Monday, March 03, 2008

Elimination Process and its Effects

In my last article at entitled, "Best Practice: The Elaboration Effect" I attempted to tie in concepts from the practices of Warren Buffett and Charles Munger that explain why they appear immune to the convestional framing effects. Link: This next best practice is called "The Elimination Process and Effect" Using the process of eliminating bad and mediocre businesses from investment consideration have pushed their probability of success automatically into the higher percentiles of long term investing success.

How is this done? Chiefly by performing the four filters:
1. Understand the Business and it Products.
2. Is there a Sustainable Competitive Advantage
3. Able and Trustworthy Managers
4. A Margin of Safety if the selling price is significantly below the Intrinsic Value.
In building an A.I. interactive model of WB's Investing Brain, one approach is to use probabilities and elimination. Which words have appeared most frequently in Buffett's writings to shareholders? While this is not a complete study, this sample below shows the "word frequency" from my old compilation of the BBF, Buffett Business Factors. I will add a few comments to point out some patterns I detected.

386, business
No shocker here, the underlying business is always more important than stock's market price.
250, not
This one caught me by surprise at first until I remembered WEB talking about the importance of the human mind casting out less than desirable purchases. In the talk to MBA students in Tennessee, Buffett mentioned the reason why great chess champions can beat IBM's best supercomputers. An experienced chess champ has the ability to cast off a lot of information noise.
180, earnings
A lot of focus on real free cash flow
155, value
And the sustainable competitive advantage therein
146, businesses
386+146 = 532 times !
141, about
A preposition meaning connected or associated with. WEB and CM have lot of experiences to form pattern comparisons

140, capital

122, investment
99, managers
There is a lot of talk in the writings about able and trustworthy managers and numerous examples
96 , market
This is interesting mainly because the concept of market get mentioned so much further down this word frequency list.
I came to the conclusion that if a truly smart machine interpreted the essence of the discussions portion of his shareholder letters, the conclusion might read something like this:

"Mr. Buffett focused on the importance of individual businesses and what not to value. Because of the frequent use of the words business, not, earnings, value, about, and capital, we can conclude that this piece of literature is a cautionary tale about factors to avoid when making an investment."

Therefore, in addition to the Elaboration Process and Effect, another important Best Practice for investors is the Elimination Process and its Effects on your portfolio.

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