Reading Roundup: August 2023

This Month We Read:

• Range: Why Generalists Triumph in a Specialized World by David Epstein

• An Outsider’s Guide to Humans by Camilla Pang

• How to Decide by Annie Duke

• Chaos Kings: How Wall Street Traders Make Billions in the New Age of Crisis by Scott Patterson

• Blind Man's Bluff: The Untold Story Of American Submarine Espionage by Sherry Sontag

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Range: Why Generalists Triumph in a Specialized World by David Epstein

In Range author David Epstein argues against the conventional wisdom that specialization is the key to success. Modern society tends to promote early specialization, encouraging people to focus on a single domain from a young age. This approach is based on the belief that expertise in a specific area leads to success. Epstein argues that success in most modern environments is the result of knowledge transfer — synthesizing a solution from ideas and patterns borrowed from different domains.

We’ve all heard about the 10,000 hours rule which says that people need 10,000 of specific, focused practice to become an expert. When we see someone succeed, like Rodger Federer at tennis, Charles Darwin at science, Vincent van Gogh at art, or J.K. Rowling at writing, we assume that they’ve been honing their craft since childhood.

Epstein debunks this myth. Federer played a wide variety of sports, including soccer, basketball, and skiing before choosing to pursue tennis as a teenager. Darwin studied geology, botany, and paleontology before revolutionizing biology. Van Gogh was a teacher and an art dealer and didn’t paint his famous work until his late 30s. J.K. Rowling was a researcher, secretary, and English as a foreign language teacher before writing Harry Potter.

Epstein argues that a diverse and eclectic background prepared each of them better than if they’d specialized from childhood. Charlie Munger would say they built a latticework of mental models they could apply to their chosen field. These unconventional “tools” gave them an edge over conventional specialists who all had the same domain-specific knowledge. Their breakthrough was from applying patterns and ideas from disparate domains to a new one, not rote specialization.

Epstein writes:

You have people walking around with all the knowledge of humanity on their phone, but they have no idea how to integrate it. We don’t train people in thinking or reasoning.

Why has society gotten specialization so wrong? Epstein distinguishes between “kind” and “wicked” learning environments. Kind environments, like chess and golf, are well structured with fixed rules and predictably repeatable patterns. Wicked environments, like medicine and the stock market, are complex, uncertain, and change rapidly. There are no fixed, immutable rules (think about WTI crude oil going negative in April 2020).

While specialization can be effective in kind environments, generalists excel in wicked environments. A few thousand years ago the world was relatively stable and predictable. Today technology is changing the world as fast as ever. A bank run that would have taken weeks in the 1930s is over in an afternoon now. Fields are developing so fast that specialists can’t possibly keep up.

Of course some specialization is necessary. Epstein doesn’t argue against specialization. He argues for delayed specialization. Delayed specialization allows people to find what they really like and what suits their temperament and demeanor best. When a person finds a field that suits them, they’re more likely to work hard. The casual observer may attribute their success to grit when it is really inherent curiosity and passion.

Matt

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An Outsider’s Guide to Humans by Camilla Pang

An Outsider’s Guide to Humans was written by an author who has lived with high-functioning autism (Asperger’s syndrome) and a variety of learning disabilities since she was a child, all of which made adapting to the world more difficult than for the average person. Nonetheless she graduated with a PhD in bioinformatics and has learned how to overcome and cope with her challenges using some clever tricks.

In the book Pang uses analogies to the hard sciences - waves, prisms, electron and proton behavior, entropy, thermodynamics, etc. - to describe how and why people behave the way they do. With a science-oriented mind it was her way of making sense of the world, and many of the analogies are useful from a psychological perspective and apply to markets and investing. As someone who is always on the hunt for tying different disciplines together, I think Munger would appreciate this book.

One of the several useful concepts Pang elaborates on is applying Network Theory to every day life. Network theory is “the study of how we represent connected objects via graphs, visualize the networks they collectively create, and learn from what the connections tell us. It’s what allows us to analyse complex interrelated and dynamic systems by using the related techniques of graph theory.”

There are a lot of applications to investing by thinking with Network Theory. It’s critical to wrap your arms around the various factors that interact on and with a business and the capital markets. Thinking of the variety of forces that combine to either enhance or destroy a business or industry and mapping them onto each other helps think through the different possible “paths” an investment can take. Once you’ve got your arms around these potential paths, it comes down to thinking about how to maximize your chances of selecting the options that lead you to the long-term outcomes you’re shooting for.

I find this theory applies to both individual businesses but also industries along with portfolio construction.

Dan

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How to Decide by Annie Duke

Annie Duke is one of my favorite authors and has also written Thinking in Bets and Quit. Her books all revolve around ways to make better and more rational decisions and thinking probabilistically is a heavy component in many of her methods.

How to Decide follows a little different format than her other books and incorporates some interactive exercises which is a nice change of pace from a regular book. In the book Duke breaks down a set of tools and frameworks that anyone can use to improve decision making quality.

Duke dispels the traditional tools for making decisions such as pros and cons lists and offers a number of ways to overcome the myriad of cognitive biases that we all suffer from. The crux of her approach is that, when evaluating important decisions, you need to not only list the potential options of what you are deciding between, but also the payoffs (impact) associated with each choice as well as the probability of each outcome. This essentially allows you to come up with a weighted-average expected value rather than just a simple list when faced with tough choices.

I also like her ideas on how to avoid “resulting” - which is only evaluating the quality of a decision based on the outcome. Obviously, outcomes are what matter, but luck and randomness enter into the equation all the time, which we can’t control. We can only control the quality of our decisions, and often times a good decision leads to a bad outcome because of bad luck. Likewise sometimes a dumb decision leads to a good outcome because of good luck (you can run through a dynamite factory with a lit match, and you might not blow up but you’re still an idiot).

To avoid resulting and hindsight bias you can only assess a decision based on what you actually knew at the time (after knowing an outcome, usually it seems like other information seemed obvious or knowable at the time, but that’s just because of resulting). This is why we writeup (either publicly on the blog or privately) any prospective investment with the key business drivers, risks, and potential outcomes before we purchase a stock. This way, we have a time-stamped document about exactly what we knew and what we thought would happen, which we can check-in on when assessing the quality of the decision to purchase stock in that business.

If we didn’t do this, our judgement about the quality of the investment decision would be heavily influenced by whether the stock price went up or not. Of course, we hope for the value of our portfolio to rise over time, and that is likely to occur over long time periods if we make a collection of, on average, good decisions. Avoiding resulting and hindsight bias, and doing things like “pre-mortems” - all tools which Duke reviews - are critical in our ability to make more good decisions than bad ones.

Dan

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Chaos Kings: How Wall Street Traders Make Billions in the New Age of Crisis by Scott Patterson

After Dan wrote about Chaos Kings in our June 2023 Reading Roundup I bought the book and added it to my queue. I used to work at a small company creating and implementing tail risk hedges so I am particularly interested in tail risk.

Consistent protecting a portfolio and earning a profit from that protection over time is about as difficult and as complex as it gets in financial markets. Since everyone is risk adverse (Alex Honnold notwithstanding) and the stock market tends to take the elevator down but the stairs up, put options are more expensive than calls. Blindly buying puts is expensive insurance.

The trick, then, is to either time the market (impossible, at least for me), or find options priced cheaply (value) to buy and overpriced options to sell. Spitznagel’s hedge fund Universa does the latter. Ernst & Young calculated that Universa’s Black Swan strategy returned 105% per year between 2008 and December 2019. This excludes the fund’s 4,000%+ bonanza in March 2020.

How do they do it?

The guiding philosophy behind Spitznagel and Taleb’s trading strategy is threefold. One, the future, dominated by big, impactful events, is very hard if not impossible to predict. Anything can happen (Black Swans).

Two, extreme events are more devastating than many assume, because standard risk metrics like the bell curve don’t capture them. That means, in financial markets, extreme events are usually underpriced: a moneymaking opportunity. It also means most other investors are taking on more risk than they realize. It’s a common human frailty to assume the world tomorrow will be the same as today, despite all the signs of change around us. People focus on the mundane bulges in the center of the bell curve, rather than the wild explosions in the tails of the curve.

Three, drawdowns matter more than wins. Spitznagel years ago realized an essential truth for anyone betting on a future outcome: A single large drawdown matters far more than a long series of small wins. Say you invest $1,000 in a stock. If for some reason there’s a bad earnings report or executive scandal—or people stop buying the widgets the company makes—that stock falls 50 percent. You now have $500. Here’s the catch: To make back your money, just to get back to even, the stock needs to rise 100 percent—not the 50 percent you lost. The lesson: Avoiding big losses is crucial. Universa achieved this by purchasing options that have mammoth payoffs in crashes, and only in crashes.

Like EPC, Universa focuses on value — buying options cheaply — rather than predicting the market. Value creates an asymmetry skewed in the buyers favor. Heads they win, tails they don’t lose much. The derivatives Universa buys are themselves inherently asymmetric which only increases the returns when the strategy performs.

Spitznagel and Taleb believe that the world’s increasing interconnectedness makes it vulnerable to more black swans. 100 years ago someone that got sick in Wuhan would not have infected the entire globe within a few weeks. Jet travel makes that not only possible but likely. Jets make the world vulnerable to pandemics, global trade to invasive species, and interconnected financial markets to financial crises.

Taleb believes that the more humans try to tame this complexity with predictions, the more fragile and vulnerable we become. We cannot fight complexity with complexity. The Covid-19 pandemic showed that just-in-time supply chains collapse at the first shock. Extreme events “are necessarily increasing as a result of complexity, interdependences between parts, globalization and the beastly thing called ‘efficiency’ that makes people now sail too close to the wind,” Taleb wrote in Antifragile.

Matt

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Blind Man's Bluff: The Untold Story Of American Submarine Espionage by Sherry Sontag

Blind Man's Bluff is a series of stories about American submarine-based espionage during the Cold War. The stories were highly entertaining and often shocking. There are plenty of run-ins with the Soviets, including a collision between and American and Soviet sub. Others detailed secret cable-tapping operations and real life chase scenes that seemed straight out of the Hunt For The Red October. The book even talks about missions to create the SOSUS network which allowed the Navy to detect the Titan submersible’s implosion.

While the submarines are front and center, the book also delves into the human element of submarine warfare. Thousands of feet below the Arctic and inside Soviet waters with nuclear missiles onboard, leadership is critical. Captain and crew were often in stressful, perilous situations with only their heads, their hands, and their machine to sort it out. Help was a long way off.

The book left me with the impression that submarines are one of the most asymmetric weapons the US has in its arsenal. Nuclear subs can remain submerged indefinitely and can maneuver, undetected, almost anywhere, while carrying nuclear weapons onboard.

Ballistic missile submarines (SSBNs) form the most crucial part of the United States' nuclear triad because they assure America’s enemies that a first-strike attack will be met with retribution. Since submarines are so hard to detect, they’re impossible to eliminate in a first strike, unlike a bomber airplane which could be seen and shot down or intercontinental ballistic missile sites, whose locations are well known.

This is relevant to investors in General Dynamics and Huntington Ingalls, which make submarines for the US Navy. It’s also relevant to Northrop Grumman which manufactures mission-critical parts for each leg of the US nuclear triad, including the solid rocket engines that propel missiles launched from submarines. I touched on tome of this in Playing Offense With The Defense Industry.

Matt

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The Best of the Rest

• WSJ: How a Houston Oilman Confounded Climate Activists and Made Billions. Hildebrand, who is little known outside his hometown of Houston, has become one of America’s largest independent drillers by buying assets on the cheap, cutting costs and then squeezing out both oil and profit from wells that others left for dead. “Smite the rocks with the rod of knowledge, and fountains of unstinted wealth will gush forth,” Hildebrand said in a speech last year

• Chris Mayer: The Best Book I’ve Read This Year. For Rubin patience “begins with acceptance of natural rhythms.” For us investors, that means accepting that bear markets happen, that stocks go down and can go down or nowhere for long stretches of time, that compounding takes time and that many things are out of our control

• Brooklyn Investor: Inflation, Valuations, etc. “If you invest in a well-run business, then you shouldn’t have to worry about the economy, interest rates, inflation etc. The business will evolve and take care of those problems… A good business will have pricing power. Even if earnings take a hit in the short term, they will make it back, and usually, they will more than make it back. Recession? A good business is not going to go kaput just because the economy weakens a little, or a lot. In fact, they will take advantage of the situation and maybe buy out competitors at very low prices (JPM, BRK during the financial crisis; even though many BRKers complained that Buffett didn’t do enough back then!). Munger often reminds us, this is how Carnegie, Rockefeller and all those guys got rich; they just operated their business well, when the economy got bad, they just bought up their weakened competitors. Rinse, repeat over decades.”

• WSJ: New Lending by Mortgage REITS Has Dried Up. Mortgage REITs are pulling back to protect their balance sheets during one of the most troubled commercial real-estate markets in decades…That is leaving many commercial property owners in a bind to refinance debt as it comes due, increasing the likelihood that more owners will default and could lose their properties. 

• Barron’s: This Insurance Broker’s Stock Is Anything but Boring. Even a recession, if one comes, likely won’t derail Gallagher’s growth… There’s a good reason for that: “You’re basically out of business when you turn around and cancel your health insurance,” Kornitzer says. “Firms like this are almost immune to downturns.”

• Business Breakdowns: Copart - The Car Undertaker. Willis Johnson's tricks that set Copart up for success, why the business is growing despite lower vehicle utilization, and what it can teach all investors about good cash flow management.

• Barron’s: Interview With Morgan Housel. Your next book comes out in November. What’s it about? “It’s about behaviors and facts of life and trends that never change. There’s so much focus and attention on what’s going to change. What’s the next big industry? The next big company? What’s the stock market going to do next? Who’s going to win the next election? Everything is about what’s going to change. And not only are we really bad at predicting that, but I think it actually matters a lot less than focusing on what is never going to change. So, how do people think about greed and fear? That has never changed.”

• WSJ: The Scary Math Behind the World’s Safest Assets. “100 invested in three-month Treasury bills in 1928 grew to only $2,141 by the end of last year while it became $46,379 invested in medium-grade corporate bonds and a whopping $624,534 if invested in stocks, according to data from New York University finance professor Aswath Damodaran.”

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