Mental models and checklists of Guy Spier and Aquamarine Capital

Mental models and investment checklists - Guy Spier and Aquamarine Capital

Mental models of Aquamarine Capital

In The Education of a Value Investor, Aquamarine Capital CEO Guy Spier reminds us that not everything we learn in college is “equally valid”. Yes, general equilibrium models and efficient-market hypothesis are alluring ideas. But our education is incomplete if they’re the only models we use to perceive a complex and bumpy world. In this post, we look at the mental models, routines, and questions that guide Spier’s thinking as an investor — a checklist of sorts for our own education.

“The very institutions that we have established to teach us to think independently often close our minds in potentially damaging way.
Guy Spier. (2014). The Education of a Value Investor.

Berkshire and other Grahamites

To begin, Spier speaks at length to the enormous impact that Warren Buffett had on him. His value investing journey began with books like Roger Lowenstein’s Buffett: The Making of an American Capitalist and Benjamin Graham’s The Intelligent Investor. Spier also highlights the value in studying great companies like Berkshire Hathaway, Ruane, Cunniff & Goldfarb, Tweedy, Browne Company, Jefferies Financial (previously Leucadia National), Markel Insurance, and Fairfax Financial Holdings. Their letters make for great reading, don’t you think?

Psychology of influence

Next, Spier emphasises the importance of understanding our psychological makeup. He describes how talks and books — like Charlie Munger’s Psychology of Human Misjudgement, Robert Cialdini’s Influence: The Psychology of Persuasion, and Daniel Kahneman’s Thinking, Fast and Slow — helped him to understand his own cognitive limitations, and to defend against “mind-warping distortions”.

Complex adaptive systems

You also have to recognise that economies and markets are complex adaptive systems that don’t always adhere to the niceties of academic models. We have to go beyond traditional literature to grasp the nature of business, industry, and investing. Spier highlights, for example, the benefits of studying biology and ecology, and the interdisciplinary value of books like Bert Hölldobler and Edward O. Wilson’s Journey to the Ants. (Indeed, there are fascinating parallels between insect colonies and economic systems. But, as E.O. Wilson warns in almost every book he writes about ants, try not to see similarities where none exist.)

Accounting for accounting

Of course, is your education in business or investing complete without accounting? Accounting, after all, is the language of business. Spier says you have to understand not only the statements, rules, and ratios, but the ways in which accounting results might differ from economic reality. (One of the best books on this topic, in my opinion, is Howard Schilit, Jeremy Perler and Yoni Engelhart’s Financial Shenanigans.)

“How on earth can I claim to understand the nuances of JPMorgan’s $2 trillion balance sheet?” The answer: I couldn’t. More important, neither could JPMorgan’s own management—at least, not with great accuracy. But I could make useful probabilistic inferences about the bank’s balance sheets and earning power. I asked myself, “Going forward, are these likely to be better or worse than other investors expect?”
Guy Spier. (2014). The Education of a Value Investor.

Models from bridge and chess

Spier says playing bridge and chess helped him to “refine [his] mental habits”. For example, when he first began playing chess, he found himself losing to players that made “snap decisions” with little analysis. Their unpredictability “would unnerve” him, throwing off his game. Over time, however, Spier developed his discipline and mental toughness to “remain calm and careful” during chess matches — a safeguard against mania in financial markets as well.

Another fantastic lesson from chess, in my opinion, is the importance of strategic flexibility and a willingness to abandon old ideas. Spier reflects, for example, on his long position in Farmer Mac. At the time, Farmer Mac seemed to him “an undiscovered gem” of “the same ilk” as Freddie Mac and Fannie Mae. But after a timely conversation with Bill Ackman, Spier realised he “didn’t understand nearly enough about Farmer Mac to justify owning it”. In reversing course, Spier highlights how important it is “to be open to the possibility that we might be mistaken”.

Guy Spier’s rules, routines, and checklists for investing

The way to make good decisions, Spier says, is to “construct an environment” that minimises irrational and impulsive choices. It helps then to “develop a series of rules and routines” to promote good habits and behaviour. Pilots and surgeons, for example, follow consistent procedures and checklists to minimise risk.

Frankly, I’m surprised that more businesses, governments, and investors haven’t adopted checklists yet. My guess is that when your mistakes aren’t obvious, you’re less motivated to ensure they never happen. Let me assure you that the cumulative costs of mistakes in business and government are equally tremendous.

“Our minds are filled with all sorts of evolutionary quirks that seriously degrade the rational decision-making ability of even the most intelligent investors. I try to counter these tendencies by using checklists.”
Guy Spier. (2015). Aquamarine Fund 2015 Annual Report.

Given our limited capacity for cognition, rules, and checklists help to simplify the process. Of course, they have to be sensible, and we ought to revise them as we discover what works and what doesn’t. With this in mind, Spier shares several aspects of his investing checklist, routine, and habits with us (noting that this isn’t an exhaustive list):

“Stop checking the stock price”
“Gather investment research in the right order”
“Don’t talk to management” and salespeople
“Don’t talk about your current investments”
Before buying, ask yourself if you can handle a 50% decline in prices
“When you see a good move, look for a better one”
Look for win-win opportunities

“Stop checking the stock price”

Given our nature for risk aversion, we tend to react more strongly to bad news than to good news. Checking the stock-price too frequently, Spier says, can lead to questionable decision-making. It’s also for this same reason that Spier prefers “never [to] buy or sell stocks when the market is open”. This helps him to avoid the day-to-day hyperactivity of the market.

“Gather investment research in the right order”

Like it or not, we’re often biased towards our first impression. So, the sequence in which we process information can skew our viewpoint. The goal, Spier says, is to remove “as much heat and emotion” as you can from the investment process. Starting with social media, news media, and sell-side pitches, for example, might distort your impressions.

Spier himself likes to begin with the annual report, 10K, 10Q, proxy statement, accountant’s audit letter and the management’s letters (if any). Only after does he look at earnings announcements, conference call transcripts, press releases and related documents. Spier also tries “to minimize [his] exposure to the internet”, and its endless distractions. And in the rare occasions that he reads brokerage research reports, he is careful “never [to] rely on it”.

“Don’t talk to management” and salespeople

Spier prefers to avoid discussions with people on topics in which they exhibit a self-interest. Executives tend to glorify their achievements, while salespeople chase the commission. What’s more, executives and salespeople are talented communicators. Their charisma may distort your perception, no matter how guarded you believe you are.

“Don’t talk about your current investments”

Our desire for consistency and self-narrative preservation makes it hard to abandon bad ideas we’ve committed to in public. Radio silence, by contrast, gives us the flexibility to change our mind without letting our social instincts get in the way. For this reason, Spier doesn’t like to talk publicly about his current investments. But when he does, he is careful to do so only “with people who have no axe to grind… [and] can keep their ego in check”.

Before buying, ask yourself if you can handle a 50% decline in prices

Falling stock prices can generate a lot of negative emotion and hyperactivity. Spier himself buys “only the amount that [he] could handle emotionally” if prices were to fall precipitously. By imagining the worst-case scenario beforehand, you’re better prepared for tough times if and when it comes around. As Annie Duke writes in Thinking in Bets, it’s about framing your problem in a more objective way.

“When you see a good move, look for a better one”

This rule actually comes from chess Grandmaster Emanuel Lasker. Great investors, like chess players, must evaluate their alternatives. It reminded me also of Richard Rumelt’s observation in Good Strategy / Bad Strategy: that MBA students tend to answer questions with the first solution that pops into their heads, and spend little time exploring alternatives. We have to go beyond our first instincts, and to check ourselves when we don’t.

Look for win-win opportunities

Finally, successful businesses come in all shapes and sizes. Some companies “succeed because they get one thing right”. Others “succeed because they get a lot of small things right”. Companies like IKEA and Walmart, for example, create value by cloning a lot of good, practical ideas that their competitors fail to replicate. The point here is to keep a discerning eye as to the true nature of advantage, and whether such advantages are durable in time.

There are, however, some companies that thrive on the psychology of customers. Tupperware’s direct-marketing strategy (Tupperware parties), for example, tapped into our biases for reciprocation, liking and social proof. But sentiment and conditions can shift quickly. Not long after the success of Tupperware parties, competitors flooded the market with cheaper substitutes. Tupperware soon found it difficult to “justify its high price for a simple product”. This experience taught Spier to “invest only in companies that are a win-win for the entire ecosystem”.

The Mental Models, Routines, and Checklists of Aquamarine Capital CEO Guy Spier