As I have often admitted what I say or write (if it sounds intelligent) is stolen from someone who is intelligent and repackaged as my own (if something sounds dumb it will be original thought!).
Having admitted that the following is a brilliant summation of the key elements to a long term investment strategy as articulated by James Montier of GMO:
- This time is never different
- Be patient and wait for the home run pitch
- Be contrarian
- Always insist on a margin of safety
- Risk is not volatility, it is the permanent loss of capital
- Be afraid of leverage
- If you don’t understand it, don’t invest in it
THIS TIME IS NEVER DIFFERENT
Sir John Templeton, a ‘Hall of Fame Investor’ and creator of Templeton Fund Management was asked to name the most dangerous belief an investor can have.
He replied “It is only four words.”
“This time is different.”
When one hears of a new era, a changed paradigm or a quantum change immediately and without regret dismiss the bearer of such a view as a “snake oil sales person”.
As a simple example of the dangers of the idea of a new normal, consider what lay at the root of the US mortgage led financial meltdown, namely the assumption that because house prices had been stable or upward for the last 30 years this would continue.
This same assumption of a changed normal can be seen in the internet bubble, and all booms, bubbles and fads.
People with many letters after their names write with much pseudo-scientific evidence to prove that a new paradigm is upon us, as we now know this has never been true.
As asset prices rise those increased prices must be justified, if they increase far in advance of their long term trend values these must be validated.
When this happens the next time remember.
History may not exactly repeat but it always rhymes.
This is a story of a fickle and changeable man; his name is “Mr Market”.
Mr Market is employed to provide a price each day for his goods. So Shares, Bonds, Commodities and Sovereign debt all fall to Mr Market to price.
Most of the time Mr Market is fairly sanguine, he sees some blue sky and some cloud, the future is uncertain, could be sunny, some rain may fall, during these time he asks a fair to full price.
Mr Market is a changeable fellow. Sometimes he is in a very positive mood, he sees only blue skies and assumes they will stay blue and at these times he will ask higher prices.
Occasionally however there are darker days, he is depressed, he sees clouds and storms ahead, he can’t see a future or when the sky will be blue again, at these times he offers low prices, sometimes very low.
The key to understanding and profiting from the mood swings of Mr Market is to know that whilst it is his job to offer a price to sell or buy daily he will do this every day; there will be days when he is depressed and the prices are much lower, all that is required is the discipline to wait for these times.
To put this into a baseball analogy, the batter (investor) does not have to swing at any pitch (price) Mr Market throws, they can wait until a big fat easy pitch is offered (when Mr Market is depressed), these are the ones to swing at, these are the ones that yield the ‘home runs’.
The successful investor will have mastered a number of skills but as Warren Buffett says often, successful investing is not a factor of IQ, it is a combination of intelligences, one of the most important being “emotional intelligence.”
A key ingredient to becoming a skilled investor is to practice the emotional controls necessary to overcome the default human reactions to periods of stress and loss.
Human craving for sugary things is an evolutionary leftover from the past times when in nature these were only available in short periods (in autumn mostly so fattening up for the lean time of winter).
Our programming has not caught up with the year round availability so we crave them constantly.
In the same way humans are hard wired to seek consistency of positive results to become confident that something is safe to participate in (this is self-evidently sensible, if something is consistently safe then this is a good thing). However this logical and self-protecting analysis of risk in everyday life DOES NOT WORK when applied to investing.
It leads to following an asset price rising consistently over time which breeds the confidence and ultimately the desire to buy it.
Conversely watching an asset value fall over time and having less desire to buy it as it falls lower.
The above two reactions to actions are why the few make outsized profits and the majority lose money.
An art to successful investing is to understand that humans default behaviour to risk is to want consistency of a positive outcome to feel confident, this inevitably means assets which were once cheap become expensive before most buy them (BUYING AT PEAK PRICE).
The smart investor knows this, knows that when an asset falls in value it becomes (if the asset is fundamentally sound) more attractive not less (greater value purchased at a far lower price).
So the successful investor uses the faulty default behaviour of the majority to profit.
They practice Contrarian Investing:
“Be greedy when others are fearful and fearful when others are greedy” – Warren Buffett.
ALWAYS INSIST ON A MARGIN OF SAFETY
The practice of this is a key for the “Value Investor”.
A value investor wants to understand the value of an asset, to be able to know what something is actually worth (i.e. the intrinsic value not its price).
This is calculated in various ways including:
P/E Ratio: The multiple of a share price to profits earned (the lower the better)
Price to Book: The total value of all shares as a percentage of the actual value of the assets of a company (again the lower the better and ideally lower than one, i.e. the total shares in issue are valued at less than the actual assets are worth).
To add to initial price to value calculations the “Value Investor” will then analyse amongst other things:
- The predictability of future profits and profit growth
- The costs of production; does a company have to reinvent its products (the creative destruction of technology companies), which is expensive and unpredictable. Is it a company with a large ‘moat’ such as Coca Cola which has a wonderful franchise with no creative destruction (a more predictable future) or is it “Research in Motion” which does not and therefore is not.
- What is the break-up value of the assets of a company, if these are greater than the total value of shares in issue plus debt this is referred to as a “net net” by value investors
The “Margin of Safety” therefore is the cumulative analysis of valuation metrics which when combined identify that the share price significantly “undervalues” the actual tangible worth.
Identifying companies with resilient franchises, strong balance sheets and predictable future profits at a price that underestimates its true worth is rare but, Mr Market does on occasion prove obliging.
RISK IS NOT VOLATILITY
Warren Buffett has said:
“I would rather have a lumpy 15% p.a. return than a steady 8%.”
It is emotionally draining to invest in assets which have a volatile valuation; this is to say the value moves around far more than the index average (a high beta stock).
The assumption is that the greater price volatility is the greater the risk but this is not necessarily the case.
A consistently successful method of investing is to buy assets which have suffered from a negative period; if a company has fallen heavily in price (but crucially is fundamentally sound) the shares can then be very rewarding to buy. The volatile price has lessened the future risk of loss not heightened it as the asset can be acquired at a lower price to its intrinsic value.
Conversely a share which has risen consistently over a protracted period can often be unrewarding to buy as it has become priced for “perfection” (any mishap will then result in a significant and rapid negative rerating of the share).
The key is to identify the value of the asset and to use volatility of price as an advantage. If the price has fallen to a level significantly below fair value, the risk to buying the asset is low and attractive.
The risk that must concern all investors however is that of a “permanent loss” of capital.
If a company becomes insolvent then this is a permanent loss, by comparison if the price is depressed for a period this is not a permanent state, it is rather an opportunity and how market beating gains are achieved by value investors over the longer term.
BE AFRAID OF LEVERAGE
Leverage is another way of describing borrowing. The amount a company borrows can have a positive effect on increasing its profitability but conversely it can be its road to financial ruin.
The attraction of leverage.
If a company has £1 million of capital and makes a return on capital of 20% the profit will be £200,000.
The temptation for a company in this situation is to ‘juice’ the profits by borrowing say another £1 million, paying 5% interest charge and returning an additional (net of interest) 15% profit taking profits from £200,000 to £350,000 (i.e. an increase of 75%).
The attraction / downside of leverage (and everyone with a mortgage uses leverage) is illustrated by the metrics of purchasing a house (with and without leverage).
10% increase in price of £10,000
90% loan (so £10,000 of cash invested)
10% increase in price to £110,000 (i.e. plus £10,000)
This is the attraction of leverage.
It works equally the other way.
£100,000 house (£10,000 cash unvested)
10% loss in price = minus £10,000
100% loss of capital investment
When assets rise, when profits are strong, leverage turbo charges gains.
When asset prices fall, when profits cease (which happens in all business cycles) over-leveraged companies lose multiples of their invested capital and they fail (bankruptcy).
IF YOU DON’T UNDERSTAND IT
Many of the greatest investors decline to invest in certain sectors or companies because they don’t understand them.
They can’t accurately predict the drivers of and future for a company so even if performance is stellar they decline to own their shares.
There are many investment truisms.
“If it looks too good to be true it probably is.” One which continues to be validated.
Analysis of great companies is fundamentally straightforward.
The company’s business should be understandable; it should demonstrate a great franchise, great management unfailing commitment to shareholder value and future predictability of a good to excellent increase in sales and profitability.
It is assumed by many that successful investment is comparable to quantum physics; it requires a rocket scientist to prosper.
This is not the case, successful investment is fundamentally the practice of common sense, emotional control and the patience to first wait for opportunities and then to stick with them.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.