The 40 Year Anniversary---lessons learned

 LESSONS FROM 40 YEARS OF WEALTH ACCUMULATION

Introduction

I bought my first shares in November 1985, the 40th anniversary is here!!—here's what I learnt since, sometimes the hard way! Through the various cycles, events and characters, the journey and outcomes have been an intriguing, rewarding and interesting way to spend time.

Below, I have attempted to avoid, firstly, pointing out stocks you should have bought, as there are no time machines. Unless there is a lesson to take forward, there is little point in hindsight stock wins. Secondly, I have tried to avoid motherhood statements and the stuff everyone has heard a thousand times before.

Broad Lessons

1.      Stay in the game, protect your capital and never risk too much. To this point, I have never squeezed the lemon dry; of course, I may have increased my returns by doing so, but that would have increased the chance of oblivion. We can choose where we sit when considering the chances of oblivion. Those who fly closer to the sun may do better than you, maybe forever, perhaps for a while; it's your choice. I’ve managed my funds with low or no existential risk. Destruction of capital means game over.

2.      The best investors have an investment philosophy and process that delivers long-term value, one that they have confidence in and that they can properly execute. Your conviction will be tested, and the market may appear to push you to your limits. Investment philosophies should identify what you see as the market anomaly that you can extract excess returns from, over time. The process should be how you execute that philosophy. Remember, no process is perfect, but it should act as an investing guardrail. You cannot control the outcome, only your effort and following your process. You win over time.

3.      Non-investment decisions can have a much bigger impact on your wealth than any investment decision. The biggest for me have been two divorces, a business partner who cleaned me out (larger than the sum of the two divorces), and more subtly, short-term career decisions that seemed fine but ultimately constrained wealth creation in the long term. My 35-year compound wealth is 15.5% per annum. My records start in 1990. Adding back the divorces would be 21% pa (some assumptions are needed here, and I've been conservative). If I add back the business profits I didn’t receive, etc., the compounding rate goes higher again. If you think the difference between 15% and 21% compounded over 35 years is no big deal, do the maths. Ouch. The point here is that investment decisions are only part of the story of wealth creation; there are other potentially much bigger ones. One of my CIOs used to say that he hated his PMs going through divorces, because there was a 100% correlation to underperforming. That is understandable, and I would widen the lesson to say a supportive lifestyle is important for investing success.

4.      Further on compounding. When I became a PM, there were strict compliance rules that implicitly and explicitly restricted your personal trading (PA). Fair enough, I complied with those rules; some did not. I believed I was paid an attractive salary in compensation for that restriction, or was I? My “dormant” PA earned about market returns over this period, 9-10%. My salary was high, but didn’t grow. An alternative scenario is that I was paid half as much in wages, but given complete freedom to trade my PA. Assume I made 15% compound over that period, below the 20% I had achieved over the last 10 years. Under what scenario would I have been better off? Well, there is no comparison, and this is perhaps the most powerful story here. The half wage and better returns over a long period decimate the much higher salary but lower investment returns. That is the power of compounding. Of course, all the difference occurs in the later years. The lesson here is clear: “capital*returns*time” is a powerful combination, so do not easily abandon it.

5.      Be as detached and coolly rational as you can, identify the biases that you have and how to control them; you will have more than you think. More on this below.

6.      Remember, markets are made up of people, and people are prone to fear and greed. Learn how to identify when they take hold.

7.      Risk and luck play a part in investments; have some idea how much they have played in your returns, and if you are interested in observing others, how much luck has played in their returns. (ed. I observe that properly calibrating risk and luck relies on you having a meaningful universe of case studies to compare any individual case.)

8.      Since I started investing in 1985, every year there has been a naysayer claiming the end of the world is coming. Yes, every year. Sometimes the same guy comes back for another go. The only time I felt the end of the world was a chance was in the spring of 2008, in the depths of the GFC. Even that ended up alright, after some heartburn. I have found a base stance of being cautiously optimistic as most useful. There are times when you should not be this, but they are rare, rarer than many seem to think.

9.      Markets evolve; what worked at one time may not work or work less well in another time. This is not a revolutionary or constant change, but an evolution of markets requires that you adjust your investment philosophy and process to new long-term secular changes. Buffett has shown an evolution in his career, and all credit to him. Changing a winning game plan when the time is up is very challenging. However, evolution is likely necessary to keep winning. This is a multi-decade observation, not a week, month or yearly one.

10.   I have never relied on past performance as the sole determinant of anything, especially investment returns. Unless you have a good understanding of how those returns were generated, you cannot have an assessment of how much skill and luck were involved; numbers are just not enough to make a serious assessment.

11.   The accurate and efficient processing of information is critical. More on this below.

12.   Many commentators state that the market is more efficient now than ever, and I strongly refute that. What I can see is a mountain of passive money, a wall of momentum money that extrapolates into the never-never and social media promoting waves of fear and greed. You can't find an opportunity in all that?

Specific investment Comments and strategies.

1.      Compounding really does exist; do not do anything to get in the way of it, especially by being too impatient. It does take time. Do not be desperate to take profits, as this may show a lack of faith in your process or that you don’t have a process.

2.      The market is semi-efficient, the door of opportunity opens now and then, have your plan and have done your work beforehand. I like to say the market is efficient 90% of the time; all the excess returns are made in the other 10%.

3.      As I have described before in 1993, I assessed my investing record to date, as I was about to ramp up investing big time. My historic results were about square after seven years, but examining winning and losing trades clearly showed skill in some areas and not in others. From then on, I eliminated the types of trades that had lost money and concentrated on what I was better at. The next 10 years generated about 20% pa, double the market. The point is to discover where your edge lies as soon as possible and focus on this area. You will likely not excel in all aspects of investing. Leave your ego at the door.

4.      I was a reasonable user of debt. The 20% pa I mentioned above was higher when allowing for debt. Importantly, the debt had three positive elements: firstly, it was not margin (so couldn't be called), was flexible (could be moved without penalty) and was low-cost (being secured). The opportunistic use of this type of debt aided the growth of my wealth. Of course, leverage adds to returns but also increases risk; the moderate use of debt helped both returns while keeping risk under control. The unexpected benefit was avoiding FOMO, a bias for me, as excess cash flow was either used to invest in great ideas or pay down debt; it never burned a hole in my pocket. Otherwise, I could have invested in poor ideas. Thus, the use of some debt limits one of my biases. (I stopped using debt in my 50s).

5.      Market cycles exist; the liquidity cycle flows into risk-on when there is a lot of liquidity present, followed by risk-off periods. Liquidity can be a coward. Each of these periods has significant implications for stock returns as the market prices risk differently. Be aware that these cycles exist. Coincidentally, predicting the occurrence of these cycles and estimating their longevity and amplitude is very difficult. That fact doesn’t stop “experts” from trying.

6.      One regret is that I never found a “Munger” to be an investing confidant. Finding a like-minded investor would have been a huge benefit. The relationship takes trust, respect and the skill of two evenly matched individuals. That would have been a great help over the decades. To me, it is no surprise that Buffett retired two years after CM passed. A great team is irreplaceable, simple as that. It is certainly worth the effort.

7.      Portfolio construction is critical, and as everyone says, it's where art meets science. I have rarely made significant asset allocation calls. I understand the importance of getting asset allocation right, but I believe the ability to do this consistently over time is difficult. I tend to agree with the notion that more money has been lost attempting to time market downturns than has been lost in market downturns. I have considered unconscious correlations in the portfolio, as well as analysing factor and sectoral exposures, especially the unconscious ones.  I have also “risk weighted” positions so that lower risk/return situations have been larger, higher risk, more uncertain outcomes, have had lower exposures, but are targeting similar absolute dollar returns. These methods must be considered in the realm of risk control.  

8.      Portfolio Construction (part 2) should align with your investment philosophy. I am a “hit rate” investor and have usually run a few dozen positions. I own stocks that are included on their own merits, so I do not diversify into anything I don’t like for the sake of diversity. My success is not based on one or two outstanding calls and is usually spread across several positions. That’s my style. To give an idea of a hit rate, one organisation I worked for monitored its 150-odd analysts. Once each analyst had achieved a statistically significant number, they were given a hit rate, measured as buy/sell calls that beat or not their universe of stocks. I was delighted to finish fourth (unfortunately, there was no fame or fortune), but the interesting thing was that I had a hit rate of about 58%. Everyone was basically between 40% and 60%. Although that may seem low, remember winning six out of ten over a long period is a great outcome. Alternatively, 4/10, you likely have no business. BTW, Buffett, I've read, has a 60% hit rate. That’s how I invest and am comfortable with that. My largest positions are, firstly, the highest conviction (i.e., the most certain), and secondly, they offer the highest potential return. Operating solely on potential return skews too far to risk. Since risk is difficult to quantify, the certainty of the outcome should weigh heavily on the positioning. Actual stock numbers, I'm relaxed about, whatever works for you. I am not a “slugging rate” investor, like VC, where you invest in, for example, 10 moonshots, and you need at least one huge winner to carry the portfolio. That looks way too risky for me, that is, relies too much on luck and not process, IMO. I am also not a “hype cycle” investor; some may have the ability in this area, but that’s not me.

9.      When I was a PM, it terrified me knowing that even my best analysts would get 4/10 wrong. How could I be sure that I had the six good calls in the portfolio, not only the four poor ones? There is an advantage to doing the work all yourself; you can calibrate risk/return much more clearly, or you should be able to.  

10.   As they say, picking the bottom can be a messy business. Of course, everyone loves to time the top or bottom, and I've run into plenty who believe they can. Possibly, I may have picked the top or bottom a couple of times in 40 years out of pure chance. My style of investing requires patience, as it is usually 12-18 months on average for my ideas, if successful, to be fully recognised. Waiting for opportunities also takes patience; my longest wait, as far as I can recall, was 4 years for a specific stock. I don’t spend much time contemplating bottoms or tops, but I do spend time on intrinsic valuations, scenario analysis and identifying the most important issues for each story.

Advice to my younger self—follow the business story to identify the best businesses as early as you can and buy them at a good entry level. Attempt to understand the difference between a flesh wound and a dagger to the heart for each of these stories. Beware, outside opinions will differ on all of the above, so be it. Do your own work and take accountability for decisions.

My personal philosophy and why

I describe myself (now) as a quality growth investor. That is, to buy quality stocks when they offer reasonable value. I've been asked what that is and why I chose that investing philosophy. Quality, to me, speaks to two main things: firstly, extensive evidence of business success and positive unit economics, proven over a cycle. A simple explanation would be a company with a body of evidence that the business can earn excess profits, grow those profits and where we can form a view that growth is likely to persist in the future. Another way to look at it is that the company can add assets and maintain excess profits, which drives profitable growth. Not everyone will agree on the stocks that meet this criterion. The second important part is the ability to be relatively certain of the outcomes. Anyone can enter numbers in a spreadsheet and generate a desired result. Researching to gain more certainty around the inputs is critical for me. Then it comes to a reasonable price. That calculation is a function of the price to pay, versus the certainty of forecasts, growth and duration. Finally, quality to me is businesses that have proven themselves; there is little doubt over the business model or unit economics. The objective then mainly becomes estimating the length of the competitive advantage and getting the stock at a reasonable price. That describes my base case investment play.

The two charts below illustrate the point. The first chart is the share price of a quality growth company over several years. The second chart below shows a share price chart of a company that struggles to match its cost of capital. The straight lines estimate the intrinsic value over time. We see that for the growth company, as assets are added at a return above its cost of capital, its value increases; for the other, “nothing special” business, intrinsic value is flat. That is, it adds assets that earn its cost of capital. We can see why Buffett says that time is the friend of the good business, but not the average.

There are two significant issues to point out. Firstly, you must be able to have a degree of confidence around the estimated intrinsic value; for the vast majority of listed businesses, this is an impossible task (IMO). I do not spend time on these businesses. However, I do see others attempt it, and I think that undermines the integrity of the process, IMO. They are fitting unsubstantiated guesswork into a spreadsheet.

Secondly, we see that great businesses are not always great buys. Even poor businesses may be better buys than an overly expensive great business. My preference for great businesses is that time increases intrinsic value. To take advantage of this, you must have done the work and be opportunistic.

Below, we have the classic growth investing framework and the value framework. The growth framework involves the business attaining new peaks, while the value strategy is concerned with the valuation mean-reverting back to previous levels. There may be a different investor temperament required for investing in either style, but that’s not necessarily the case. The connection is the valuation framework, or calculating the intrinsic value, which is common to both. The term “Value” used here is the factor “value”, low PE, P/s or p/bk, while the apparent “value” appears between the SP and intrinsic value for both, whether that is in a value or growth context. I differentiate between value and valuation, as well as growth and value. Both growth and value stocks can offer “value”.

When I started in the industry, Australia was mainly comprised of mean-reverting, low-returning commodity businesses. Slowly, more growth-type companies with higher returns on equity began to appear. It took me some time to realise the importance of the distinction. The listing of technology, health and other specialised high-return businesses came later, and often these were attributed with a scarcity premium. The concept of the growth investing model, unfortunately, took me some time to understand.

 

Why does the quality growth style suit me? What are my core competencies? Fortunately, I have 35 years of investing experience to observe and come to a conclusion. I have worked closely with dozens of investors over the years; some were very good, and I could assess my strengths and weaknesses compared to others over time. This is under real-world pressures and real-time decisions. I have also, fortunately, participated in thousands of hours of company meetings and listened to many thousands of results presentations from many companies over a long time period. In real time, I have seen how countless plans have been represented and how they panned out. This experience aids the calibration of risk assessment, imo. That means I can identify where I sit versus others, in terms of what I am good at and not, and secondly, I have a reasonable library of experience and information across time and industries. That leads me to a certain style of investing.

In summary, I view my strengths as being very strong in data analysis, interpreting various data, company strategy and assessing industry and company economics. My advantage lies in analysing companies with a reasonable amount of data. The lower the amount of data, the more uncertainty and luck are involved. So I am less interested in those challenges.

Do I believe that the market is full of investors having the same skill set and able to execute it in an unconstrained manner, driving inefficiency completely away? No.

From a viewpoint of temperament, I am slower to change my mind than others. I fall in and out of love with stories much more slowly than others. That means for strategies where many decisions are constantly required and positions are traded, it is not my style; I will fail there. I see no significant personal advantage in reading market sentiment or assessing moonshots. This leads me to where I am: more data, less operational volatility, more patience required and more opportunities to execute my skills. What that strategy implies is fewer moonshot returns and fewer opportunities, as the market is reasonably efficient in pricing my target stories, so the opportunities rarely come up. So be it, there are enough.

Finally, over time, my style has evolved. Perhaps the largest being post the GFC, as I believe some large structural changes come about in the market. This note will not go through those structural changes in detail (this note is long enough). In brief, the changes involved the muting of the bank credit cycle, lower secular growth, a fall in the cost of capital, as well as the rise of index and momentum investing to overtake fundamental investing as a style.  Causation versus correlation is difficult to differentiate, as always in investing, but the ramifications, imo, were huge. These were lower growth, a lower chance of recessions, the value factor-mean reversion style of investing became more challenging, growth investing became easier, and developing companies became less risky. Valuation becomes less relevant and less precise, with PEs higher and, importantly, more spread (due to the lower cost of capital). Ok with all that occurring, an adjustment was necessary, and I attempted it.

What does this mean? I believe my style complements my analytical skill set, as well as my temperament and risk tolerance, while maintaining my conviction that share prices move with intrinsic values over time. Long answer, but it makes sense to me.

Comments on the Fund Management Industry—why professionals underperform

Over my career, I worked at seven fund management organisations. Every one of them no longer exists, or not in any recognisable state. On average, the end was 4-5 years after I left them. In their prime, some of these managers won and were nominated for investment excellence, and some included investors who would go on to excel at different shops. Below, I attempt to answer why. Why do most active managers fail to beat their benchmarks? (Of course, this assumes that outperforming is the major goal; it may be a nice-to-have, and making money may be more important.) lol

1.      From the outside, what is not properly understood is that professional fund management is a business; returns to owners and staff are generated through profits and fees, usually not returns on investments. Excess investment returns may or may not generate significant extra fees, bonuses and profits. Usually, extra FUM is required for that. What is the correlation between extra FUM and excess investment returns?

2.      That is the first and major difference with someone who is solely concerned with earning returns from their investments; investors are and should be concerned with risk-adjusted returns, while FM businesses are concerned with profits. No profits, no existence.

3.      I specifically differentiate those businesses managed for returns as opposed to those asset gatherers run for profit; the former can be individuals, retail managers, or you can even classify Buffett's operation as run for returns, not for growth in FUM. Note, he does not raise outside money and specifically does not engage in that business.  My comments do not cover these operations that are focused mainly on returns. I am interested in those where outside fundraising is critical. These comments will be directed towards professionally managed fundraising businesses, which can have quite different cultures.

4.      In the land of investment management, I found the investing side much easier than the management side. That is not to say investing is easy; it's not. On the management side, the interplay of product development activity, continually convincing outsiders and insiders of the game plan, dealing with incompetence and immorality, coordinating with people with differing abilities and desires, I found quite challenging and, in aggregate and in hindsight, expended too much energy without a great deal of reward. Managing perception is critical; it includes a culture of never admitting that you were wrong or that you don’t know (which may be worse). That is not great for being intellectually humble, an important part of investing success.

5.      After many observations over a long period, most of the failings can be grouped into three buckets. The first is morally bankrupt behaviour. With FM, there is big money involved, and for some, that temptation is too much. Schemes usually revolve around brokerage kickbacks and involve the wrongful use of confidential information, which are two of the most common. These are rare but can be devastating. The second bucket is short-termism. Short-term fixes may seem reasonable at the time, but over time, they drain the firm of its potential. An example may be allocating scarce resources to poor products and strategies, such as launching products based on the latest fads. Launching products outside the firm's area of competency in the hope of increasing FUM is a common strategy. Usually, this results in a poor product, an adverse outcome for the core product due to the lack of emphasis (investing is difficult), and reputational damage, which undermines the integrity, trust and confidence. Thirdly, not protecting the investment talent. Investment talent is rare, especially when they are part of a successful team. Losing talent is likely to undermine the performance and stability, highlighting the importance of retaining the best people in the firm. Replacing someone talented who understands, agrees with and can successfully execute the investment process with someone who can't is a potential disaster. Ultimately, these decisions lead to poor investment performance. Hard not to understand the direct chain of events.

6.      The best chance of investing success would comprise the following. A small, stable team, having independence, having an agreed-upon investment philosophy and process that can be executed, not overly constrained or unduly influenced by outside factors. Where the investment talent manages the firm and is properly incentivised for the firm’s success. A culture of respect and trust where mistakes can be made and examined.  Understanding the limits of the firm's resources and product capabilities. With members relying on investment returns to make up a reasonable share of rewards and sharing the spoils fairly. Ok, I'm in fantasy land now. Lol.

7.      Remember that the funds management industry and firms are a pressure cooker of large egos, large money and a lot of stress. Not always a great cocktail for rational outcomes. Investing is hard; it is infinitely harder if you are also barraged by external pressures from investors jumping ship, colleagues with their own commercial agenda, and bosses who lose faith in you at precisely the wrong moment. As well as markets that can move against you while displaying daily attribution for all to see. When dealing with others over a period, how, where and with whom you want to play becomes an incredibly determining factor in success.

8.      The most relevant or interesting question you can ask a fund manager is “What’s your edge?”. Most don't have one.

9.      The above is a rundown on why fund managers underperform. IMO

 

Investment Philosophy and Process—further thoughts

“It is hard to pray to two Gods”. Following one clear process with conviction is challenging enough. Once you find one that works for you, refinements may occur, but wholesale changes and moving across different philosophies can be confusing and lead to trouble and inconsistencies.

An investment process is a framework comprising procedures leading to systematic, sound decisions. The process is a derivative of your investment philosophy on market anomalies that can be arbitraged for gain.

I am a big believer in frameworks and pattern recognition. Starting from scratch on every investment case, without following an investment flight path, or having a framework to categorise the issues you are considering, seems way too hard to me and open to (more) error. Understand how the investment proposition fits into your process, the risk/return proposition and where your understanding ends. It may not fit at all. Let it go.

There will always be errors of omission. These are stocks that you could have bought but didn’t. In fact, there are likely to be a lot of these for every investor. There is only useful information if you discover a systematic error in your misses. There may be biases you uncover by this exercise that you can attempt to allow for or consider in your frameworks.

The aim is to win over time by taking the right bets. You increase your chances of a good outcome, but they are not guaranteed; nothing is certain. Understand what your edge is, why it appears and in what areas. Have a plan and follow it. Always remember that investing is usually not a black and white game of absolutes.

Run a checklist that is aligned with your investment philosophy.

You probably need to have a broad understanding of the risks with various investments so that you can properly calibrate and be objective in choosing which level of risk you want to take. Risk should be considered in conjunction with your investment philosophy, temperament, goals, wealth, etc. Do not avoid risk or overly embrace it; integrate it at the level you can comfortably bear. Do not let risk run to the point it makes you fearful or paralysed to the point of becoming irrational in decision-making. That will differ with individuals. Mistakes will be made; they should not end the game for you.

Your belief in your investment philosophy must be unwavering, for it will be fully tested. There is no perfect plan; nothing wins all the time.

I believe the power of using a great investment philosophy and process can make average investors good and good investors great, etc I have witnessed this outcome.

The Sell discipline.

Selling is intricately tied to your investment philosophy, and this should be read together with my personal investment philosophy. Again, over time, my self-discipline has evolved.

Firstly, I would say that I am over the anchoring bias (famous last words). The price you pay is just irrelevant; your valuation isn’t, but if you're wrong, you're wrong. You can argue on valuation, but not on entry price. The only reason the entry price is important is for tax reasons, and that can be a red herring.

I am a valuation-based investor, but note that valuation has become less important due to the previously stated reasons. IMO, stocks trade in a wider spread around intrinsic value, which I believe is justified. IMO, valuation is just not as important as it was before; that is, it was very important before, less so now. In this investing world, true quality growers are so rare; so I have cut them some slack on valuation. In other words, I have widened the buy/sell band.

My valuation, due to my investing style, incorporates a specific view of future business returns. This is more than a narrative; it's an understanding of how the business is expected to perform, a trajectory. An analysis is warranted if a divergence occurs. You should cut some slack for the normal volatility we see in results. Having said that, the style of companies that I invest in are not that volatile. If I cannot explain divergence, it’s a sell. In fact, most of my errors come from being too lenient on this and making excuses for a company that is clearly off path. Admittedly, there is a large degree of subjectivity in this decision. That’s where, over many bets, knowledge-based judgment is an advantage.

Selling is a relative game. Making decisions is not always clear-cut. In periods of market volatility, switching exposure from drifting stories to stronger conviction plays, if the opportunity arises, makes sense. This is also a tax-efficient time to switch, and volatile markets can throw up anomalies.

Maybe one more thing. I am a reluctant seller of great companies, just because there are some possible dark clouds on the horizon. Those clouds could be harmful or may float away; we don’t know. I want to see evidence of damage, even if that means I may be late with the decision. I have made good returns following this strategy and will continue to do so. It’s a variation of the saying that more money has been lost anticipating market drawdowns than lost in market drawdowns, but at a stock level.

Dealing with uncertainty

Resulting bias. Perhaps the most difficult bias to comprehend. There is a great deal of difficulty in understanding that a poor decision may lead to a great outcome, but it was still a poor decision, and alternatively, a great decision may lead to a poor outcome. I used to joke that if I presented to a room full of retail investors and told them I put all their money on the fourth at Randwick, there would be a deathly hush. Then I tell them it came in by half a head, and celebrations erupt. In my travels, I have found that few can surmount this bias because it not only involves having humility, but it is counterintuitive and requires a broader understanding of the risk world and the variability of outcomes.

How far do you get before it is “I'm not sure”? How much blank space is there? One of my sayings when looking at a risk proposition is “three ifs”, and it's out. This highlights that as more favourable events are required sequentially for an investment thesis to work out, the chances of a good outcome fall, depending on probabilities, usually quite significantly. Buffett and Munger have spoken about risks in terms of jumping one-foot hurdles and playing in their area of competence. My preference is for playing close to my pads.

Build up your experience in decision-making under uncertainty. Quickly work out where you have any competence and why it exists.  That is a cornerstone in investing, together with a very efficient means to source and integrate information into your decisions

There is a difference in the level of certainty when dealing with facts or opinions. When you find a “fact” you don't know, incorporate it into decisions as quickly as you can. When an opinion is encountered, deal with it on its merits.

Be mentally prepared for different scenarios. Think about what you would do under different outcomes. Then you are less likely to be rattled when they occur. Especially dealing with poor outcomes, they should not be a surprise.

Understand the degree of difficulty you are undertaking in any analysis. I'm constantly amazed that new investors attempt the most difficult tasks. Perhaps they don’t know how difficult it is. Keep asking Where is my edge in this? And as importantly, what do I do if I'm wrong, and when will I realise that? For example, going to cash if you believe the market is set for a large fall. You may not want to be waiting ten years later!

Remember, outliers will always exist; sometimes, the low probability wins. Investing involves inherent variability; there will always be outliers, and invariably, they will be touted as reasons to undermine any investment process. Be aware that outliers are part of the landscape, but do not be rattled by them or those who attempt to make them the base case. Accurately identify outliers.

People cannot live with uncertainty; they rely on quick, easy and comfortable answers. Sometimes there is no answer, and only a range of possibilities exists. Methodically whittle them down, realising sometimes there is just uncertainty. Be comfortable with uncertainty. Accept it and wait.

As uncertainty increases, the risk or the level of the unknown increases; adjust accordingly. Move the size of the position or increase your discount to the intrinsic value (lower your buy point). Remember that the base construct here is that intrinsic valuations can be accurately calculated, in the first place.

Learn to live with someone being luckier than you, someone less experienced doing better, someone who does better but works less hard, someone having privileged information, or being in the right place at the right time, etc, etc. Life is not always fair or rational, especially in the short and medium term. Don’t let that rattle you into chasing unattainable dreams, losing your discipline and abandoning your process, which, you observe, is working fine.

Constraints

Constraints are another way of saying reducing your options or limiting your scope. Constraints can be imposed from outside or self-imposed. Constraints should be carefully considered; limiting your investment flexibility can have large impacts over time. Investing is hard enough without introducing constraints. If constraints are introduced, they should align with your investment philosophy. Constraints can be contrasted with the disciplines of an investment philosophy, as the IP focuses you on your strengths and anomalies you want to arbitrage out, while constraints limit investment options. Constraints and objectives can often prove to be mutually exclusive, as in aiming to outperform the market, but desiring a very high yield. I may want to outperform the market, but I want an aggressive ESG filter that excludes sectors. Constraints may lead to a disappointing outcome.

Diversification, for example, hard stock numbers, is another constraint. I am agnostic to concentration; stock numbers should align with your level of risk and your investment philosophy. There is an inherent increase in risk with concentration that should be considered in other parts of the portfolio composition, that is, lower fundamental risk and better knowledge.

In summary, beware of constraints that limit returns. Constraints come in various guises, being biases or non-investment preferences, client-mandated or philosophically based. Opportunism is one of the greatest assets an investor can turn to. Do not limit it. Some constraints include only buying cheap stocks, ESG constraints, only buying high yield, asset allocation constraints, and institutional limits on your ability to act or the universe of investments you cover. etc. The only constraint should be your investment philosophy and competence.

Information sourcing, analysing, and calibrating.

Sourcing quality data, interpreting it properly, and incorporating it into your decision-making process, free from bias and error, is a critical sequence to master and can break down at any point.

Ideally, source data from those who align with your investment philosophy and style. It is best if they are known to you with a history you can judge, and they suffer consequences if they are wrong. Differentiate between fact and opinion.

Beware of those who torture the data until it confesses. The finance industry is adept at formatting and presenting data that suits its story. Look for data that is cherry-picked, unusual timelines or scales, including stupid, irrelevant analogies, etc.

Don’t be overinfluenced by what doesn’t matter or is unpredictable. Focus on data that matters and that has a tight range of outcomes. We can see that many people spend way too much time on issues for which we cannot find a useful answer. The subject may be important, but no answer exists that we can attach sensible probabilities to. Alternatively, we can obsess on issues that are insignificant to the investment case. You may be right, but who cares?

Flawed or incomplete information should be recognised as such as quickly as possible.

Information from different categories of investors must be treated cautiously. For instance, someone holding huge profits on a stock can afford to be blase. Alternatively, you may not know the full exposure or actual holdings, that is, the full story, about any stock.

Verbal reasoning is a critical skill for analysis, for it is at this point that information enters the decision-making process. The information should be fully understood at this juncture, like company announcements. Sometimes, a word or an emphasis can change the meaning of information. Those who only casually read this information are vulnerable to misinterpretation. Read the releases very carefully. Maybe a few times.

Not all information is beneficial; identify and block poor information sources or other sources that are intentionally or inadvertently working to subvert your process. Listen to coherent and considered alternative views, but not to ridicule, cheerleading, people with agendas or glib experts.  Some views are not relevant to your process. Classify some information as entertainment, not source material. So, who do I pay attention to? Those with a comparable investment philosophy, and I can make that determination. That is, long-term investors who are valuation-based and have a “hit rate” mentality consider company and industry fundamentals, and an assessment of competitive advantage. The point is to be quite discerning with the information you let in; not all information is good for you.

Realise that share price action is different to business progress. Focus more on the business than the SP. Perhaps this is the biggest difference I see between my approach and many others.  

In summary, there are three layers of information, and all should be handled well. Firstly, sourcing accurate and relevant data. In the past, sourcing information was a challenge. These days, it has flipped with being able to sort data, being more important than access to data. Secondly, properly interpreting data. Although we are all exposed to the same data, interpretation can differ, even across similar investors. Proper interpretation is critical; otherwise, you are running in the wrong direction. Verbal reasoning skills are important. Finally, the efficient transfer of information into your decision-making so that it impacts the real money should be done well.

Biases-my big ones

Biases are so ingrained in ourselves that identification and attempting to understand them may be all we can achieve.

Allow new information to calibrate your view; a bias is the inability to change your view. Unwelcome new information is uncomfortable, and it is too easy to dismiss.

The crowd (market) is usually right until it loses its independence, and then it can become very wrong. Social media probably increases this bias.

There is an ongoing battle between conviction in an idea and being too stubborn. Your ability to easily incorporate new information is important. Consider the opposite view; do not discard or ignore it. Another battle is confidence versus hubris. You must have confidence to enact your strategy; however, hubris, which some success can encourage, can blunt our objectivity.

Beware of the envy of others that will undermine your investment process. FOMO is a subset of envy.

I have never been one for cheerleading. Stocks are not sports teams. You lose your objectivity by publicly becoming a cheerleader, IMO. Be cool and rational.

You are most likely lazy, envious and impatient; work hard to limit the damage here. Beware being so far in denial, or you will end up in the Mediterranean!

Psychological strength is a competitive advantage. Dealing with adverse outcomes while staying rational is important.

Extreme patience and extreme decisiveness are required. Be calm, objective and independent.

Biases are so strong that sometimes they overcome you. As an admittedly irrational cop-out, if a stock is burning me up with a sense that I must buy it, and I'm obsessing over it, I will buy a small parcel that scratches that itch. Then I can go on to the serious stuff. Biases are tough. In this instance, any damage done is negligible. Some may call this a “research” position; I like that. lol

Measure your returns as little as possible. Constantly looking leads to mistakes and second-guessing. Plenty of times I was behind at half-time and was ok at full-time. Leave it be, be patient.

My favourite Twain (?) saying is “it's not what you don’t know that hurts you, it's what you know for sure that just ain't so”. Keep looking at your big positions and reminding yourself why they are there and what others say is wrong with your thesis. What would it take to make you negative? Is there anything? Remember to closely monitor what you are sure of, as they will be your biggest positions.

Some of your positions will always be disappointing. Maintain a holistic view and try to gain any lessons, not “resulting” takeaways.

Below is the chart of the AllOrds index from May 1987 to May 1992. That is, from my 25^th to 30^th birthdays. Many consider the formative investing period to be between 25 and 30 years old, when you start to accumulate reasonable capital and seriously engage with the market. The lessons learned then probably stay with you for life.

What was my experience? We can see that over 5 years, the market fell. This was not a buy-the-dip and everything will be ok type of experience. The malaise lasted a long time, time enough to destroy investor conviction. Clearly, the 1987 crash stands out. Then we had the 1990/1 recession, which, IMO, was the last true clearing event in Australia. By a clearing event, I mean that the banking system was in such a state of disarray that there was insufficient capital available to bid on assets. The opposite of what we have today. Unwritten in these numbers is that the smart, new, innovative dreamers and investing trendsetters went to zero. It would be like TSLA, BTC, PLTR, whatever, all disappearing, truly traumatic for some.  

Unsurprisingly, living through a period has made me think of what happens if liquidity dries up. Could I survive? My investing style has a survivor bias that I just don’t see in others. It is an insurance that I pay for, which costs in performance, but I need my sleep, lol.

 

Accountability

Diarise your actions so you don't rewrite history. Admit mistakes. Find mistakes even when the result was positive. Identify times when luck played a large part.

Attempt to identify what went wrong and why you didn’t pick it up.

There is little point in regretting various mistakes of commission or omission unless you can take something into your future from them. Try to identify a systematic error in your process or biases that are frequently impacting your decisions.

Judge yourself by your own scorecard. Don’t worry about others. Develop a tough benchmark and judge yourself against that, not what others do. Your ability to accurately measure the performance of others is impacted by getting the full picture, as in assessing the risks taken and the role luck played in the result. How you achieve results is as important as the results themselves. There are just too many unknowns that can undermine the comparison. The real negative is that you may change your process due to false conclusions.

Success has many fathers, failure is an orphan. Own your results; even if you outsource decision-making, you decide who to rely on. You should have vetted them and the info yourself.

Be honest with yourself, perhaps keep a journal or some form of record so you can see what you were thinking and why you decided a certain course of action. Don’t rewrite history. Everyone makes errors, especially in investing. Errors of commission occur; see if there is any pattern to yours. I found some in mine.

Other bits—far from comprehensive

One of the observations that has intrigued me over the years, when I was a “professional” investor, is the advice I received from amateur investors. It amused me because there is little chance I would, for example, think I could do a better job than almost all pilots, dentists, lawyers, surgeons, etc. Why do amateurs feel confident enough to tell me how to do my job? A big part of the answer lies in the amount of luck involved in investing. You cannot call investing a profession, since there is no barrier to entry, although skill is involved. The difference is that skill can be overwhelmed by luck or randomness, sometimes for a while. Of course, I'm not saying every professional investor is better than every amateur investor; just read the section on fund management. The randomness of outcomes and “resulting” do not exist, to anywhere near the same extent, in those other professions.

Identifying when companies are over- or under-earning is one of the most basic and productive ways an analyst can add value to a company assessment.

Poor behaviour in almost any aspect is usually not an outlier.

Become competent at analysing company accounts and identifying unusual issues. Note them and the implications. Watch for changes and excuses.

Portfolio churn is quite interesting. It is another factor that is an outcome of your investing style. IMO, it does say something about the investor and consistency. I define turnover as sales divided by average funds under management. Most long-term investors target 20-40%pa turnover. So, a complete portfolio turnover between 2.5 and 5 years. I'm usually around 30-40%. That is an output I use for a sign of style consistency rather than a target. Of course, many professional managers have churns over 100%. I find it amusing that these managers can call themselves LT investors when the average holding period is under one year. Call them what they are, traders, who require timely and significant information flow. That is not a criticism; if they are successful, fair enough, just be transparent. I'm not interested in following traders.

Many terms and processes are misused in investment analysis. Some of my favourites to be wary of are anything comparing stock and flow. Stock is a point-in-time measure, eg a market capitalisation, a net debt level, while flow is measured over a specific period, usually a year. The trouble is that it may be completely inappropriate to use a certain flow and compare it to the stock. Peter Lynch did no favours in introducing the PEG ratio to the masses, and I think it is the most misused ratio I have come across. I've even seen people compare one year's earnings growth to a P/E, which is clearly wrong. Remember, everything is derivative of a DCF model. Of course, another big one is the PE ratio itself, being a stock, the market cap in this instance, divided by one year's earnings. That may be meaningful or it may not, depending on how representative that earning number is. I can go on, with ND/EBITDA being another one. The lesson here is to look carefully at the flow number and ensure it is relevant.

Over time, capital allocation becomes increasingly important to company performance. Understanding the duration of a competitive advantage is what most analysis is concerned with.

Markets are relatively efficient, good stories at a reasonable price are rare, recognise them through your process, and once you own them, be a reluctant seller.

I often read about “cookie jar” investing, which I interpret as putting your investments in a jar and going to play golf for five years, then opening the cookie jar and being surprised. I couldn’t disagree more, although I think you may be surprised. If you are an active investor, be active. When I was under personal trading restrictions and had a dormant portfolio, I thought it would look after itself, with a few good stocks. Stuff happens; you need a detailed analysis at least a couple of times a year, and act if required. Good stuff rarely just happens, not to me anyway.

Beware false precision and false certainty. Be acutely aware of what is most readily measurable and what is not. Do not force a thesis where it should not and cannot go.

Sometimes companies get lucky or unlucky; be aware and move quickly to act. Sometimes outcomes surprise, and you should be able to assess good and bad news quickly. I do not consider myself good at this, as I am slow to assimilate new information.

Obsolescence and excess debt are the two big destroyers of established companies. Beware of them.

Immature companies carry “development” risk. Establish a path you expect the investment to follow, and be decisive if it strays. These companies have a wide dispersion in scenario outcomes, and valuation is less important; staying on the development path is more important.

Focus on great companies, wait for opportunities, back success and have a good idea why it persists.

Be careful doubling down in losing positions. Understand what the market is concerned about. I have found that keeping to quality, that is, low/no existential risk when doubling down, is wise. Otherwise, it can cripple you. Often, this is how bankruptcy occurs.

Over the decades, the required investment skill sets have changed. To remain relevant over time, you will need to observe outcomes and changes and adapt to them. There have been a couple of big changes over my investing time. Evolving is very difficult, especially if you have been successful and have to adjust a winning formula. Thankfully, evolution is slow; you usually have time.

Understanding the inherent level of risk in your portfolio is critical. Markets go through periods when they readily accept risk and other times when they will not. IMO, this is mainly driven by the liquidity cycle, and liquidity can be fickle and volatile. You can measure the fundamental risk in your portfolio by looking at the amount of FCF and debt levels across your holdings. Remember, this is not an average assessment but the percentage exposed. How much of your portfolio is not FCF generating, etc? There are numerous measures you can use. Another measure is in a market reversal, assessing how much your portfolio declined. If it is a multiple of the market movement, it is most probably riskier than the market. Therefore, you are likely to have market leverage influenced by the above liquidity cycle.

When assessing luck, I would say it is hard to define but easier to see. Some instances of luck that stand out to me are when the portfolio return is due to one winner, while the remainder are average or worse returns. Then there are corporate actions (eg takeover) which crippled the buyer but got you out of a pickle that you were completely unaware of. It must be a big impact and a poor outcome for the buyer. In a broader sense, luck is anything that is outside the control of the investment case. There will usually be some luck involved; the degree is important when looking forward and considering any investing skill. Luck—a thousand soldiers march across a minefield. As the mines go off, soldiers are killed, but they persevere. Finally, a small group reach the other side. The question is, are they the best soldiers (investors) or just lucky? You would have to run the same scenario several times to assume it was skill, not luck. Do not confuse survivor bias with skill.

When I hear stories of wealth gained through lucky speculation, my reply is well done. In reality, however, I am not interested at all in this story. I am not a speculator, and after 40 years, I can say I'm not a lucky investor.

Almost all valuation techniques are derived from a DCF model. When there are significant differences in valuation outcomes that are undertaken by the same person when using different valuation methods, be careful, as these indicate inconsistencies.

Risk—a group stands at one end of a field, and at the other is a pot of gold. They are told that anyone who reaches the other side gets the pot of gold of undetermined size. All agree to cross. Now they are told there is one mine buried somewhere in the field. Some drop out, others consider the risk worth it. Now, the number of mines increases to two, and more people drop out. Etc etc., How do we weigh up this risk? The size of the treasure, the number of mines, and the result of stepping on one. Having all the data is critical, but everyone’s ability to bear risk is different, and the outcome is not the determining factor. When we set our risk parameters with full knowledge of the data, it is a case of where we want to sit on the risk curve; people will spread across the curve. How much existential risk do you want to bear? Personally, very little, but those who do bear this and obtain great rewards, so be it. They are on a different part of the curve. 

Beware contrived outcomes. Remember, there are plenty of bad actors who know what buttons to push and what aspects to highlight to promote a favourable response from you. Many of these outcomes are back-solved, purposely made enticing to lure people in. For example, if a company is looking to raise finance, the alternative investment option will be known, and they will price it at the right level so that you will choose them. That may have little to do with the actual value of what they are offering. Often, a more attractive return is just a reflection of extra risk.

Certain people spend every day thinking, with the main purpose being how to get money out of your pockets and into theirs. The schemes vary greatly and are only limited by the imagination of those actors involved. Unlike some other crimes, however, investment scams do not force an outcome. Usually, they aim to gain your trust and confidence so that you become a believer in them and drop your guard. Remember, their stories are constructed to appeal to both greed and the credibility of the plan. Put yourself in the bad actor's shoes and ask if I want to take this guy's money, what would I do? What is going to make him lower his guard? How can I gain his confidence and trust? Remember, the Devil doesn't force you; he tempts you, and you make the decision. There are crooks everywhere, but finance is over-indexed (due to the money involved). “White collar” crooks are different to “blue collar” crooks. Blue-collar crooks approach with a balaclava and a shotgun, no mistaking their intentions. White-collar crooks are full of smiles, compliments, and encouragement, all aimed at building trust and ingratiating themselves into a position of influence and trust before their true intentions become apparent. Not good.

This is a game where being fully committed is likely to get the best outcome. It is a game where being curious and prepared to invest a lot of time and effort pays off, as well as having the right temperament. Having said that, those with less skill, time, and the inclination to do the huge amounts of work can still do well by being patient, sensible and following a well-constructed investing strategy.

 

CONCLUSION

I often discuss the importance of having your own investment philosophy and process. In plain words, that means working out what works for you, why it works and will continue to do so, and then executing it with the conviction to carry it on.

Building a self-sustaining ecosystem built around your investment philosophy and process is important. Information flow should be carefully watched and free from bias and error as much as possible. Your process should flow from ideas to portfolio action in a considered and methodical way.

Consider risk in your investments from multiple perspectives. Risk is measured by what is unknown and unknowable. Assess the fundamental strengths of your investments. Look at unconscious bets and correlations. Decide how much risk you want to let into your life. IMO, risk is the least understood aspect of investing, and there are reasons for that, discussed above.

Be realistic in your ability to counter biases. Your best outcome may be to identify them and attempt to adjust or limit the damage.

After reading the above, I can, again, see my weaknesses. If I had the discipline to follow the above advice in detail, I would have done much better. We do the best we can.

Good luck, but set up your process so little luck is required.

Disclaimer: this document is not investment advice, is compiled on a best endeavours basis and may contain errors.

PS For those interested, my first share purchase was Comalco, an alumina and aluminium subsidiary of the Rio Tinto group. I bought it for circa $1.70 and sold it a few years later for circa $4.50. Did I think I was a genius? No way, by then I was fully aware of how difficult investing is, and had been burned numerous times.

 

Worth a read

Poor Charlie's Almanac

Thinking in Bets by A. Duke

Thinking Fast and Slow by D. Kahneman

All the Berkshire shareholder letters, plus Buffett and Munger Unscripted by A Morris, which are the Q&A sessions at the AGMs.

Seeking Wisdom by P Bevelin

R Hagstrom, the Warren Buffett Way and Investing the last liberal Art.

That's enough for now.