- This article provides 5 main investment tenets enterprising investors should follow.
- The 5 points include avoiding negative influences, thinking better than average, paying attention to valuation, thinking about risk before reward and having patience.
- While the investing environment will change, the author believes these tenets should not change. Investors should read them with care.
- This article should be of interest to Berkshire and/or Oaktree followers.
This article is aimed at providing 5 main investment tenets for enterprise investors, which will serve as a follow up two my prior two articles on investment strategy (found here and here). I am grateful for Ben Graham, Warren Buffett and Howard Marks; they help to shape my current investment philosophy. I believe this article should be of interest to any Berkshire (NYSE:BRK.A)(NYSE:BRK.B) and/or Oaktree watchers (NYSE:OAK).
What Is An Enterprising Investor?
"The enterprising investor, by definition, will devote a fair amount of attention and efforts toward obtaining a better than average investment result"
The Ben Graham quote above provides an excellent definition of what is an "enterprising investor." As he mentioned in The Intelligent Investor, enterprising investors are not those who actively trade in the market. Enterprising investors are those who are willing to devote a significant amount of time researching their potential investment ideas and figuring out the intrinsic value. The enterprising investor's goal is to achieve better than average results, which is equivalent of "beating the market."
There have been many academic studies that have shown that investors shouldn't try to beat the market since the price of all securities are "efficient" all the time. They conclude that most investors should buy index funds. I agree with them on the point that the majority of investors (around 95%) should invest only in index funds because of their simplicity and diversification. However, I do not agree with academics that prices are efficient all the time. There are too many restrictions on institutional investors' activities (e.g. short selling, owning stocks or bonds in certain capitalization range or sector etc.) that prevent a perfectly efficient market theorized by the academics. Moreover, investors, retail and institutional investors, often stumble because they fall prey to their cognitive and behavior biases. These biases will lead to suboptimal investing decisions, which will lead to mispricings in the market.
The occasional mispricing in the stock market will allow enterprising investors to profit and achieve above-average returns.
Point #1: Eliminating Negative Influences
"The Investor's chief problem - and even his worst enemy- is likely to be himself. (The Fault, dear investor, is not in our stars - and not in our stocks- but in ourselves...)"
Ben Graham, often called the father of security analysis, realized that an investor's worst enemy is himself/herself. The worst enemy is not the stocks that might have performed poorly, but rather his/her own behavior and thinking. Those behavior is what I called "negative influences" and I believe investors can achieve better investment results if they can mitigate their own negative influences.
Some of the negative influences include:
- Following the herd
- Checking prices too often
- Overconfidence (inability to balance arrogance and humility)
- Loss aversion
Following the herd:
Following the herd is one of the most common negative influences in my opinion. While it is easy to understand the dangers of following the herd, it is hard to resist it. When markets are rallying, it is often envy that will drive investors' decision to buy stocks that others are buying. In 1999 or 2000, everyone bragged how they were making 100% or more by buying internet stocks. Those poor souls who were left out envied those who made the large gains and decided that they should get rich too. Any buying decision on impulse or a feeling of envy will often have disastrous consequences. A perfect example is when investors bought social media stocks late last year because everyone who has purchased them made 20-50% within a few months. Never purchase a stock until you know exactly what you are buying and the underlying risk of the company. Another rule of thumb is avoid all "hot" stocks everyone is buying because it is very likely that the opportunity to buy has passed already. As Buffett explained in his shareholder letters "What the wise man does in the beginning, the fool does in the end."
Similarly, following the herd during market declines can be hazardous as well. The urge to get out is highest when the market is near the bottom and stock prices capitulate. When everyone is getting out, shrewd investors should not consider selling stocks. Instead, they should be consider buying. Therefore, whether everyone is selling or buying, investors should consider going the opposite direction of the herd. Patience is key to contrarian decisions (see point #5 below).
Checking prices too often:
Because I started out trading stocks, it was hard for me not to check prices often. What is the problem with check prices too often? One issue is it amplifies the pressure to follow the herd, a big problem described above. Furthermore, checking prices often may increase the pressure to buy a stock when prices are rising or sell a stock when prices when are falling. Thus, watching stock quotes too frequently will lead to more trading (more transaction costs) and less thinking (less rational decisions based on underlying fundamentals). While investors aren't forbidden to speculate in the market, they should try to avoid short term trading or speculation for their retirement or any other long term portfolio. By ignoring the market's daily fluctuation, investors can avoid the mistake of trading too much and making irrational decisions such as following the herd.
Good investors need to find the right balance between arrogance and humility. Whenever I purchase a stock, it is an arrogant act because I believe I know more than other market participants about the stock. However, I am careful not to let my arrogance override my humility. I always write down, in order to avoid hindsight bias, why I purchase a stock and how I could be wrong on the investment thesis. By writing down and admitting I could be wrong, it will reduce my arrogance and mitigate the overconfidence effect.
Another point about the overconfidence effect is investors should acknowledge that not all favorable investment outcomes are due to skill. Therefore, don't brag or feel proud after making a few outstanding investments. Try to balance your arrogance with humility. For readers interested in reading more about the role of luck in investing, I highly recommend Marks' January memo on luck.
Many investors frequently sell winners and keep their losers. Why? It's due to a psychological effect called "loss aversion." The pleasure of winning $2 does not offset the pain of losing even $1. Therefore, investors often sell their winners and let their losers run because the fear of realizing a loss.
How to mitigate the negative influence from loss aversion? The answer is to remove the loss anchor, which implies removing the original purchase price from your memory. This may sound like an absurd suggestion, but without the purchase price in your mind, there is no loss or gain. Too many investors focus on their profit and loss and not on whether the stock is a bargain at the current price (not based on your original purchase price!). If you own a stock, then pretend you don't own the stock and ask the following question: If I have ample of cash and is evaluating the stock today at the current market price, would I purchase the stock? If the answer is "no", you should sell the stock. If the answer is "yes", you should hold the stock or even considering adding your position if you have some cash. Using this method, there is limited negative influence from loss aversion because the original purchase price is removed from consideration. Moreover, this method will allow a direct evaluation of the expected return at the current market price.
Summary Point #1:
While there are many other negative influences, such as other cognitive and behavior biases, I believe I picked out four important negative influences that investors should avoid. For those interested, I would recommend reading Rolf Dobelli's The Art of Thinking Clearly. His book provides a wonderful list of behavior and cognitive biases. By mitigating negative influences, investors can achieve better investment results.
Point #2: To Be Better Than Average, Think Differently
"The upshot is simple: To achieve superior investment results, you have to hold nonconsensus views regarding value, and they have to be accurate. That's not easy."
Marks offered the following diagram to illustrate his point.
|Conventional Behavior||Unconventional Behavior|
|Favorable Outcomes||Average Good Results||Above-average Results|
|Unfavorable Outcomes||Average Bad Results||Below-average Results|
Source: The Most Important Thing page 5 (By Howard Marks)
As readers can see from the diagram above, if investors make consensus-like decisions, they will get the average result. The only way to achieve above-average result is to make unconventional decision and making sure that decision is the right one.
The way to achieve unconventional thinking is apply what Marks call "second-level thinking". Below is a short excerpt from his book titled The Most Important Thing (page 4):
First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority....Second-level thinking is deep, complex and convoluted. The second-level thinker takes a greater many things into account:
- What is the range of future outcomes?
- Which outcome do I think will occur?
- What's the probability I'm right?
- What does the consensus think?
Below contains my take on second level thinking, which is an excerpt from my blog post titled "My Thoughts on Investing":
For investors who want to achieve above average returns, their thinking should be deep and avoid common pitfalls. That deep thinking is called second-level thinking. Successful investors should be able to think at a higher level and consider all possibilities. First-level thinker, the majority of market participants, only focus on the obvious facts and fail to draw thorough conclusions. A common first level thinking is buy companies with a growing business or high earnings/sales growth. Without even considering the valuation or the competitiveness of the business, investors may lose a lot of money because of their flawed thinking. Nifty-fifty investors learned that lesson in the 1970s when they lost 90% of their money by buying stocks of the best 50 corporations. Many market participants still avoid in-depth thinking when making investment decisions. To quote Bertrand Russell, "most men rather die than think. Many do. "
Difference between first-level and second-level thinking:
- A first-level thinker would say "the company is a great company and has a great brand; hence let's buy the stock" (Too much focus on quality). A second-level thinker would say "the company does have a good brand but it's already reflected in the share price. With its shares trading at 50 times earnings, the stock is priced for perfection. Time to sell."
- A first-level thinker would say "the company is trading only at 8 times earnings and has a high dividend yield of 10%. Time to buy" (Too much focus on yield and low PE ratio). A second-level thinker would say "although the company trades at 8 times earnings, it's not a value buy because it faces double digit revenue decline and higher expenses over the next few years. When those two factors are considered, the stock is actually trading at 25 times earnings. With its dividend payout ratio at 90%, any large earnings decline would impair the dividend. There is no margin of safety with this investment. Sell."
Point #3: Valuation is Key, Always Have A Margin Of Safety
"Price is what you pay, value is what you get"
In my December post titled "5 Most Important Points For Investors To Remember As 2014 Approaches", I emphasized the need to focus on valuation and less so on momentum. Even after the pullback in momentum stocks, I am not changing my view. Valuation is always important. The intrinsic value is a critical input to any investment decision because it will allow the investor to decide if there is profitable opportunity to buy a stock that is significantly below the intrinsic value. Intrinsic value is simply defined as the discounted value of the total cash flow any business can throw off in its lifetime. Even if the business is currently not generating cash, the intrinsic value calculation should be done on its expected cash flows in future years. If the stock under consideration is not expected to generate cash any time soon (on a 3-5 year horizon), the stock is a highly speculative investment and should be avoided, at least for the retirement accounts.
One point to note is that the intrinsic value is best expressed in terms of a range rather than a precise number. Also, intrinsic value is not constant. The value of the underlying business will grow as its earnings generation capability (earnings power) changes over time. Investors should review the valuation of each stock in their portfolio on a quarterly basis to see if intrinsic value is increasing, remaining constant or decreasing.
Of all the investing terminology I encountered, the best three words in investing are "margin of safety." Margin of safety is commonly defined as the difference between the current market price of the stock and the calculated intrinsic value. The higher the spread between the current price and the intrinsic value, the higher the margin of safety or safety cushion. Although many investors are aware of the term, a lot of investors, in my opinion, don't realize the importance of margin of safety. Intrinsic value is based on estimates of future financial performance. Since not all estimates can be 100% right or even 50% right, investors need a large margin of safety to ensure that even if they are wrong, they won't lose too much money. Graham suggested that investors should at least have a 50% margin of safety (price-to-value of < 0.67).
I'm constantly amazed at how many analysts would recommend a stock with price targets only 8-10% above the current price. There is no real margin of safety at all. Investors should at least have a 33% margin of safety (price-to-value of <0.75).
Point #4: Risk Before Reward
"You only find out who is swimming naked after the tide goes out"
The Buffett quote above shows the challenge of assessing investment risk: you won't find out the true risk behind any investment until something bad happens. Investors learned how risky CDOs can be only after liquidity froze in late 2007 and prices were falling like a stone. Similarly, AIG (NYSE:AIG) learned the risk of selling (shorting) CDSs only after everything blew up. Hence, it is important for investors to evaluate the risks before considering the reward (expected return).
Some risk management questions I ask myself include:
- If I'm wrong, how low can the stock go given extreme negative assumptions? (This is trying to figure out liquidation value)
- What is the probability of the worst case being realized?
- What's my risk-reward ratio? (defined as worst-case value divided by my intrinsic value)
- What risks are priced into the stock price at the moment?
- Is the stock overpricing or underpricing risks the risks involved?
Investors should analyze risks from all angles. They should analyze the risks of the business operations, the financial risks and even management risks. The biggest mistake is committing the man with a hammer mistake and focus only on one aspect of risk while ignoring other viewpoints. Readers interested in reading more on my view on investment risk should see my blog post on risk.
Point #5: Patience, Patience and More Patience
"No Matter how great the talent or effort, some things just take time: You can't produce a baby in one month by getting nine women pregnant"
When investors complete their research and analysis of underlying value, they should act on their analysis. If your reasoning and logic is correct, don't worry if other market participants don't agree with you. To quote Graham: "Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it - even if others may hesitate or differ. (You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right)."
To have the courage to act on your analysis, you need to have the courage and a boatload of patience. Often, it will take time for a stock's intrinsic value to converge. As long as the fundamentals remain intact (remember to check every quarter!), you should exercise patience and wait. To quote Peter Cundill (a Canadian value investor): "patience is patience is patience." Investors should exercise patience and don't forget that successful investing requires a long term view. Don't count in terms of months or quarters, count in terms of years.
"Experience is what you got when you didn't get what you wanted."
The Marks quote above shows the importance of learning from your mistakes. I learned a lot from my mistakes and from the mistakes of other famous investors. The tenets stated in this article reflects what I learned. I hope I provided a good lists for investors to remember. As always, do continue to learn and grow as an investor. Investing is a marathon, not a sprint. Being a tortoise is better than being the hare.