Google Talk- The Prejudices of Mr.

Market

I would like to talk to you today about empathy which is the ability to step into the shoes
of another person, aiming to understand his or her feelings and perspectives and to use that
understanding to guide our actions.

Empathy? Normally, you wouldnt associate empathy with the world of capitalism and
investing. And I have to admit I used to think the same way too when I started out as a value
investor 21 years ago. But today, I think differently. Today, I think that every value investor
should count empathy as one of the key tools in his or her toolkit. Today, I use empathy to
really understand a business and its market valuation.
Let me tell you how.
I am a value investor who focuses on investing in moated businesses in India. A moat, as
you know, is a metaphor Warren Buffett uses to illustrate the idea of a competitive advantage.

Google Talk- The Prejudices of Mr. Market

According to Mr. Buffett:

What were trying to find is a business that for one reason or another .... has this moat around it. And
you throw crocodiles and sharks and piranhas in the moat to make it harder and harder for people to
swim across and attack the castle.1

Its quite obvious to me that investing in a business with a moat carries a very low risk of
permanent loss of capital. A durable competitive advantage makes a business resilient to
economic shocks as well as managerial mistakes. It gives the business what Tom Russo calls
the capacity to suffer.2
My own experience of more than two decades of value investing has persuaded me that
investing in a business with a moat is likely to deliver higher returns with lower risk of
permanent loss of capital, than investing in a business without a moat. I am also convinced
that buying into scalable businesses with moats at sensible prices, and then holding on to them
for long periods of time, is a very profitable, low-stress investment strategy.
But what about empathy? How do I use it for analysing moated businesses? Well, while
evaluating a business for a potential investment, I try to empathise with four types of persons.
I try to step into their shoes with an aim to understand their feelings and perspectives and to
use that understanding to guide my firms actions.
Who are these people in whose shoes I try to step into? Well, here is the list:
# 1: THE CUSTOMER: I think its terribly important to understand well about the pain
of the customer that the business alleviates.
Why does she prefer to buy from the company you are evaluating? Whats so special
about the value proposition to customers that will make them want to come back again and
again?
#2: THE COMPETITOR: Why would a potential competitor not enter this market? If
he tried to, why would it be painful for him? What are the entry barriers? You really have to
put yourself in the shoes of a potential competitor to feel the pain that would be created by
taking on a moated business.

Google Talk- The Prejudices of Mr. Market

#3: THE ENTREPRENEUR: What drives the entrepreneur? Is he an intelligent fanatic?

What struggles did he face in making this business a success? What would he do during tough
times? What are his shortcomings? Are they so significant that youd reject partnering with
him? Why?
#4: MR. MARKET: Why is the stock market misunderstanding this business? What are
its prejudices? What will make them go away?
For the rest of this talk, I will focus on the this fourth person only Mr. Market. Who is
he?
The Semi-Psychotic Mr. Market or a Weighing Machine?
Mr. Buffett likens him to a semi-psychotic creature.

In his classic book, The Intelligent Investor, Ben Graham uses the metaphor of Mr.
Market which Mr. Buffett has written and spoken about many times:
Ben Graham, my friend and teacher, long ago described the mental attitude toward market
fluctuations that I believe to be most conducive to investment success. He said that you should imagine
market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your
partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will
either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable,
Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional
problems. At times he feels euphoric and can see only the favorable factors affecting the business. When
in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and
rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for
both the business and the world. On these occasions he will name a very low price, since he is terrified
that you will unload your interest on him.3
Mr. Market has another endearing characteristic: He doesnt mind being ignored. If his quotation is
uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your
option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and
mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you

Google Talk- The Prejudices of Mr. Market

will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore
him or to take advantage of him, but it will be disastrous if you fall under his influence.

So, it appears that Mr. Market really is a semi-psychotic creature given to extremes of
elation and despair. He is utterly irrational sometimes and whenever that happens, value
investors take advantage of his prejudices.
But, heres the thing: If Mr. Market is irrational, and stays that way, then how will value
investors make any money? For them to make money, Mr. Market should mis-price assets only
temporarily. And thats exactly what Ben Graham meant when he said that

Therein lies our opportunity. Once we know (1) the stock market has a tendency of being
prejudiced against some business which, in our view, is exceptionally good; (2) such a
prejudice produces attractive market valuations for that business; and (3) the market would
have a tendency of correcting its prejudice over time, we can really understand how to make
intelligent investments.
If we can understand why the market is prejudiced against a business we love and what
will make those prejudices go away, then we will have a basis of betting against the market.
This is exactly what Seth Klarman meant when he wrote about his need to have necessary
arrogance.
Why Necessary Arrogance and Hostile Stereotyping Can Make You Rich

Google Talk- The Prejudices of Mr. Market

Klarman writes:
At the root of value investing is the belief, first espoused by Benjamin Graham, that the market is a
voting machine and not a weighing machine. Thus an investor must have more confidence in his or her
own opinion than in the combined weight of all other opinions. This borders on arrogance, the
necessary arrogance that is required to make investment decisions. This arrogance must be tempered
with extreme caution, giving due respect to the opinions of others, many of whom are very intelligent
and hard working. Their sale of shares to you at a seeming bargain price may be the result of
ignorance, emotion or various institutional constraints, or it may be that the apparent bargain is in fact
flawed, that it is actually fairly priced or even overvalued and that sellers know more than you do. This
is a serious risk, but one that can be mitigated first by extensive fundamental analysis and second by
knowing not only that something is bargain-priced but, as best you can, also why it is so. You never
know for certain why sellers are getting out but you may be able to reasonably surmise a rationale.4

Klarman makes a very important point about the need to know the prejudices of Mr.
Market. And many of those prejudices arise out of a shortcut called the representativeness
heuristic which means that we look for similar past experiences to make judgments about the
probability of future events. So, for example, if you run an insurance operation, youd have
vast amounts of customer data that allows you to determine future likely behaviour of a
potential buyers of insurance. You determine that probability (and accordingly determine the
insurance quotation) based on categories. A potential buyer of insurance might, in your
judgement belong to a high risk category because he is male, 20-year old young, alcohol
consuming, college-going student who has never owned a car before. For such a buyer, your
quotation for selling car insurance would be higher than that for a low risk category
comprising of, say, 35-year old mother of 2 children, who has never had an accident in the 10
years of car driving experience.
Such type of categorization or stereotyping is essential for making quick judgements in any
domain. Indeed, the very word stereotyping has an unnecessary negative connotation, as
Daniel Kahneman writes in his book, Thinking Fast and Slow:

Stereotyping is a bad word in our culture, but in my usage it is neutral. One of the basic characteristics
of System 1 is that it represents categories as norms and prototypical exemplars. This is how we think
of horses, refrigerators, and New York police officers; we hold in memory a representation of one or
more normal members of each of these categories. When the categories are social, these
representations are called stereotypes. Some stereotypes are perniciously wrong, and hostile
stereotyping can have dreadful consequences, but the psychological facts cannot be avoided:
stereotypes, both correct and false, are how we think of categories.5

When Kahneman writes that some stereotypes are perniciously wrong, he is referring to

Google Talk- The Prejudices of Mr. Market

such stereotyping as a key source of prejudice. In his wonderful book, Mistakes Were Made But
Not By Me, Elliot Aronson writes:

Prejudices emerge from the disposition of the human mind to perceive and process information in
categories. Categories is a nicer, more neutral word than stereotypes, but its the same thing.
Stereotypes are energy-saving devices that allow us to make efficient decisions on the basis of past
experience; help us quickly process new information and retrieve memories; make sense of real
differences between groups; and predict, often with considerable accuracy, how others will behave or
how they think. We wisely rely on stereotypes and the quick information they give us to avoid danger,
approach possible new friends, choose one school or job over another, or decide that that person across
this crowded room will be the love of our lives.6

But when Kahneman also writes that hostile stereotyping can have dreadful
consequences, he is referring to sensitive social contexts such as hiring and racial profiling
and not investing. In the world of investing, hostile stereotyping by Mr. Market can have
wonderful consequences for the value investor.
Take the case of the airline industry. Anyone who has read Mr. Buffetts letters knows just
how bad the economics of the airline industry is.

Source: https://youtu.be/5D6znniUbyY

Mr. Buffett, of course, is taking about the idea of insensitivity towards base rates. He is
telling us that before we invest in the airline industry, we should be aware that the odds of
making money in that industry are bleak. Thats because the overall economics of the airline
industry sucks. But that does not have to mean that we put every airline in the crappy
business category in our mind. If we do that, then we will never invest in a Ryanair or a

Google Talk- The Prejudices of Mr. Market

Southwest both of which are solid businesses which have beaten market indices handsomely
over the long run.

Perhaps the analyst who did invest in either of these two businesses thought differently
from the market without falling for the prejudice of applying the crappy business label to
them. Perhaps she dug deeper and found that both businesses had durable competitive
advantage and were run by entrepreneurs whom Charlie Munger would call as intelligent
fanatics. Perhaps she had reliable and persuasive evidence specific to those businesses which
would go against the conclusion in the base rate that airlines are crappy businesses. Perhaps,
these were exceptional businesses which defied the rule. Perhaps she had the necessary
arrogance based on facts that she was right and Mr. Market was wrong.
Exactly this type of thinking produces exceptional returns. When Mr. Market is deeply
prejudiced against what you know to be a wonderful business, that very prejudice creates a
fabulous investment opportunity.
And so, lets empathise with Mr. Market and understand its prejudices in the pricing of
moated businesses. Before I do that, however, some words of caution. First, these are the
prejudices I have found and exploited which means that there may be others I have not found
yet. Second, I only refer to prejudices in the pricing of moated businesses. To be sure, there
are many ways of practicing value investing and moat investing is just one of them. Finally,
there will be overlaps in the sense that sometimes you will find multiple prejudices in a single
situation and when that happens, you can expect what Charlie Munger calls as a
lollapalooza outcome.

Google Talk- The Prejudices of Mr. Market

Prejudice # 1: Marshmallow

Here, I want to talk about the tendency of investors to categorize stocks of businesses as
cheap or expensive based on their reported P/E multiples. For example, many of my
value investors friends wouldnt want to buy into a business selling at a P/E multiple of 25.
Thats a prejudice in my view for two reasons.
First, theres plenty of evidence which disconfirms the notion that businesses selling at P/
E multiples of more than 25 are expensive. By definition, a business thats expensive, if
purchased at that expensive price, should deliver poor investment returns over the long term.
But theres plenty of research which shows thats not the case. While the average business may
well be over-priced at 25x, that doesnt mean that exceptional ones are also expensive at that
market valuation. The following observation of Charlie Munger applies.

Second, in moated businesses, reported earnings often understate true economic earnings.
Thats because money spent on successful moat expansion activities is charged off to P&L but
should be treated as an expenditure with benefits spanning more than a year.
They is a key point that Mr. Buffett has made in his letters and one which, in my view, is
often not fully understood by investors. Charlie Munger's observation that almost all good
businesses engage in pain today, gain tomorrow activities also means that after making the
necessary adjustments, one would find that the multiple of their economic earnings the
ones that really matter are sometimes significantly lower than P/E multiples based on

Google Talk- The Prejudices of Mr. Market

reported earnings. And so, what looks optically expensive is really not that expensive.
In my view, the markets tendency to categorize a business as expensive simply because its
stock is trading at 25 times earnings is an exploitable prejudice. Mr. Buffett agrees.
The term value investing typically connotes the purchase of stocks having attributes such as a low ratio of price to book
value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in
combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is
therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics
a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield are in no way inconsistent with
a value purchase.7

At this point, you must be wondering why did I title this part of the talk as
marshmallows. The answer to that question lies in a famous experiment which I am sure
many of youve heard about: The Marshmallow Experiment conducted by the psychologist
Walter Michel at Stanford University in the late 1960s. The experiment is beautifully
described in this video.

Source: http://www.youtube.com/watch?v=g75lwNUpUQg

Why did most kids not wait? Well, if you think about it, they were implicitly using DCF to
make their choice. The kid who could not wait for 15 minutes for another marshmallow was
implicitly, at the subconscious level, using a very high discount rate to determine the present
value of that second marshmallow. To her, two marshmallows 15 minutes later, were not
worth as much as one marshmallow now. And the only way that can happen is if she was
using a very high discount rate.
If kids can be myopic and overweigh instant gratification and under weigh delayed
gratification, then why not Mr. Market? Indeed, Mr. Buffett offers clues about how he thinks
about discount rates for valuing a business.
When we look at the future of businesses we look at riskiness as being sort of a go/no-go valve. In other words, if we
think that we simply dont know whats going to happen in the future, that doesnt mean its risky for everyone. It means we
dont know that its risky for us. It may not be risky for someone else who understands the business. However, in that
case, we just give up. We dont try to predict those things. We dont say, Well, we dont know whats going to happen.
Therefore, well discount some cash flows that we dont even know at 9% instead of 7%. That is not our way to
approach it.
Once it passes a threshold test of being something about which we feel quite certain we tend to apply the same discount
factor to everything. And we try to only buy businesses about which were quite certain. And as for the capital asset pricing

Google Talk- The Prejudices of Mr. Market

model type reasoning with its different rates of risk adjusted returns and the like, we tend to think of it well, we dont
tend to think of it. We consider, it nonsense.
But we think its also nonsense to get into situations or to try and evaluate situations where we dont have any
conviction to speak of as to what the future is going to look-like. I dont think that you can compensate for that by having a
higher discount rate and saying, Well, its riskier. And I dont really know whats going to happen. Therefore, Ill apply a
higher discount rate.8

Clearly, Mr. Buffett does not use an equity risk premium in the discount rate. He does not
heavily discount distant cashflows (delayed gratification) like the children in the marshmallow
experiment. And that gives him an edge over competition because he can pay up for quality,
without actually overpaying for it.
Prejudice # 2: Hidden Champions

In his book, Hidden Champions of the Twenty-First Century, Hermann Simon writes about
extremely successful businesses which remain below the radar for long periods of time.
Large corporations are the subject of close and constant scrutiny by academic researchers, analysts,
shareholders, and journalists. Hidden champions, on the other hand, remain a virtually unexplored
source of knowledge. Scattered across the globe, thousands of these highly successful companies are
concealed behind a curtain of inconspicuousness, invisibility and, in some cases, deliberate secrecy.
This applies to the products these companies make, how they beat the competition oreven more
difficult to researchhow they are managed internally. Even their names are known to only a handful
of experts, consultants, journalists, and researchers. This secretiveness contrasts starkly with the
dominant positions the hidden champions enjoy in their markets. Many of them have global market
shares of over 50%, and some even hold shares in their relevant markets of 70%90%. On average,
they are more than twice the size of their strongest competitors. Only a few large multinationals achieve
comparable market positions.
Why have these outstanding companies, all of which occupy leading positions in their markets
worldwide, remained hidden? There are many reasons, but the most obvious is that a large number of
the products offered by hidden champions go unnoticed by consumers. Many of these companies
operate in the hinterland of the value chain, supplying machinery, components or processes that are
no longer discernible in the final product or service. As a result, the products lose their distinct identity
or autonomy.
[Their low profile] does not mean that the hidden champions are not well known to their direct
customers. The opposite is true. Most hidden champions have extremely strong brand names in their
markets. Their brand awareness is high, they enjoy outstanding reputations, and competitors often see
them as benchmarks.9

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Google Talk- The Prejudices of Mr. Market

The most interesting part of this quote is:

The products offered by hidden champions go unnoticed by consumers. Many of these companies
operate in the hinterland of the value chain, supplying machinery, components or processes that are
no longer discernible in the final product or service.

Such businesses not only go unnoticed by consumers. Often, they also go unnoticed by
investors.
A related tendency of the market is to categorize all businesses in a commodity industry as
crappy businesses something I described earlier in the context of the airline industry.
Some of the best ideas in which my colleagues and I have invested have exploited these
prejudices of Mr. Market mis-priced B2B businesses which have business models as good
as or even better than some exceptional B2C businesses, as well as profitable niches hiding
inside commodity industries. Indeed Mr. Buffett and Mr. Munger love the idea of investing in
profitable niche businesses operating in industries with commodity characteristics. For
example, Berkshire Hathaway owns several profitable niche insurance operations and Mr.
Buffett has written about occupying niches in that industry.
The insurance industry is cursed with a set of dismal economic characteristics that make for a poor
long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated
in any meaningful way. In such a commodity- like business, only a very low-cost operator or someone
operating in a protected, and usually small, niche can sustain high profitability levels.10

In another lecture, Munger said:

In nature and in business, specialization is key. Just as in an ecosystem, people who narrowly specialize
can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people
who specialize in the business world and get very good because they specialize frequently find
good economics that they wouldn't get any other way.11

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Google Talk- The Prejudices of Mr. Market

Prejudice # 3: Learning Machines

You live in that part of the world where making mistakes and encountering failures is
celebrated and is often is a pre-condition for getting funding from VCs or even a job. The
world out there is very different from all this.
Mr. Market has a prejudice against people who make mistakes. For a while, it is unable to
distinguish between people who make mistakes and who will continue to make them and
people who Charlie Munger would call learning machines. In other words, it has a
tendency of categorising all mistaken entrepreneurs as dumb people. This tendency doesnt
last forever of course but sometimes it last long enough to make it exploitable.
A few years ago I invested in a business which at one time was in bankruptcy but is today
one of Indias most profitable listed businesses as measured by return on invested capital. The
chief cause of bankruptcy was a series of mistakes made by the founder. Unlike many other
entrepreneurs, however, this one was not only candid about his mistakes, he was also
determined not to make them again. And he didnt. He got out of a lot of businesses that
destroyed value and became really good at doing one thing very well. He outsourced
manufacturing operations to eight vendors which dramatically boosted returns on capital. He
got out of debt and now have a liquid balance sheet with surplus cash. He made a very wise
acquisition at a ridiculously low price which not only gave him access to important patented
technology, it also opened up a new big market for him.
And there was this period of time, when the market pretty much ignored all the lessons he
had learnt and the stock continued to languish even though during that time, his company
became the worlds most dominant player in the industry. But, as Graham says, in the longrun the stock market is a weighing machine and thats how it treated this business too. Today
it is far more appropriately valued and its obvious that Mr. Market has overcome its
prejudice against this particular learning machine.
Theres a pattern here of course. I think value investors should consciously look out for
learning machines which havent yet been forgiven for their past mistakes. Thats a prejudice
worth exploiting.

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Google Talk- The Prejudices of Mr. Market

Prejudice # 4: Serial Acquirers

Its a well known fact that most acquisitions dont create value. Thats because the
acquirers become over-optimistic about the prospects of the targets and over-estimate the
synergies of the acquisition. So statistically speaking, the stock market is absolutely right to
view serial acquirers with a great deal of skepticism. But this does not have to mean that all
serial acquirers will destroy value. There are a few exceptions and sometimes the market is
prejudiced against them. The markets tendency to categorize all serial acquirers as value
destroyers is an exploitable prejudice in my view.
Now, lets example the common factors in those serial acquirers which do create value.
There are a few examples. Henry Singleton was one. Warren Buffett is one. Prem Watsa of
Fairfax Financial is another one.
The common factors are: (1) extreme financial discipline i.e. willingness to walk away
from a deal that doesnt make economic sense; (2) providing a permanent home to a
promising business; (3) preserving the successful culture of the acquired business; and (4)
providing growth capital for inorganic growth though bolt-on acquisitions.
For value investors, making an investment in such a business, when the market is
prejudiced against it, makes a lot of economic sense because of the option value embedded in
such a situation. Successful serial acquirers like Berkshire Hathaway carve out a niche for
themselves to become a preferred owner of wonderful businesses. This competitive advantage
of sourcing deals not available to others has significant option value over time.

The investor is, in effect, making to borrow a term coined by Richard Zeckhauser in his
wonderful paper titled Investing in the Unknown and the Unknowable a sidecar investment
with an individual who has exceptional sourcing skills and a track record of value creation
through inorganic growth.

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Google Talk- The Prejudices of Mr. Market

Zeckhauser writes:
The investor rides along in a sidecar pulled by a powerful motorcycle. The more the investor is
distinctively positioned to have confidence in the drivers integrity and his motorcycles capabilities, the
more attractive the investment.12

Prejudice # 5: Freaks and Misfits

I am almost sure youve seen this. A few months ago someone asked a question on Quora:

And Elon Musks ex-wife, Justine gave an answer which went viral and ended up being
quoted by The New York Times, Vox, CNBC, CNN, The Huffington Post and Time.
Heres an excerpt:
Extreme success results from an extreme personality and comes at the cost of many other things.
Extreme success is different from what I suppose you could just consider success, so know that you
dont have to be Richard or Elon to be affluent and accomplished and maintain a great lifestyle. Your
odds of happiness are better that way. But if youre extreme, you must be what you are, which means
that happiness is more or less beside the point. These people tend to be freaks and misfits who were
forced to experience the world in an unusually challenging way. They developed strategies to survive,
and as they grow older they find ways to apply these strategies to other things, and create for themselves
a distinct and powerful advantage. They dont think the way other people think. They see things from
angles that unlock new ideas and insights. Other people consider them to be somewhat insane.13

The term freaks and misfits which might rings a bell with you was taken from Justine.

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Google Talk- The Prejudices of Mr. Market

Why is it important for us to understand Justines perspective?

Harvard Business School professor, Joseph Badaracco offers an explanation. Heres a
professor who uses literary fiction to teach leadership to his students at Harvard Business
School. In his book, Questions of Character: Illuminating the Heart of Leadership Through Learning,
Badaracco writes:
How does serious fiction help us understand leadership? The answer is simple but extraordinarily
powerful: serious fiction gives us a unique, inside view of leadership. In real life, most people see the
leaders of their organisations only occasionally and get only fleeting glimpses of what these leaders are
thinking and feeling. Even interviews with executives have their limits. Executives say only so much,
even when they want to be candid: sensitivities have to be observed, memory fades and sometimes
distorts, and successes crowd out failures.
In contrast, serious literature offers a view from the inside. It opens doors to world rarely seen
except, on occasion, by leaders spouses and closest friends. It lets us watch leaders as they think, work,
hope, hesitate, commit, exult, regret, and reflect. We see their characters tested, reshaped, strengthened,
or weakened.14

The reason why Justines perspective is important for us is because as Badaracco puts it
it opens doors to world rarely seen except, on occasion, by leaders spouses and closest
friends.
In my view, when it comes to evaluating the quality of extremely successful entrepreneurs
in the early part of their journey, the market displays a prejudice. The prejudice is derived
from not only the complex personalties that some of these entrepreneurs have many of
whom are definitely not likeable people but also from the limited view about the individual
in question that investors get.

I have seen this prejudice play out over and over again. Market participants are just too
judgemental about such people. Instead of focusing on the track record of entrepreneur, they
draw pre-mature and incorrect conclusions by looking at incomplete fragments of data about
his character.

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Google Talk- The Prejudices of Mr. Market

Source: http://youtu.be/tx-mQZqXaKo

Source: http://youtu.be/t3EVM_x63Go

But the reality is that by riding on the coattails of such extraordinary human beings is a
key source of compounding capital for public market investors. Charlie Munger agrees:

In an interview with with Miguel Barbosa of Simoleon Sense, successful value investor
Paul Lountzis says:

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Google Talk- The Prejudices of Mr. Market

The ability to identify a young Phil Knight, a young Howard [Schultz] from Starbucks, a young, John
Mackey from Whole Foods is becoming ever more important
Im typically attracted to a company because of the numbers. But what can make you enormously
successful for your clients is when you identify qualitative features that have yet to appear in the
quantitative results.
The key is to identify these situations early. You still have those opportunities when the companies are
small but its getting harder because there are many smart people looking. For example if you see
Progressive generating an 82 combined ratio and making $0.18 of every dollar on their underwriting
before investment income and you might say, My God, State Farms at 110. How are these guys so
profitable?
It is really hard to identify these unique teams and cultures but if can do it or get lucky, then you can do
very well for your clients. By having this edge you will avoid overpaying. You are protected on the
downside and you have enormous upside because you are piggybacking on a visionary whos building
an extraordinary culture with a long run way and because of this mispricing you can stay with them
for 20 years.
Furthermore, because you have done your research you understand how this visionary is building the
business and you have the confidence to survive all the vicissitudes of the market. So when they go
through tough times, you recognize they have a stable competitive advantage. Theyve got better
people. Theyre tenacious and theyre likely to come out of this stronger. Its an important distinction
that Im trying to make that the qualitative is becoming more important. I still think qualitative features
are subordinate to the business model and valuation but the business model is infinitely more impacted
by management (and culture) than it was in the past.15

I think its terribly important for value investors to recognize that a key source of
investment success is to become long-term, passive partners with extraordinary human beings
whom many would regard as freaks or misfits. When George Bernard Shaw said:

was he talking about freaks and misfits? Shouldnt the label of freaks and misfits not
sometimes be relabelled as intelligent fanatics?
One of my key learnings from studying such people is that as an investor I have to teach
myself to overlook many of these personality traits, some of which are not admirable. Indeed,
I think these traits are a consequence of their fanatic focus on their work. I have been
consciously training myself to empathise with such extraordinary human beings.

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Google Talk- The Prejudices of Mr. Market

In Defence of Mr. Market.

In his wonderful book, The Social Animal,16 Elliot Aronson talks about the insidious nature
of prejudice. He quotes a fictional dialogue from Gordon Allports classic book, The Nature of
Prejudice:

The dialogue illustrates the insidious nature of prejudice far better than a mountain of definitions. In
effect, the prejudiced Mr. X is saying, Dont trouble me with the facts; my mind is made up. He
makes no attempt to dispute the data presented by Mr. Y. He either distorts the facts in order to make
them support his hatred if Jews or he bounces off them, undaunted, to a new area of attach. A deeply
prejudiced person is virtually immune to information at variance with his or her cherished stereotypes.
As famed jurist Oliver Wendell Holmes, Jr., once said, Trying to educate a bigot is like shining light
into the pupil of an eyeit constricts.17

While Aronsons words a deeply prejudiced person is virtually immune to information

at variance with his or her cherished stereotypes apply to many prejudiced human beings,
they do not apply to Mr. Market. Thats because Mr. Market is a learning machine. He
corrects his prejudices over time. While the five patterns of prejudice I described keep
repeating, the prejudice against specific examples conforming to those patterns tend to
disappear over time. We have a name for that and we call it re-rating.
I think there are two lessons here. The first one I have already told you about. The second
one is that we should look at Mr. Market with some respect. After all, he is far less prejudiced
than us. Why couldnt we learn to get rid of our own prejudices from him?
Sanjay Bakshi
August 31, 2015
Googleplex, Mountain View
California
Ends
1

Warren Buffett on Franchise Value: http://youtu.be/plw8luDu8Tg

Tom Russos Interview: http://youtu.be/GSNBTaPYAng
3
Warren Buffetts letter to the shareholders of Berkshire Hathaway Inc.: http://
www.berkshirehathaway.com/letters/1987.html
2

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Google Talk- The Prejudices of Mr. Market

Seth Klarman quoted: http://www.valuewalk.com/2015/05/seth-klarman-on-thearrogance-of-value-investing-barrons-1999/

5
Thinking Fast and Slow: http://www.amazon.com/Thinking-Fast-Slow-DanielKahneman/dp/0374533555/
6
Mistakes Were Made But Not By Me: http://www.amazon.com/Mistakes-Were-MadeBut-Not/dp/0151010986/
7
Warren Buffetts letter to the shareholders of Berkshire Hathaway Inc. http://
www.berkshirehathaway.com/letters/1992.html
8
Warren Buffett speaking at 1998 AGM of Berkshire Hathaway Inc.
9
Hidden Champions of the 21st Century: http://www.amazon.com/HiddenChampions-Twenty-First-Century-Strategies/dp/0387981462/
10
Warren Buffetts letter to the shareholders of Berkshire Hathaway Inc.: http://
www.berkshirehathaway.com/letters/1987.html
11
Charlie Munger on Elementary Worldly Wisdom: http://csinvesting.org/wp-content/
uploads/2014/05/Worldly-Wisdom-by-Munger.pdf
12
Investing in the Unknown and the Unknowable by Richard Zeckhauser: http://
www.hks.harvard.edu/fs/rzeckhau/InvestinginUnknownandUnknowable.pdf
13
Justine Musks reply to a question on Quora: https://www.quora.com/How-can-Ibe-as-great-as-Bill-Gates-Steve-Jobs-Elon-Musk-and-Richard-Branson/answer/JustineMusk
14
Questions of Character: Illuminating the Heart of Leadership Through Learning
http://www.amazon.com/Questions-Character-Illuminating-Leadership-Literature/dp/
1591399688/
15
Paul Lountzis Interview: http://www.simoleonsense.com/conversation-with-paullountzis-investing-scuttlebutt-research/
16
The Social Animal: http://www.amazon.com/Social-Animal-Elliot-Aronson/dp/
1429233419/
17
The Nature of Prejudice: http://www.amazon.com/Nature-Prejudice-25thAnniversary/dp/0201001799/

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