Book Summary: Pitch the Perfect Investment

Book: Pitch the Perfect Investment

Author: Paul D. Sonkin and Paul Johnson

Key takeaways: It’s a very useful book, though it could have been a lot shorter if they had just thrown away the few beginner-level chapters where they discuss items such as how price of a security is the sum of future cash flows discounted (really, guys?). Also, please don’t be put off by cartoons, such as those of lemonade stands. There’s actual good info in this book that’s best appreciated by moderately-seasoned analysts, but is undercut by signals (cartoons/discussions of DCF) that would suggest that book is meant for beginners.

With all that out of the way, below are my take-aways.

 

PART I : WHAT MAKES FOR A GOOD INVESTMENT

Sources of Alpha:

Three potential advantages that an investor can develop:

  • Informational Advantage (here’s something important I know)
  • Analytical Advantage (here’s something that I think will happen)
  • Trading Advantage

 

Cost of Capital:

I personally find it frustrating that generally so much brainpower is spent on figuring this out this variable when it’s wildly subjective (and mostly used by analysts to crowbar their DCF valuation into a number they wanted to arrive at in the first place). I think that the extreme difficulty to figure out the correct discount rate is easily the biggest drawback of the DCF methodology, hobbling it for most purposes.

This book does a good job of highlighting two things I have found most useful:

  • When in doubt, use 10%
  • Buffett’s quote: “…just look to do the most intelligent we can with the capital that we have. We measure everything against our alternatives.”

Personal side-note: if “value” of a security is CF1/(1+r) + CF2/(1+r)^2 + CF3/(1+3)^3 and so on… in which field would everyone agree that if values of CF1, CF2, CF3 etc. change, we should change the value of r as well to adjust for variability in CF1/CF2/CF3? Why is this accepted as a formula at all in security analysis at all (by some) is confounding to me.

 

Market Efficiency:

The book does a great job of how the process of market efficiency works.

An individual’s process for estimating intrinsic value –

  1. Dissemination: make an observation
  2. Processing: the individual uses available facts and his/her expertise (from his/her domain-specific knowledge) to arrive at a revised estimate
  3. Incorporation: using the estimate arrived at above, trade.

Market’s process for estimating intrinsic value –

  1. Dissemination: make an observation
  2. Processing: a diverse set of individuals, using independent models,
  3. Incorporation: using the ability to express, trade and the price the security

An interesting thing here is that individuals will make errors in arriving at their estimate of fair value, but their error will not matter, unless there’s a systematic error in the collective. The systematic errors happen when individual errors are correlated (this is where behavioral finance comes in).

 

Personal side-notes:

  • I think EMH is best understood as a process, and not a state.
  • Security prices reflect all available information that’s considered (a) relevant, and (b) accepted as common knowledge by a diverse set of market participants (note the highlighted conditional).

 

PART II : HOW TO PITCH

Portfolio managers have a template in their mind of what their perfect investment looks like based on a schema they have developed over their years of experience.

They also have little time, so think if your pitches in three sections: (a) 30-second hook, (b) 2-minute drill, and (c) Q&A

 

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