My Investing Epiphany

 Having a Plan and following it is Critical---My Epiphany

Over the years I have written this story a few times but have lost the old copies, so here we go again.

The moral of the story here is that having a plan is critical and that following a well-thought-out plan is more important than what the actual plan comprises. The correct plan depends on the individuals' skills and biases.

 Towards the end of 1993, I had a big decision. Although I had been investing in the stock market since 1985, the amounts were not huge, although meaningful in the scheme of things at that time. My mortgage which I had taken out a few years before was about to be paid out.

Side note for Millennials—this is not the main point of this note. The reasons I was able to pay off the house so quickly, were threefold. Firstly, it was a modest house, I have never invested heavily in property even a principal residence, I didn’t spend that much on other things, and property prices were lower back then.

As I was inclined to invest all excess cashflows into shares and not buy a larger property (like all Australians lol), I thought it helpful to measure how my investing had gone since 1985. That being a reasonable amount of time to be significant.

The overall results were quite disappointing being around 0%pa. The period measured did include the 87 crash as well as the brutal 1991 recession which was a true clearing event. However, even including these headwinds it was not good enough.

My analysis wasn’t complete. Next, I dissected every trade, classifying them under different measures. Were they value-based, macro-based, a hot tip, etc. there was no pattern or consistency to the investing it was a real hodgepodge. The most instructive analysis came from making a profit and loss for four categories of trades, large-cap industrials, small industrials, large resources and small resources.

The results were stark, the variation in profitability significantly differed. The large-cap industrials were very profitable. Large resources were not too bad, small industrials were passable and small resources were a disaster area. The next level of analysis broke down trades by size and where the idea originated. The results again clearly showed a strong correlation with my knowledge base. The companies I knew well, combined with those where forecasting predictability was higher and luck or volatility played a lesser part were where the profits resided.

The results of this analysis were clear if I was to put serious money into the market I had to be extremely disciplined in where I invested and not to participate in areas where I had much lower (no) skill.

Over the next 10 years, I kept close to the game plan. The results changed immediately and didn’t deviate much. The portfolio returned just under 19 %pa versus 10% for the broader market.

These returns were generated across many investments and were not dependent in any way on a few calls. Alpha was generated across various sectors, but mainly mid-sized industrials. There was one year the portfolio underperformed the market and one year was negative.

One tactic that delivered returns was the careful use of debt. The level of debt was usually 30% of total exposure, so modest. The above returns are measured before debt and would be markedly higher if debt adjusted. The gains from debt came from a few areas. Firstly, it gave a measure for an opportunity cost being the after-tax cost of debt as a measure of minimum return. Secondly, it geared up results, which comes with the returns being above the cost of debt. Thirdly, and probably more importantly, it removes the fear of missing out, or money burning a hole in your pocket, which can result in poor decision-making and tests your discipline to be patient. The reason for this was that, simply if there were no attractive opportunities, I would pay down debt. When the opportunity appeared, I would draw down debt. That strategic flexibility was a supplier to alpha in itself.

When I talk about large industrials here, I am talking about profitable businesses, some of them had small market capitalisations but had a large degree of predictability as the major attraction more than size.

The stock numbers were probably around 10-20 for most of that time. The largest positions were usually around 6-7%. The portfolio had adequate diversification and was not reliant on one or two moon shots. To me that talks to stable predictable returns and a lower risk.

Although the returns were derived from quite diverse sources, a couple of strategies. One, stolen from Buffet was regional media companies which were close to monopolies until the internet arrived. Several companies were relatively cheap but had a high multiple growth business embedded in the company as it grew the multiple expanded. A couple of examples, Southcorp with its growing wine business and Howard Smith with its hardware retail chain that would become Bunnings.  There was also a steady stream of takeovers as many of these companies were profitable, mid-sized and not expensive.

Another strategy I developed was about position sizing. The size of the position took risk into account and each investment was assessed and sized on the probability of outcome. In other words, large positions were taken where the returns were expected to be more modest but much more certain, and smaller positions that could return large payoffs but were more uncertain.

The message to me from this story is quite clear. That is, work out where you have an advantage and stick to it. Every time I stray the results are invariably the same, disappointing.