Part 3 – Lesson 18
Below, we have compiled some important advice and lessons that we have learnt in our many years investing professionally in the equity markets. This advice will not be suitable for every investor since every investor needs to develop his or her own style, but through many years of successes and mistakes, this is what works for us.
Advice 1: Have conviction in your stock idea, but avoid over confidence
Over-confidence is a fatal error amongst new and experienced investors. It leads an investor to take on large position sizes and hold onto positions long after they’ve been proven wrong on the idea. Over-confidence compounds errors more so than any other mistake.
Our number one piece of advice to investors is to have conviction, but to remain humble. While an investor must have conviction in his/her idea, it is imperative to remain intellectually honest and open to changing your viewpoint as new data comes in.
Advice 2: When you’re wrong on a stock, admit it and move on
Investment funds often judge the performance of their analysts and portfolio managers by a metric called “hit rate.” Hit rate is simply the percentage of stocks that the analyst or portfolio manager made money on out of the total portfolio. On Wall Street, a hit rate around 60% or better is very good!
Think about that. Some of the best professional investors can be wrong 4 times out of 10 and are still considered to be doing well. You will make mistakes as an investor. And when those mistakes happen, learn from it and move on. A common mistake is to hold onto a position even after the investment thesis is broken.
Advice 3: You can make back losses in a different stock
Related to Advice #2, when investors lose money on a stock, the temptation is to hold onto it and hope that the stock price rebounds so that they can make their money back. This is a huge mistake because hope is not a strategy.
If the investment thesis in a company is broken, hoping for the stock to go up is a sure-fire way to handicap your portfolio. It sucks up time and energy as the investor focuses on the losing position as opposed to finding new, profitable ideas.
If you lose 20% in Company A stock, then, Company A stock must go up 25% for you to make your losses back. Should you bet on the fundamentally broken Company A (with no investment thesis) going up 25%? Or should you invest in Company B with a strong investment thesis that could lead to 25% upside?
We’d rather move our capital into Company B and have conviction that we’ll make our 25% back rather than hope that Company A will miraculously rebound.
Advice 4: Create a process and stick to it
Many investors get into trouble when they start deviating from their investment process. Throughout Part 3, we highlighted how an investor should source ideas, research ideas, value ideas, and create investment write-ups. This type of discipline ensures that an investor thinks of all the angles and forces an investor to make rational decisions.
Without process, investors are much more prone to making trading decisions based on “gut” or emotions. Good investments require hard work and research, so stick to a process that ensures that you do not take short-cuts.
Advice 5: Follow well-respected investors and see what they are investing in
Sourcing ideas from other investors is a great way to accelerate your pipeline of ideas. You can find what other funds are invested in by looking up their 13-F filings at www.sec.gov or using a website like www.whalewisdom.com to see what other institutional investors own in their portfolios.
Refer to Part 3, Lesson 4 for more detail on sourcing new investment ideas.
Advice 6: ALWAYS do your own research
Even if you identify a stock that Warren Buffett owns, you must do your own research on the company for a few reasons:
Even the smartest investors on the planet can be wrong. Your research may reveal something about the company that the other investor failed to see.
Doing your own research on the company builds your personal conviction on the company. It gives you conviction to withstand volatility. Without conviction in the stock, it will be hard to justify owning the company if the stock price goes down sharply and if you don’t understand the long-term investment thesis for the company.
The friend you gave you a stock recommendation or the 13-F filing that details a fund’s portfolio will not be giving you real-time updates on what to do. If you pulled an idea from a 13-F filing, remember that these filings are only updated every three months. No one from that fund is going to call you to let you know that they changed their mind and decided to sell the stock. You must know why you own a company and when it’s time to sell.
Advice 7: Align yourself with great management teams
Great management teams who are conscious of creating value for shareholders will think like an owner and utilize all the tools at their disposal to create shareholder value. Investors often reward companies with great management teams with a superior valuation multiple since investors have greater confidence in the growth outlook of the company.
Management mis-steps can often create large declines in the stock price due to questionable corporate actions such as large acquisitions, overly aggressive guidance (which leads to disappointment down the line), and poor expense controls.
Advice 8: Look to invest in companies with long-term, durable growth
In addition to aligning yourself with great management teams, look to buy companies with long-term, durable growth outlooks. Ask yourself, “Will this company exist in 20 years? Will this company grow for the next 20 years? What can happen to threaten this company in the next 20 years?”
By owning companies with strong staying power, the risk profile of your portfolio can be greatly reduced. A good example of a company with very durable long-term growth is Google. Without opining on the current value of Google stock, it is hard to argue (based on what we know today) that anyone can supplant the dominancy of Google Search, YouTube, Gmail, and Google Maps (to name a few of their key products).
Advice 9: Think of investing as buying a business, not buying tradeable security
An important part of investing is removing the emotional stress created by watching the daily price movements of the stocks in your portfolio. If you are a long-term owner of a company, the day to day movements of the stock price can be extremely distracting and frustrating when not going in your direction.
If you owned a pizza parlor, you would not re-value the business every single day. If you own a piece of real estate, you would not re-value your real estate every single day.
Likewise, you should not become overly concerned with the revaluation of your public equity investment every day. Instead, you should view the daily change in stock prices as an opportunity to buy the companies you like at a discount. If you have your eye on buying a Sony television, for example, would you panic if the price of the TV dropped 25% as part of a Labor Day sale? Of course not! You would be excited to buy the TV at a discount.
Investors should view stock prices in the same manner. Assuming no change in fundamentals, investors should welcome lower stock prices as an opportunity to buy more of the companies that they like.
Advice 10: Maintain dry powder for buying more of the stocks you like
When stock prices decline, you can only take advantage of the dip if you have cash to invest. It is prudent to maintain some cash balance to take advantage of market dips and to build more of a cash balance when stocks become very expensive.
Advice 11: Avoid trading too much
For most investors, fast and frequent trading is the enemy of profits. From the sec.gov website, “Day traders typically suffer severe financial losses in their first months of trading, and many never graduate to profit-making status.”
But it’s not just day-trading that can be dangerous. In our experience, investors are tempted to increase their trading during periods of market volatility. Investors often panic and are tempted to sell their stocks into a market decline, but then, are tempted to buy them back once the market starts rebounding. Investors caught in this viscous circle of trading in response to the market will often find themselves donating money to Mr. Market.
Pick the companies you like. Pick the stock price level you’re comfortable buying and selling. And avoid the temptation to think you can out-trade the market.
Advice 12: Don’t react to the stock price, react to the company fundamentals
It is easy to fall victim to fear and greed. As a stock price rises, many investors feel that they will miss out by not buying into the momentum. As a stock price falls, investors often sell in a panic due to fear of losing more money than they have already.
As an investor, you should make your decisions based on the company fundamentals and news. Imagine if you had no stock chart to look at. Then, decide if you are a buyer or a seller. The stock price movement should not be the driver of your decision making process.
There are some investors who use momentum indicators, stock charts, and other technical indicators to guide their investment decisions, but as long-term investors, we do not incorporate technical analysis into our investment process.
Advice 13: Pay attention to investor sentiment
Remember to always compare your view to how other investors currently feel about the stock. It is prudent to adjust your risk-taking based on your view relative to consensus. For example, let’s assume you like Google as a long-term investment and believe they will compound revenues at 20% per year. Let’s also assume that the consensus view is very bullish on Google, and investors believe that revenue will compound at 30% per year.
Since the current valuation of Google will reflect future expectations of 30% revenue growth, the investors will ultimately be disappointed if revenue only grows 20%. The stock will correct to reflect the slower 20% growth. At this profile, the risk profile of a Google investment has improved substantially even though your personal view on the company’s growth (20%) has not changed at all. Once sentiment and expectations have reset to a more realistic level, the stock becomes a better buy.
Advice 14: If you don’t have time to research stocks properly, invest in an ETF or mutual fund
Finding, researching, and executing stock ideas is a time-consuming process that requires an investor to be focused on his/her portfolio and the markets on a frequent basis. If you are not willing to commit the time it takes to learn how to invest properly, it is safer route to passively invest in an ETF or mutual fund.
Advice 15: Avoid the use of margin
Maintaining a portfolio is not just about assembling investments in high quality companies. You must always think about your downside and how much you can tolerate to lose without getting into financial trouble.
If you avoid the use of borrowed funds (margin), it is unlikely that you will be a forced seller of stocks when markets crash. With the growth of ETFs and algorithmic trading, sharp spikes in volatility and flash crashes are becoming more common.
If the stock market crashed 25% in a single day, would your portfolio survive? Would you live to fight another day? Never assemble a portfolio that will create a situation where you become a forced seller of stocks during a downturn.