approximately right than precisely wrong.”  Everyone should agree with that maxim, but in the business world, many processes don’t work that way.

Take auditing as an example.  I’ve only experienced it as an actuary working in financial reporting, and it amazed me to see the detail work that they went through of checking cash flows (which should be done — how else do we detect fraud?), but with little to no attention on reserving assumptions.  Spending time on the “bigger picture” questions is important, and shouldn’t be neglected.

Or, consider earnings spreadsheets that analysts do.  They can be valuable, but I find it more valuable to look at the broader industry picture to see if an industry as a whole has a favorable economic picture, or, might be close to a turning point.

Then again, I think more like a portfolio manager, and less like an analyst.  That makes me better for some tasks, and not others.  My boss at Provident Mutual taught me the you need to identify the main 2-3 drivers of future profitability, and focus on them, because they will drive 80-90% of the results.  (I call this Cioffi’s Rule.)  If you get the main factors right, you will make more money than most investors.

Sometimes, I get labeled a lightweight because I don’t dig deep on certain issues.  I’m just trying to stay focused on the important issues.  Now, on financial stocks today, I own a bunch of insurers that put me over market weight for financials, but I own no credit-sensitive companies.  Even high-quality names are under stress.  (Consider the rate American Express had to pay to borrow money recently.  And I thought MetLife had it bad.  Ah, to be a corporate bond manager again… there are bargains to be had if one has an adequate balance sheet.)

What we don’t know is a significant factor.  I need to see some significant failures before the financial sector will be interesting.  I’m not investing to be courageous.  I’m here to make money over the cycle on a risk-adjusted basis.  It’s not that I avoid risk, it’s that I avoid taking it when I don’t see that I am paid to take it.

Also, even though my portfolio is concentrated, with 35 almost-equally-weighted companies, I avoid going “socks-and-underwear” (as my Dad would say playing Sheepshead) on any single company.  Even on industries, I try to be measured in my overweight positions.  But the objective is to take risk when you are being paid to do it, and avoid it otherwise.  Focusing is a popular strategy, and those who do well at it do very well.  Those who fail at it fail big.  On average, the strategy of focusing doesn’t of itself add value.

My eight rules help me be approximately right.  That doesn’t mean that I don’t make mistakes.  I make mistakes, and sometimes they are big.  But, my mistakes haven’t been frequent and big.

Consider this as you invest.  Focus on the big factors that affect profitability, and look for positive industry trends that are underdiscounted, and negative industry trends that are overdiscounted.  And, in the process, only buy companies that you know will survive.  More money is lost buying marginal companies than is gained.  Remember the margin of safety concept.  Your first job is not to lose money, so choose wisely.

Disclosure: Long MET