In “The Joys of Compounding”, author Gautam Baid distills the wisdom of investing and life lessons all in a book. He integrates the value investing philosophy and thought processes from generations of prominent figures, including Warren Buffett and Charlie Munger.
Baid devotes a significant portion of the book to self improvement and lifelong learning. With practical applications to investing and life, there are many timeless lessons gained from this book.
A comprehensive guide, the content is organised into five main sections; (1) Achieving worldly wisdom, (2) Building Strong Character, (3) Common Stock Investing, (4) Portfolio Management and (5) Decision-making. This is Part I of the book review which covers the first 3 sections.
I. Achieving Worldly Wisdom
In the first section, Gautam Baid shares the importance of life long learning. Through reading and building a framework of mental models, we can become better investors, and more importantly, better thinkers.
If you have the right mindset, everything in life can be a teacher. And as Warren Buffett says, the best investment you can make is in yourself.
Become a Learning Machine
Go to bed smarter than when you woke up.
“In my whole life, I have known no wise people who didn’t read all the time — none, zero”Charlie Munger
Sounds simple, but it’s difficult.
We all know that reading is one of the best ways to increase knowledge. A book is an accumulation of one’s expertise, experiences and decades of work. Where else can you get the entire life’s work of someone in the space of a few hours?
In a world full of distraction, everything is fighting for our attention. Social media is an addictive drug. And as humans, we often take the path of least resistance (e.g. it’s much easier to watch Netflix than to read).
Warren Buffett and Charlie Munger are learning machines. Even after achieving huge success, they spend about 80% of their time reading.
No one becomes smart overnight. Knowledge takes time to build up like compound interest. Understand that the sooner you start learning, the better returns you get in the long-run.
Set aside time in your day to read, it could be just 10 minutes before bed. Build good habits for reading and let the magic of compounding happen.
Reading is only Part of the Equation
But reading alone is not enough. You have to be able to retain the information. The best way to know if you have fully understood a topic is if you could explain it to a 10-year-old.
The Feynman Technique is also a popular method to test your understanding of a subject:
- Pick and study a topic
- Write on a blank paper your knowledge of the subject
- Identify gaps in your understanding
- Go back to the source material and relearn
Build A Latticework of Mental Models
“An experienced, good decision maker has at his disposal repertoires of possible actions; that he had checklists of things to think about before he acted; and that he had mechanisms in his mind to evoke these, and bring these to his conscious attention when the situations for decisions arose.”
In life we have to make plenty of decisions. Building mental models are helpful in enabling us to make better decisions.
What are Mental Models?
Mental models are key ideas from each discipline (e.g. Mathematics, Physics, Accounting etc). It’s a framework or worldview you have in your mind to help you understand how the world works.
Traditionally in school, we study subjects in isolation. Information about each subject is compartmentalised into distinct folders in our brain – Math, Science, Arts etc. Often there is a lack of synthesis between subjects.
However, this learning style does not mirror the complexity of the real world. Our outcomes are shaped by forces from various fields, coming at different magnitudes.
By integrating information from various disciplines, we can see the many forces at play. This allows us to problem-solve effectively. Charlie Munger calls the interaction a “Latticework of Mental Models”.
Why are Mental Models important?
The stock market is more than just numbers and equations. Fundamentally, the market is driven by human beings, who are subjected to an entire range of emotions. Thus, to take a purely quantitative approach and ignoring human nature would not allow us to succeed as investors.
Building up your repertoire of mental models helps you think critically. When making decisions in investing and life, avoid human biases and common psychological pitfalls.
As Charlie Munger said, “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
Here is a non-exhaustive list of mental models I have compiled:
Collection of Mental Models
Investing: Circle of Competence, Margin of Safety, Time value of money
Accounting: Basic Accounting Equation, Free Cash Flow, Depreciation, Maintenance CAPEX, Growth CAPEX
Mathematics: Compound Interest, Decision Trees, Law of Large Numbers, Probability theory
Microeconomics: Asymmetric Information, Comparative advantage, Creative Disruption, Diminishing ultility, Supply and Demand
Physics: Activation Energy, Friction, Relativity, Inversion, Leverage
Psychology: Availability Bias, Anchoring, Confirmation Bias, Dunning-Kruger, Mere exposure effect, Survivorship Bias
Do note that memorising these mental models alone is not enough. To become a truly great thinker, you will have to connect them together into a latticework and see how they interact with one another.
II. Building Strong Character
In the second section, Gautam Baid highlights the importance of choosing the right role models, teachers and associates in life.
Look for people who are successful in the field, or those who have struggled with the same problems you are facing. Learning vicariously through others experiences is valuable.
Apart from associating yourself with the right people, achieving success requires you to delay gratification.
Finding the Right Mentors and Associates
Finding the right mentors and peers are important in life. They can help you to improve and accelerate your life. In a previous essay, I have written about How to Find Mentors.
Among other tips mentioned, trust and reliability is key.
Build trust with others by having honest conversations. Show your authentic self and be sincere.
Be reliable and never overpromise and underdeliver (do the opposite). Trust is earned when actions meets words.
Delayed Gratification as Investors
The key to success in life is delayed gratification.
“The ability to delay gratification is a better indicator of future success than raw intelligence, because the former is an important part of emotional intelligence.”
Most investors are looking for ways to earn a quick buck, the best investors defer their gratification for larger gains in the future.
To become a good investor, you have to learn to manage your emotional rollercoasters.
Stock price fluctuations in the short-term should not be a reason for you to panic and sell the stock, if your thesis and the fundamentals of the company does not change.
Also, whether the crowd agrees or disagrees with you, you should not be motivated by it. Temperament is key.
“The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”Warren Buffett
Delayed Gratification in Business
In business, the concept of delayed gratification also applies.
A key characteristic of good management is whether they can “delay gratification”.
Successful companies we see today have management which focuses on the long-term prospects of the business, instead of the short-term metrics.
To meet Wall Street’s expectations, the management of most companies are pressured to report good quarterly numbers.
We can see this represented by the “r” variable in the compound interest formula, which the management often focus too much on. High profit margins, high growth in reported EPS, all these near term numbers are boosted.
On the other hand, there are companies which focuses on maximising shareholder value by maximising “n”.
Take Amazon for an example. It took Amazon 14 years after their IPO in 1997 to make profit. This would not have been possible if the management chose to give in to pressure from Wall Street, and boost their numbers just to meet analysts’ expectations in the short-term.
“A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time – with the potential to endure for decades. When you find one of these, don’t just swipe right, get married.”Jeff Bezos
Jeff Bezos is laser-focused in building Amazon as the most customer-centric company in the world. Indeed, delaying gratification bears fruitful returns; Amazon’s initial years of losses are a speck of dust in the grand scheme of things.
Most companies cannot stomach the hit in their short-term earnings. As investors, it can be useful to ask yourself these questions:
- Are you investing in a company that has the capacity to suffer and withstand “short-term pain for long-term gain”?
- Does the business have the capacity to reinvest to build their long-term competitive advantage?
- What is the return on invested capital (ROIC)?
III. Common Stock Investing
When purchasing a stock, have a business owner mindset and think as if you are the CEO of the company. Also, understand how to gauge the intrinsic value and the margin of safety.
Business Ownership Mindset
“Investing in publicly listed companies is like reaping the benefits of running your own business, without being exposed to disproportionate risks of directly managing one.”
When you are investing in a stock, it is not just a piece of paper or the ticker you see in the stock market. You own a fraction of a real business.
Having a business ownership mindset gives you the conviction to hold and think long-term. Instead of just viewing stocks as “target prices” to be hit.
Understanding Intrinsic Value and Margin of Safety
The intrinsic value of an asset is the sum of the cash flows expected to be received over it’s remaining useful life discounted for the time value of money and the uncertainty of receiving those cash flows.
In the calculation of the range of the intrinsic value, there are plenty of assumptions one has to make. That is why people say that valuation is more of an art than science.
“The process of determining the intrinsic value of a business is an art form. You cannot follow rigid rules to plug data into a spreadsheet and hope that it spits out the value for you.”
As Mohnish Prabai believes in his Ten Commandments of Investing, “Thou Shall Never Use Excel”.
The investment process is simple. If you need Excel to figure out if something is a great investment, you need to take a pass. Buffett has said something similar about figuring out investments on the back of a napkin.
Margin of Safety
“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments. — Warren Buffett”
The three most important words in investing: Margin of safety.
Most people would think about deriving the margin of safety from the gap between price and value.
Another way to think about margin of safety is by examining the quality of the business.
Quality increases margin of safety over time.
A business can that can grow it’s intrinsic value at 18% annually is worth much more than a business that is growing 6% annually, all other things equal.
“If you plan to hold a share for the long term, the rate of return on capital it generates and can reinvest at is far more important than the rating you buy or sell at.
Turnarounds seldom turn. Great businesses tend to remain great, and poor businesses tend to remain poor and generate below-average returns.
It’s better to buy a good business purchased at a fair price than in a poor business purchased at a bargain price.
Remember, the market is your servant, not your guide. Buy good quality businesses at the right price.
I. Achieving Worldly Wisdom – Become a Learning Machine & Build a Latticework of Mental Models
II. Building Strong Character – Find the Right Mentors & Practice Delayed Gratification
III. Common Stock Investing – Understand Intrinsic Value & Margin of Safety
Stay tuned to the second part of the book review of The Joys of Compounding.
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