Turn-Of-The-Year Reflections: 2, Golden Mean In Investing

Summary

• Dear Followers, Happy New Year!
• In this article, I continue with my turn-of-the-year reflections.
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The Golden mean

2020 taught me once more about the importance of the Golden Mean.

The golden mean is the desirable middle between two extremes, one of excess and the other of deficiency.

In search of an edge: esoterism or 'crowdology'

Staying in the middle of the crowd can be mentally comforting but as an investment strategy, it is known to never generate an above-average rate of return. To attain a better RoR than the neighbors, one has got to have an edge. Successful investing is the process of monetizing one's edge over his counterparties.

The pursuit of that edge can lead an investor to esoterism. After an untravelled trail, one may think he alone chances upon a land where treasure troves are hidden. Finding no competition nearby does not necessarily mean one uniquely possesses an advantage. Seeking esoteric edge is a mistake I made in 2019 when I tried to find weird deep-value, and a mistake I managed to largely avoid in 2020.

From the viewpoint of running a sustainable investment operation, it's a far better idea to tap into recurring common market dislocations. Less due-diligence is required the next time you buy the same stock. All one needs to do is to wait for a pre-identified opportunity to mature and pull the trigger, and repeat the process again and again. It takes relatively little effort to produce an endless series of successes. This sounds very much like an air-conditioned toll booth on a much-traveled highway.

Warren Buffett calls it the circle of competence. His circle of competence is (1) to identify wide-moat businesses; and (2) to buy those wide-moat stocks by taking advantage of recurring bouts of human insanity. Buffett found a golden mean between esoterism and mingling with the crowd; he is quirky because his approach is used by few investors (it's against human nature); and he shows up among the crowd for game hunting, rather than to gain warmth.

The natural resources sector is an extremely fertile hunting ground for discerning investors:

• Firstly, society never ceases to need hydrocarbons and minerals, so natural resource exploiters rarely need to worry about no buyers of their products (despite the fluctuating realized price).
• Secondly, human events such as pandemics, politics, or military conflicts do not diminish the in-the-ground natural resources, giving the natural resource owners an asset-based value anchor.
• Thirdly, information inefficiency is commonplace in the natural resource sector, especially among micro and small-cap stocks, much more so than any other industry.
• Lastly, even the large-cap natural resource exploiters cannot escape from the commodity cycles, driven by the nature of projects (capital-intensive, long lead time) and episodes of market over-reactions (oscillating between overselling a commodity and overbuying it, neither extremes being justified by the supply-demand fundamentals).

I think the investment approach pursued by TNRH^® (i.e., sticking with high-quality assets operated by capable and shareholder-friendly management, and buying at commodity bottoms and selling around commodity peaks) strikes a balance between esoterism and 'crowdology'.

Picking investment targets: market timing or defeatism

Regardless of the amount of money involved, you are running an investment operation. For the operation to succeed, you will need to spend time thinking about it. On the other hand, you don't want your investment operation to consume too much of your time, and you want to sleep well at night.

It is imperative to strike a balance between investing and life. There are several approaches:

• The defeatism approach is to delegate stock picking to the professional mutual fund managers. However, a casual look at those mutual funds reveals a fact we have known all along: mutual fund managers just want a cut of your money year in and year out, with little skin in the game and regardless of whether he makes any profit for you. Voting by foot usually lands you at the door of a similarly-incentivized peer.
• Some favor ETFs, a kind of investment vehicle designed to enable regular investors to time the market without risking the mistakes that would be made in stock picking. However, market timing rarely ends well. Without spending a fair amount of time understanding the ins and outs of the underlying theme of the ETF, one takes an uneducated risk. But to know enough about an investment theme (e.g., an industry) is to enter a rabbit hole, much more complicated than any individual company. In the end, buyers of ETFs give up dreadful hard work that can produce good results while taking up a game that is impossible for them to win. Buying ETFs, as it were, is in essence putting blinds on for fear of stepping on a snake on a never-traveled path. (Granted the ETFs do have some limited utilization, i.e., as a vehicle for hedging.)

Between mutual fund buying (settling for less) and the speculative practice of market timing (attempting the impossible), lies intelligent stock picking (hard but doable) - the golden mean. A few tweaks, however, are necessary to make stock picking less time-consuming, which is mostly about managing the risk.

• Assets: high-quality is a must-have. The property must be richly-endowed so that the finding-and-development (F&D) cost will be low, supportive jurisdiction and accessible infrastructure must be present such that the operating cost will be moderate, both relative to the realized price of the production. We don't want the project to end with no mine/oilfield built. We don't want to worry about mine/oilfield shut-down in the event of low commodity prices. The property must also have a large volume of economical reserves because we want sustained growth of production and we don't want to worry about resource depletion.
• Management: The management that operates the assets must be competent enough to execute the exploration and development program, including securing low-cost finance. We don't want the management to blow an otherwise promising project. The management must be shareholder-friendly. We want him to have substantial skin in the game and be properly incentivized. We don't want to be robbed by the CEO from within.
• Magin of safety: Even though the assets are of high quality and the management is super, we still want to get an adequate discount on the way in. An early gain resultant from the big discount can help us to overcome the innate fear of losses triggerable by a sell-off, lest we may exit the position prematurely.
• Near-term catalysts. The company should have a series of operational events (news flow) lined up, or the investment may end up being dead money. Preferably, a bull market of the underlying commodity is brewing. Nobody wants a sustaining commodity bear market.

Managing portfolio: concentration or diversification

Portfolio diversification is said to be a free lunch in risk management. I can see the benefit of spreading bets across independent commodity classes and jurisdictions. In addition, as independent investors, we don't have access to a lot of information that institutional investors have; even the insiders have to cope with a myriad of uncertainties in the business. As a result, we often cannot distinguish a great idea from a fairly good one; sometimes, it's just a waste of time cudgeling one's brains to tell them apart.

At the other extreme, if we know one particular idea will absolutely be a 10-bagger in two years, we don't want to dilute that idea with iffier ones? After all, we are not supposed to confuse the means (diversifying) with the end (to attain superior RoR).

The key is to ask whether the conviction to the idea can be justified. Build a meaningfully-sized position around that high-conviction idea but keep a diversified group of ideas to which we are not certain of the level of conviction. That's the golden mean.

Generally speaking, a human being has four innate faculties, namely, instinct (we run from risk, existent since the first reptile), social (we interact with others, the lack of which is detrimental to our development, existent since the first mammal), emotional (we have feelings, probably shortly after the social faculty), and cognitive (we think, existent since the first homo sapiens). These four faculties have to be in a state of balance for us to function as a healthy soul. The golden mean is the state where the balance is.

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