The Dao of Capital by Mark Spitznagel
John Wiley & Sons, 2013
The Dao of Capital connects several mental models (see Charlie Munger at Farnam’s Street great blog) that put together provide a superb framework for an investment philosophy. The author details teachings and insights from biology, philosophy, history and military strategy.
Mark Spitznagel is the president and CIO at Universa LP, a tail hedging specialty finance boutique, where Nassim Nicholas Taleb, author of Incerto (“Fooled by Randomness”, “The Black Swan”, “The Bed of Procrustes” and “Antifragile”) acts as scientific advisor. The bottom up approach so keen to Taleb is clearly articulated and detailed throughout the book.
The Dao of Capital means that there is a process for capital creation and destruction. Capital is not something static.
The book is divided in 3 parts.
The first part is dedicated to the roundabout strategy, where the main quote is that from the trader Everett Klipp, which greatly influenced Spitznagel’s early years in the pit of commodities trading in Chicago:
“You have to love to lose money and hate to make money to be successful, there’s no other way.”
A core principle of investing, and actually a characteristic, that unfortunately is so far from the day to day Wall Street routine. You should be prepared to lose in the short term to improve your advantage in the long term. In the famous psychology experiment of the marshmallows by Walter Mischel, you have to refrain from eating the marshmallow put in front of you so that you get more in the future. Patience and discipline are key. This roundabout strategy is based on planing several steps ahead and being prepared to make sacrifices to reach an advantageous position for large gains in the future. The analogy is made with conifers and military strategies from Sun Wu (“Art of War”) and Carl von Clausewitz (“On War”).
The second part details key tenets of the Austrian School of Economics that focuses a lot of attention on the individual and their choices. For this school, state intervention (top down) should be kept to a minimum, because of the unforeseen impacts that it generates. The intelectual framework is clearly contrary to keynesian economics. The main tenet is that by supressing small self correcting problems, intervention lays the basis for more devastating problems in the future. This is the oposite of the roundabout strategy.
The example used is forest fires, where the desire to prevent even little fires that would keep the ecosystem in balance, makes it very likely to expose the ecosystem to a very large and damaging fire in the future. From this concept, the analogy is made regarding the control of interest rates by central bankers, that distort an essencial price in the economy - the price of money. This distortion creates problems going forward and generates the boom and bust economy we have experienced. For this school and the author should there be a free market price for interest rates and the economy would be more able to self correct.
In the third part of the book a framework for Austrian investing is presented. Without going too much into the philosophy, that would be fruitless if one doesn’t invest in fully exploring its basis, the strategy includes two main parts. First, it looks at the whole market for the signs of overvaluation and proposes to be out of the market when the overvaluation occurs. The valuation signal is similar to Tobin’s Q where the market value of assets is compared to replacement value. Then, stocks are selected using an approach similar to Joel Greenblatts “Magic Formula”, where the investor ranks companies according to a quality criteria (e.g. high ROIC) and a valuation criteria to select a subset of the market that shows the best compromise between quality and value. This approach is indeed a very sound basis for equity selection and resonates with value oriented investors and systematic approaches that have been shown to provide better investing outcomes in the long term.
The book makes interesting connections between areas of knowledge and delivers a sound investing framework, that I believe is useful to expand investors’ analytical and strategical toolboxes and leave them better prepared to navigate markets.
I also recommend Mats Larsson’s review at Investingbythebooks:
and Mark Spitznagel’s video explaining tail hedging: