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Apr 27, 2010

Getting Better: Deliberate Practice for Investors

In a previous post, I described my attraction to the theory of deliberate practice. Deliberate practice is an idea popularized by Malcolm Gladwell in his
excellent book Outliers (read it — even Charlie Munger recommends it). The idea goes something like this:

When we look at any kind of cognitively complex field — for example, playing chess, writing fiction or being a neurosurgeon — we find
that you are unlikely to master it unless you have practiced for 10,000 hours. That’s 20 hours a week for 10 years. The brain takes that
long to assimilate all it needs to know to achieve true mastery.

The ‘10,000 Hour Rule’ (Bottom Line Secrets)

But sheer hours aren’t enough. You have to ensure that you are putting in a lot of hours of the right type of work. To me, this is where most new
investors trip up. Instead of actually analyzing companies, they often become fixated on celebrity-investor navel gazing. What I mean is, instead of
going out and finding undervalued companies, they spend most of their time reading about what famous investors are doing. They have no real

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knowledge of the companies they invest in aside from the fact that someone famous has a stake in the company. You become the equivalent of a
chicken running around with your head cut off. The other problem I saw was that some investors merely advocated the daily reading of a 10k. This
kind of practice does not yield much if you are not able to connect what you read with the company and the industry they inhabit.

Recently, Cal Newport used Dr. James McLurkin as an example for how to become a star in your field by using deliberate practice:

In 2008, when James McLurkin graduated with a PhD in Computer Science from MIT, he was unquestionably a star. Four years earlier,
Time Magazine profiled James and his research on swarm robotics as part of theirInnovators series. The next year, he was featured on an
episode of NovaScienceNOW. The producer of the show, WGBH in Boston, built an interactive web site dedicated to James, where,
among other activities, you can watch a photo slide show of his life and find out what he carries in his backpack. Earlier this year,
TheGrio, a popular African American-focused news portal, named James one of their 100 History Makers in the Making — a list that also
includes Oprah Winfrey and Newark, NJ mayor Cory Booker…

“Every semester, my supervisor, Anita [Flynn], had me write out goals,” James told me. “We would go back at the end of the semester
and look at what I did and didn’t do. She would tell me, ‘it’s fine that you didn’t get this all done, but what’s not fine is your inability to
estimate how long something will take.’”

James describes this lesson as perhaps the most valuable he learned as an undergrad at MIT. Under the tutelage of his supervisor, he
honed his ability to choose projects that were hard enough to stretch his ability, but still reasonable enough that he could complete them.
She wanted him to be ambitious and set big goals, but she had no tolerance for goals so big that they were beyond his ability to finish in a
reasonable time frame.

How to Become a Star Grad Student: James McLurkin and the Power of Stretch Churn (Study Hacks)

Newport calls this stretch churn:

With this in mind, I argue that the secret to James McLurkin’s success is his ability to choose the right projects. By resisting work that
reinforced what he’s comfortable with, yet also sidestepping overly-ambitious projects, he consistently advanced his skill until he arrived
at the bleeding edge of research robotics. Once there, the “breakthrough” projects that cemented his reputation became obvious next
steps.

Put another way: stretch projects are an effective way to integrate deliberate practice into fields without clear competitive structures and
coaching. If you’re a figure skater, a top coach can walk you through the hard jumps you need to get better. If you’re a grad student (or
entrepreneur, writer, or knowledge worker), however, there are no such coaches to guide you through this process.

Stretch projects can fill this role.

To make this more concrete, let me give you a couple definitions:

Stretch Project: A project that requires a skill you don’t have at the outset.
Stretch Churn: The number of stretch projects you complete per unit of time.

How to Become a Star Grad Student: James McLurkin and the Power of Stretch Churn (Study Hacks)

I believe stretch projects and stretch churn can be implemented by those of us hoping to improve our abilities as investors. We often hear Warren
Buffett talk about circles of competence and having a ‘too hard pile’ for investments. The problem is, some investors hide behind these ideas and in
turn, limit their ability to improve as investors.

I want to outline some of the steps I’ve taken and actually implemented in order to improve my abilities as an analyst.

1. Seek out peers and mentors

James McLurkin benefited from working in MIT’s robotics lab with people who were more experienced researchers. Advisers like Anita Flynn were
able to provide the kind of feedback and guidance that he needed for self-improving.

I’ve also sought out mentors. What I try to do is find investors from diverse backgrounds with differing amounts of experience and viewpoints. You
must be open to different perspectives when it comes to investing because bias is your worst enemy. Finding people with an expertise in an area you
are trying to master is always helpful. For instance, starting in the summer of 2009, one of my goals became improving as a financials analyst. During
the crisis I had no luck with analyzing banks, I defaulted and claimed they were in my ‘too hard pile’ or out of my circle of competence. But I wanted
to get better. I now know four different analysts that have a speciality in financials, with their help, I can start analyzing a company and then converse
with them on whether my thought process is correct. They have also in turn, helped my by teaching me their different approaches to analyzing banks.

The result? I’ve become comfortable with looking at banks. I can’t say I am confident in a valuation for something like Citigroup, but I can analyze
smaller, more community-focused banks. I’ve completed write ups and valuation models on four different banks so far.

Beyond that, I’ve also made contact with peers/mentors that specialize in everything from global value investing to special situations. Whenever I am
looking at a situation that fits into one of their specialties, I can run it by them to get constructive criticism.

2. Increase your skills (stretch projects)

McLurkin figured out how to expand his knowledge by setting goals that would stretch and increase his knowledge. For me, this means striving to
analyze and value companies with business models I’ve never encountered before.

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For example, as many of you know, I enjoy looking at spinoffs. They are my favorite type of special situation. One spinoff that I analyzed a couple of
months ago was Madison Square Garden (NASDAQ:MSG). Madison Square Garden is a company that might be daunting to value at first. There is no
readily available comp for the company. With three different operations (sports, television networks, and entertainment) you must to take a sum of the
parts approach when valuing it. From there, each part could be valued by more traditional methods, e.g.: the television network might be an EBITDA
multiple or the sports franchise value might be determined using recent transactions. For me though, MSG was made up of three different businesses
that I had never valued before. The benefits of that experience were tremendous. Now, I can apply some of those same principles when looking at
companies that are tangentially connected. As an example: the methods for valuing MSG’s television business might be applicable when valuing
Liberty Media Starz, a premium cable TV network.

To me, the more types of companies you can value, the more opportunities you can have. By being a generalist, you can look at practically anything.
You should strive to be a generalist because there are times when one sector or another becomes overvalued. If you strictly stick within that domain,
you need to be extremely disciplined in your approach. What I have seen is that most investors end up lowering their standards so they can remain
active. Or, they over estimate their expertise – Wall Street is a great cautionary tale for this, for all their sector specific expertise, they missed the
crisis.

3. Pick projects that you can complete (stretch churn)

With Anita Flynn’s advising, McLurkin picked projects that would not only stretch his ability, but also get completed on time. Setting goals and then
accomplishing them creates a motivation loop that keeps you going.

At the moment I have a spreadsheet in Google Docs that contains my watch list of 90+ stocks. Why 90+ stocks? In my research on Michael Burry, I
was really taken back by his drive for valuing companies. I remember that he had a watch list of 80 businesses that he would buy at specific prices. In
light of the most recent crisis, I didn’t do much buying. I actually made just one investment. If I had a watch list of 90 companies that I knew really
well, I believe I would have been able to profit to a greater degree from the market’s draw down.

Part of my goal with using deliberate practice is to value all 90 companies on the list and expand my circle of competence as much as possible with it.
In order to get through so many companies in a reasonable amount of time, say 2-3 per week, I tend to gravitate towards smaller businesses. They
have fewer moving parts and are easier to analyze (for more on analyzing nano-caps, read my interview with Paul Sonkin) than large conglomerates,
but offer varying business models. Value can be anywhere, so you don’t have to strictly look at nano/microcaps, but they make wonderful starting
points.

More practically, it might take you an entire month to really master your analysis of General Electric. The trade off is that during that month, you may
have been able to learn 8 different nano-caps. You’re better off working on those 8 because you increase your chances of finding an undervalued
company. I’d rather know the value of 90 companies than 12 because it expands my hunting ground for profitable opportunities.

In the last 30 days, I can say that I have somewhat met my weekly goal. I’ve valued about 10 companies which is within my ideal range of 8-12.
When I mean I’ve valued them, I don’t simply mean that I have opened their latest 10K, pulled an earnings figure, and slapped a multiple on them.

5 of the companies valued over the last 30 days were in the same industry. I had to go back about 6 years and collect data to see how they traded at
different points in the capital cycle (they are cyclical), furthermore, I spoke to the management teams at two of them. Two of the companies were
nano-caps, where I spoke not only to management but also customers and competitors. With nano-caps, this kind of approach is key because they
often have significant customers as a percentage of revenues. The loss of one can be devastating to the business. You must get comfortable with their
abilities as businessmen and I think the scuttlebutt approach works extremely well for this. One company was in a sector where I had little expertise,
but where I had analysts as friends. I tapped their knowledge for valuing the company and learned a lot.

To deviate, the last two companies were special situations. These are a bit different because the past is rarely a good predictor of the future, with
special situations you are often analyzing the intricacies of a transaction. Often, in something like a spinoff, when you do the pro-forma analysis you
might find you can buy the parent and get the spinoff for free. Much of the analysis comes down to seeing how much one share of the parent gives
you of the spinoff and then separate analyses on the two different businesses. These can require more work on your behalf, since you are valuing two
companies, but the rewards are wonderful. What’s great is as you go through more and more of these transactions, you pick up a lot of knowledge
about the granular transaction details which makes looking at the next situation less complicated. Plus, Special situations can help give value investors
investments that have clearly defined catalysts in place and can sometimes be market neutral. Two qualities that are helpful in choppy markets.

So far I’ve been really pleased with my progress through my watch list. I don’t want to say that the list is my only source of investment ideas, I still
look every day for new ideas, which is why the list is hovering over 90. But, I have found it useful for formalizing my learning process with clearly
defined goals in place. For newer investors hoping to improve their abilities as analysts, this formal approach to practicing is probably better than
looking at 13F filings all day.

Category: Mental Models

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sandesh trivedi 5 days ago

Great post as always, tariq. and also ur research on michael burry was very extensive and absolutely amazing. keep up the good work.

Flag

nihardalal 5 days ago

Enjoyed reading the post, Tariq. However one important aspect of deliberate practice is feedback which you don't talk about. Without feedback there is no way of knowing whether one is proceeding
in the right direction or not. I don't mean feedback from mentors etc. I am referring to objective feedback from the market. How do you factor that in your practice?

Nihar Dalal,CFA

Flag

Tariq 5 days ago in reply to nihardalal

What is objective feedback from the market? I don't think 6 month returns are terribly insightful. Especially when you are in an environment where the market is rocketing upwards. It doesn't
really take a rocket scientist to pick 8 stocks and do better than the market in that kind of environment, concentration has a tendency to juice returns.

There is a great quote by Benjamin Graham:

"You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

Even though returns have been pretty good in the last 6 months, they aren't enough to provide what I would call 'objective feedback'. You really need a longer stretch of time for that if you're
investing. If you are trading, that is an entirely different story.

I disagree with your assertion about mentors - if you have the opportunity to work with a variety of people well established in the field and are submitting write ups to them while getting
criticism/responses in return, you should undoubtedly improve your process as an analyst. As an analyst, your job is to uncover and analyze the facts. While that sounds simple, it is undoubtedly
not. Especially when you begin to look at more complicated situations. But I think as long as you are a good analyst and then have the right mindset about identifying risk (e.g.: ch. 8 and 20 of
Intelligent Investor) you will likely see that translated into investment success.

Flag

nihardalal 5 days ago in reply to Tariq

Here is a good anecdote from Stanley Druckenmiller that is particularly illuminating for young analysts:

When I first started out, I did very thorough papers covering every aspect of a stock or industry. Before I could make the presentation to the stock selection committee, I first had to
submit the paper to the research director. I particularly remember the time I gave him my paper on the banking industry. I felt very proud of my work. However, he read through it and
said 'This is useless. What makes the stock go up and down?' That comment acted as a spur. Thereafter, I focused my analysis on seeking to identify the factors that were strongly
correlated to a stock's price movement as opposed to looking at all the fundamentals. Frankly, even today, many analysts still don't know what makes their particular stocks go up and
down." -- Stanley Druckenmiller, Market Wizards

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nihardalal 5 days ago in reply to Tariq

I believe one is not practising to be an "analyst" but to become better at generating returns whether in the short term or the long term. I often find people blaming Mr. Market and his
irrationality when they cannot beat the markets.

Nihar Dalal, CFA

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Leila 1 week ago

Tariq -- it's BECAUSE of your devotion to the analysis part of being an investor that I trust you and your research so easily. Great outline here. Actually, most people do not have this sort of
commitment and drive, but it's clearly evident that you do!

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seanbrown 1 week ago

Great post. However I think MSG is actually 2 businesses rather than 3. The sports teams provide all the content (well, all the worthwhile, truly valuable content, besides the non-owned hockey teams)
for the networks. You can't really value the networks separately with any kind of precision because the internal transaction price they have is definitely way too low for the rights to the Knicks and
Rangers for such a wide viewer footprint. Most NBA teams capture a greater % of the total value of their TV rights than if you believe MSG's segment breakout. I do think that valuing the
entertainment businesses separately is appropriate but we can never know their true cost structure as a separate business because there are so many shared costs. At the end of the day the lion's share
of MSG's value is generated by the long-term performance of the Knicks and Rangers (drives TV cable channel fees, commercial revenues, ticket revenues, concessions, jersey sales, etc. which is all
multiplied by making the playoffs), end of story. Trying to value the businesses individually using the given segment breakdown (i.e., giving a cable-channel multiple to supposed network EBIT, then
valuing the sports teams at ridiculous "private market vanity valuations" or else with an extremely high multiple) doesn't seem to be a very realistic approach to me.

Flag

Tariq 1 week ago in reply to seanbrown

One of the reasons I hesitated during my analysis of MSG was precisely that - when you look at Forbes' valuation of the team and combine that with a value for the TV business, you run the
risk of double counting.

Conversely, I saw some arguments that because there are intersegment revenues between the operations, you really aren't double counting. I took Forbes' valuation and actually discounted it a
bit (varies per my 3 valuation scenarios).

Ultimately, the business never got down to where I wanted it to be and I found better value elsewhere.

Flag

David K. 1 week ago

Tariq,

The best blog post I have read in ages. It has been printed and added to my notebook of inspirational articles I try to review at least once a month! I hope all is well.

-David

Flag

Tariq 1 week ago in reply to David K.

Thanks David!

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About Me

My name is Tariq Ali, I run Street Capitalist. I recently graduated from the University of Texas at Austin. There, I stumbled onto value investing via
the school library. I read everything I could and now I'm here, writing out my thoughts and investment ideas.

I have a lot of heroes when it comes to investing, it seems like every investor has some kind of niche. Some, whose books and writings have had the
biggest impact on me are: Warren Buffett, Benjamin Graham, Joel Greenblatt, Seth Klarman, and George Soros.

Have any questions? Want to stay in touch?

Feel free to e-mail me at TariqTX@gmail.com

Follow me on Twitter:
@ValueInvestr

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