blogging, diversification, fear and greed, Margin of Safety, portfolio allocation, size effect, value investing, Warren Buffett
Continued from here.
vii) ‘Sorry, I don’t have any sure-fire winners’
Do I feel confident about my portfolio? Yes, I do…
But with an important caveat: I feel long-term confident. I’d even dare to say I expect to out-perform my benchmark indices. [Well, another caveat: That’s really not my objective – I’m more focused on absolute returns & generally improving my risk-reward ratio].
But do I feel confident about my individual stock picks? No, not necessarily…
Unfortunately, this is a reality we all face as investors. No matter how diligent your research, no matter how rigorous your quantitative & qualitative analysis – all too often, individual stocks feel just like a roll of the dice. Most obviously, the insidious effects of fear & greed are to blame – but no matter how hard you stamp these out, you’re still subject to the tender mercies of Lady Luck. And there’s no escaping her. [Though it helps if she looks like this…] As any good boxer will tell you: If you box, you will get hit… The sooner you resign yourself to rolling with the punches, the better – but don’t forget, the best boxer (usually) wins in the end.
And over time, investing skill & experience will inevitably beat luck, while diversification is also your ultimate secret weapon. Sure, I confirm my portfolio allocation for each stock I write-up – and that’s a great indicator of my confidence level – but the real lesson I preach is diversification, not concentration. Imposing relatively mechanical limits within your portfolio (see Well, Are You The Right Size?) is a great way to remove emotion from the equation. [Over the years, I’ve homed in on 3-7.5% as an optimal allocation for a single stock, in a portfolio of 15-20 (core) holdings]. As any smart investor will tell you, they’re usually confounded by their portfolio winners & losers in any one performance period. And trying to predict (or buy) just a few top picks is a fool’s game. So, no matter how confident you are, you still need to spread your bets…
viii) ‘I’m sorry it’s a micro-cap, and you hate the price & spread’
Well, really, I’m not…
I get quite a few emails from readers who are frustrated I focus on micro-cap stocks – which aren’t necessarily their cup of tea! First off, we need to correct this impression: Looking at my recent top 10 holdings, the average market cap is a very respectable EUR 324 million (or USD 433 million). Even if we exclude my largest (FIG:US) & smallest (ZMNO:ID) holdings – we still have an average market cap of EUR 93 M (or USD 125 M). [OK, to be picky: The median market cap is EUR 78 M, but that’s still USD 104 M]. Now, a market cap of USD 100 M+ might be chicken feed to Fidelity, but for us mere mortals, that’s none too shabby a market cap/company to consider investing in..!
And why the aversion to small/micro-cap stocks anyway? OK, I might concede a small-cap stock is – on average – more risky than a large-cap stock (um, forgetting all those countless large-cap disasters…). But a well-chosen selection of small-cap stocks diversifies away much of this risk. And we scarcely need to debate the size effect – it’s long been proven small-caps have consistently out-performed large-caps. Even with some incremental volatility, doesn’t that make small-caps a really smart bet (presuming you have a long-term perspective)? I certainly think so, and Buffett would back me up on that (well, if he could): ‘I’d rather have a lumpy 15% return than a smooth 12%.’
The real problem here isn’t a lack of empirical evidence, it’s simply human psychology… For many investors, clinging to large-cap stocks provides an illusion of safety. To know other investors, inc. the big boys, are all buying the same stocks is very reassuring. To talk about stocks/companies your friends & family actually know about is comforting too. [Hmmm, wonder how that feels..?!] The million large-cap research notes churned out each year offer another compelling endorsement. The sliver of a bid-offer spread is painless & oddly respectable. And the fact you can sell at a moment’s notice lulls you nicely back to sleep when you awake with the 3 am portfolio night sweats. The small-cap investor, on the other hand, enjoys none of these creature comforts. But let’s man up here… All that stuff’s just window-dressing, and how does it relate to actual value anyway?
For me, risk/reward’s all about a margin of safety…not just an illusion of safety. I don’t necessarily believe small-caps are cheaper (on average) than large-caps, but they’re definitely far more extreme in their valuations. Which presents us with a far more bi-polar Mr. Market, and many more chances to enter stocks at dirt-cheap prices. [And also to exit them, ideally, at ridiculously expensive prices]. I’d gladly deal with wide spreads & low trading volumes in return for such opportunities.
And a wide spread means little in the scheme of things, if you have a long-term perspective & holding period. While a combination of bored/impatient investors & low trading volumes often pukes up crazy prices for the patient investor. [Patience may be the most important skill an investor can possess, in all aspects of their craft – and nothing hones patience better than trying to enter/exit a low-volume stock!] Anyway, I recommend you Average In, Average Out & also Average Up, Not Down – it makes for a much easier investing life.
As for price itself: If you have a strong conviction regarding the intrinsic value of a stock, does it really matter if its upside potential’s shrunk from (say) 120% to 80%?! And if it does matter, just look around, there’s always another neglected & unloved stock out there waiting for the first brave soul to find it…
ix) ‘Sorry, I
may not don’t have all the answers…’
People regularly comment/tweet/email, asking me new & urgent questions about stocks/companies. I’m very flattered they do…sometimes I manage to answer definitively, sometimes I’m forced to guess (authoritatively, of course!?), and sometimes I really don’t have a clue. I’ll certainly bug the company for an answer, if necessary. [Though I’m occasionally stunned how neglectful some companies are about their investor relations. Most CEOs would reasonably expect a same-day answer (to a fairly simply question) from one of their employees. Well, we expect the same!] But sometimes too many questions & too few answers are a warning sign…
In my experience, the more I know about a company’s history, its management team’s history, its annual reports/accounts over the years, its peers, and the market in general, the more likely it is I actually have answers to the questions I & others ask. And writing about a company helps me anticipate those questions (see Why I Write…). I definitely recommend it – even noting down a brief cheat sheet/investment thesis (for your eyes only), I’m sure you’ll discover this too. [And it’s probably your best chance to analyze your investing mistakes properly – see Learn To Love The Black Box].
But with some companies, questions about their press releases, their accounts, their strategy etc., are simply left begging for answers. And that’s not good… It usually means management has failed (or refuses) to communicate with shareholders in a consistent & coherent fashion. Even worse, management’s strategy may simply be incoherent! And if I can’t answer your questions about a company (I own), there’s really only one question left to ask – why exactly do I own the stock..?!
x) ‘Sorry, I don’t have the inside scoop…’
On occasion, I receive emails about certain stock write-ups, asking how on earth did I happen to know certain facts & figures and/or anticipated certain developments. Unfortunately, the answer’s far less dodgy, and far more dreary, than readers might like to imagine… Most of the time, my source is a footnote buried 50 pages deep in the back of an annual report, an old & random news article, a snippet from a six year old press release, or maybe it came from a forgotten corner of the corporate website. Or perhaps it’s just an inference I arrived at while juggling eight different documents & nearly going blind! But now & again, it’s more tenuous – for some nagging reason, I’ll lay out a potential scenario I have a strong suspicion about (and I’ll present it accordingly).
Of course, with the latter, I may be (& have been) totally wrong…but that tends not to bother me so much. First, I’m loathe to pay up for the future (whatever it may be), so I’m often painting a scenario which offers a free option. Ideally, I’m also relying on a catalyst, or two – for example, the presence of an activist investor – which makes it that much easier to anticipate certain scenarios & events. So if I’m wrong, ideally it’s just a matter of timing… And if I’m way off base, hopefully it’s a case of no harm, no foul! 😉
As regards inside scoop itself, I definitely consider its prevalence & impact is vastly over-estimated. Obviously, I meet with management occasionally – I’ve always been impressed how conscientious (paranoid!?) CEOs & CFOs are these days about avoiding any kind of improper disclosure. As for investors, the idea of spending an entire meeting with management (and/or all your other resources) attempting to ferret out some revenue growth number ahead of the next results, seems like a ludicrously fleeting advantage to me. How on earth would that help me in assembling a diversified portfolio, the majority of which I hope will compound for years to come?!
In reality, the events that cause the biggest price moves (like M&A activity) are already closely monitored. [And info’s strategically ‘leaked’ by one or more parties anyway]. So these days, the real insider trading that makes the headlines is almost inevitably based on short-term highly leveraged trading which exploits relatively small price movements (plus you only hear about winning trades from the prosecutors). And just to be a little cynical & sinister here, actual prosecutions remind me of security theatre – in this instance, let’s call it litigation theatre, a diversion of the
suckers’ taxpayers’ attention away from the really criminal insider trading. Um, another bankers’ coup d’etat…anybody?!
xi) ‘Sorry for the repetition, repetition, repetition’
Do you feel suitably bludgeoned yet?! ‘Til they drag me from the stage – ‘A horse! a horse! my kingdom for a horse!’ – I shall keep on chanting my investing perspective, tips & advice, accompanied by a valuation process I’m sure you can repeat in your sleep by now. OK, I’m exaggerating, a teensy little bit – I mean, you’re still reading – um, aren’t you?! But sorry, the first person who needs this constant repetition is me, to ensure I stay on the bloody straight & narrow. Otherwise, God knows what might happen – believe me, going off the rails and waking up in the sack with a junior resource stock CEO, a dwarf, an empty wallet & a killer hangover is not to be recommended…
And while stock selection may ultimately be an art, stock valuation is most definitely a science. Which requires consistency, rigour & discipline at all times – they serve as anchors when the market’s tempting you to feel exuberant, and as pillars of strength when the market keeps beating you down for months on end. The goal here is to strive for a pretty rigid absolute value approach, and not to settle for some cosy relative value process that changes with the bloody season. Sure, there’s lots of companies & sectors which clearly deserve a variety of different valuation approaches, ratios & metrics – but on the other hand, the same operating margin and/or earnings growth rate (for example) surely doesn’t deserve a ridiculously higher multiple in one sector vs. another. [Though that’s exactly what you’ll find huge numbers of investors arguing online every single day]. And valuation should rely primarily on current & historic financials – the future is another country you may never visit, so it’s probably best to consider it mainly as a qualitative component of your stock analysis & selection.
This consistency can be particularly rewarding if applied to assets/businesses, regardless of their listed status. I’m often bewildered by investors who award large-cap & small-cap companies very different valuations, even when they sport the same set of fundamentals. This makes no sense – you may well attach a different level of risk to a small-cap company, you may even demand a higher upside potential, but this should in no way imply its underlying intrinsic value is inferior to that of a large-cap company. [An obvious reminder: The status & ownership of any business could be very different in a year’s time]. In fact, I’d argue the same exact premise even if it was an unlisted company! Which reminds me of Buffett’s approach: ‘I buy on the assumption that they could close the market the next day, and not reopen it for five years.‘ Basically, you need to buy the business, not the stock…
Recently, I’ve been somewhat surprised to realize I’m still reasonably bullish on the (developed) markets. [Though I should note, this isn’t the same as saying I’m actually optimistic about them]. Plus I still have plenty of potential buys stacked up. And this week I’ve been racing through ‘The Snowball’ again (just to celebrate a $200,000 BRK/A!) – so now I’m feeling like that over-sexed guy in the harem. [Actually, I think Buffett’s actual quote referenced a ‘whorehouse’ – Forbes bowdlerized it]. Which seems to stand in stark contrast to an increasing number of bloggers & investors these days. Let’s hope it bloody fades a little before September & October, the cruelest months of the year…
Over time, esp. when you’ve enjoyed some nice profits, it’s all too easy to lower your standards, raise your multiples, and count on a permanently rosy future. What’s worse, you don’t even notice you’re doing it! But now, whenever the blood’s rising, I have a written record I can go back & check, plus I know I can also rely on your eagle-eyed scrutiny: Am I still valuing stocks with the same consistency, rigour & discipline – or have I drifted? Go on, you tell me…
xii) ‘Not to forget – most of all, I’m sorry for the boredom’
I’m sure I’ve warned you before, I guess this blog is essentially a selfish endeavour. [Uhoh, the message-board muppets will love that admission, their little conspiracy-twaddled minds will explode]. It’s an integral part of my investment process – and I get far more back from the blog, and from my readers, than I actually put into it.
But from day one, I pretty much decided my write-ups would focus almost exclusively on stocks I actually owned. In fact, it was more the opposite, it really didn’t occur to me to write about stocks I never envisaged/ended up buying. What can I say – I’m not a journalist, I’m not an analyst, I don’t love corporate strategy & business models simply for the sake of it, I’m just an (overly-focused) investor. [A bit like politics really. I’m very interested in the end, but God spare me from the bloody means!]. And how much could we learn really from the dozens of companies I set aside before finally settling on a candidate to buy?
Couple that with the fact investment theses & valuations generally change quite slowly (well, in my opinion), and it doesn’t really make for an action-packed portfolio – in terms of activity, or reporting. My bad, definitely… A stock write-up here is like the unexpected detonation of a tin of paint – exciting, that is until I suggest we sit around for months just watching the paint dry & waiting to see what pattern emerges. I’m sorry, this has all the makings of:
The most boring investment blog ever…
But in my defence, I’ve written far more about my thoughts on investing than I ever expected originally. And I’m also a duck – um, by which I mean there’s actually a lot going on below the surface, stuff we may not necessarily see or talk about here. But you do get to see the nuts & bolts of an actual portfolio on a real-time basis, complete with investment theses, valuations, allocations & price targets. And surely a good portfolio should ultimately be…dare I say it, boring?! But if you can remove the fear & greed, remove the mistakes, remove the unnecessary trading, etc. – what are you actually left with?
Buffett’s ‘twenty punches’ approach to investing certainly comes to mind. It’s obviously a bit of an impossible ideal – shhh, I’m already ashamed of my number – but I’ve gotten much much better over my investing career. Now it might take me years to buy a stock, and even more years (ideally) before I sell it, so all I really need is two or three great ideas a year to keep the show on the road. 🙂 [Whadda ya know, I may even have a few new stock write-ups coming, soon enough – hey, when it rains, it pours..!]
So here’s to punches & compounding, and watching paint dry…
xiii) ‘And finally, last but certainly not least – Dad, I’m sorry…’
Yes, you’re right, I probably should drop the fucking swearing from the blog… 😉
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