My Investment Principles

December, 2020
After almost two decades of practising stock investing, I have come to the conclusion that successful investing requires at least three key ingredients with each of them equally important for the final result, but any one of them is not sufficient without the other two.
Three key ingredients are:
I
Investment principles
II
Investment tools
III
Psychology

I. Investment principles:

1. Stock is a share of a real business. Stock performance cannot deviate too much from the performance of the underlying business. Businesses grow for years and do not change overnight – so having a long-term investment horizon is important for successful investing. Focusing on business fundamentals and ignoring 'noise' coming from TV commentators is also very important.

2. Value of a stock equals the sum of all net cashflows that the company will generate discounted to present value. If reversed, this also means that your return from owning a stock would equal to the ratio of a normalised (typical) cashflow divided by the price of a stock.

3. Price you pay for a company's stock and future performance of the underlying business are the two key drivers of your overall investment result. The importance of Price diminishes with the growing holding period, while the importance of the underlying business grows with time. If you bought a business that generates 30% return on capital (measured as profit relative to the sum of all assets used to generate it) and if you own that business for 50 years, then your investment returns will be very close to 30% regardless of the price you pay.

4. Risk is the permanent loss of capital, not volatility of a stock. If one investor bought shares of a well-known global franchising company (e.g. McDonald's) and another invested in a similar company but privately (becoming a direct partner in the business which has no shares listed on the market) – then the first investor would see the price of his stock change every minute depending on market quotes. The second investor would not be exposed to such 'volatility' simply because the shares are not listed company. But the risks for both investors would be very similar and related to the performance of underlying business, strategies of competitors, changes in regulation etc.

Two major sources of real risk come from leverage and technological innovation. Leverage is both – financial and operational. Financial leverage represents the total amount of financial liabilities that the business has to pay down eventually as well as regular interest payments that it needs to make in relation to those liabilities. Companies in cyclical industries with low barriers to entry and no pricing power are more exposed to risks of leverage than businesses with established brands operating in sectors with high barriers to entry.
Technological innovation can make a product obsolete (e.g. Blackberry, Kodak) or disrupt economics of an existing service (e.g. e-commerce vs physical shops).

Other forms of risks come from changes in regulation, natural catastrophes, geopolitical conflicts and wars, general market cycles, fraud and mis-allocation of capita. Some of these risks affect all stocks (e.g. recession) and their exact timing is very hard to predict.

To avoid risk an investor should not try to predict when a bad event will happen, but rather should try to avoid stocks that will be affected the most in a negative scenario.
Well known negative outcomes that could happen are often at least partially reflected in the price which reduces the risk (e.g. if a company is valued by the market at a discount because investors are concerned about potential fine, then when the fine is issued – the stock would unlikely drop as its price has already reflected this outcome).

One of the biggest risks is not knowing all possible adverse outcomes and not knowing or assigning the wrong probabilities to them.

5. Circle of competence. To adequately assess the business and the cashflow it can generate in the future requires deep knowledge and skills. Without enough knowledge any view becomes just a bet. We have deep knowledge of very few things or areas of life, so our investing process should focus on few niches that we understand well. This also helps to avoid potential risks. As Warren Buffett says, 'I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over'.

One reason many highly intelligent people do not achieve outstanding investment results is that they tend to ignore their areas of competence and would analyse and take a view on wide range of situations. A person with lower IQ can achieve better investment results if he acknowledges his limitations and focuses on what he knows best (e.g. residential property in a small town).

6. Contrarian. Opportunities to find great businesses selling at low prices are higher in areas where with fewer investors are competing against each other (less glamour industries) or sectors that received 'bad' reputation which has little to do with their underlying economics. With the rise of passive investing in market indices, certain stocks or sectors can fall simply because their weight in an index benchmark was reduced which has nothing to do with fundamentals.

To borrow a quote from Charlie Munger, 'Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position is a way more likely to win than a horse with a terrible record and extra weight. But if you look at the damn odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then, it's not clear which is statistically the best bet…The prices have changed in such a way that it's very hard to beat the system' [1] .

Another world's best investor, John Templeton, used to say that 'it is impossible to produce a superior performance unless you do something different from the majority'. He also said on the importance of taking a contrarian view that 'the time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell'.

7. Competent and honest Management with 'skin in the game'. There are many examples when skilful managers improved performance of a business and generated superior shareholder returns (e.g. Satya Nardella as a CEO at Microsoft). Managers are also important as allocators of capital since this impacts returns that the company generates in the long-term. When managers own a significant portion of a company or have a significant part of their net worth invested in the business they run – they tend to make more long-term decisions aimed at creating more value and avoiding unnecessary risks.

At the same time, managers can do little in a business that lacks competitive advantage or has fallen behind in the technological race. Buffett underscored the importance of a business over management skills when he said: 'You should find a business that even a fool can run, because someday a fool will'. He also famously said that 'When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, the reputation of the business remains intact'.

8. Patience. Importance of being patient is crucial for investment success. Patience is needed when a good business continues to sell at a discount until something changes (e.g. the market starts to realise the true value of a company, strategic investor comes with takeover bid , company launches large buyback programme). Patience is also required in doing your research before buying shares and not to follow short-term ideas. Patience is a virtue when 'hot' stocks continue to rise making random people richer every day, while the stocks in your portfolio continue to stay out of favour.

One of the key reasons for Warren Buffett's success has been his ability to wait for the 'fat pitch' (using the baseball terminology). 'The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot'.
However, it is also important to remember Principle 5 (On circle of competence). Patience can ruin anyone if it is followed for its own sake without a clear understanding of the true value of the business that investor owns, competitive dynamic in the industry and its long-term economics. Only if you buy a company that is within your area of competence patience can add to your investment returns.

II. Investment tools

Successful investing comes from finding great businesses and buying them below intrinsic values. So, the key investment tools are focused on How to find such companies and How to evaluate their intrinsic value. In simple terms a successful business is the one that earns a high return on capital which is sustainable in the future and has many options for reinvesting capital (growing the business). Ability to maintain high returns is often linked to having unique competitive advantage ('moat' as Buffett refers to it) in an industry with relatively low competition and high barriers to entry (scale advantage, brand, unique R&D process, patents, regulation). Such businesses are normally run by exceptional management teams with strong alignment of interests (who have direct interest in the business).

A summary of investment tools and questions:

1. Economics of a business. What is company's product, what determines its price and costs. Is the product more of a commodity (easily substituted by other suppliers) or well differentiated product with a strong brand? What is the profit margin of this business? How much capital it requires to maintain the current operations and to grow? What are returns on capital?


2. Future economics of a business. How can it change relative to the current state? How unique is the product, how strong are competitors. What is the size of the market that the company operates in? Is the market growing and why? Will customers need this product in 10-20 years?


3. Leverage. Does the company use a lot of financial leverage relative to its assets, profits, cashflows? How significant is operating leverage (share of fixed costs relative to variable costs and relative to gross margin).


4. Management. How competent is the management team, what is their track record? What are their key KPIs, incentive structure? Have they purchased company's stock


5. Capital allocation. How does the company allocate its cashflows – what share goes on maintenance capital, growth investments, M&A, dividends, buyback? What big investment projects has the company undertaken historically, what results they have achieved (incremental profits relative to capital spent).


6. Valuation. What is the current price relative to profits, dividends and buyback, what is the current price relative to profits / dividends in 5 years? What return could you achieve if you pay the current price relative to the shareholder yield (dividends + buyback) + long-term growth? How does it compare to government bonds, dividend yields on equity market + 3-5% (level of GDP growth + inflation)?


7. Risks. Where can you be wrong in your analysis, what could go wrong? Are you extrapolating the favourable conditions from the recent past far into the future? Is the business in a cyclical industry? What could cause the stock to drop 20%? Would you still be happy /comfortable owning the company after the drop? Will it be able to survive 5% drop in GDP, materially higher inflation, interest rates? Would you like to own this business for the next 5 years, 10 years, 20 years, for the rest of your life?


Other practical tools include:

8. Sourcing ideas. It is more likely that a mis-priced company would be in a sector / country that generates little interest for the broader market currently. This could be out-of-favour industries especially if investors avoid them for non-fundamental reasons or based on broad concepts ('uninvestable sector') or simply 'boring' sectors or countries / sectors that are just not on many investors' radars.

- Reading financial press to identify such sectors or companies going through a turnaround is a useful tool.

- Reading annual reports and conference call transcripts of companies that catch your attention can help to better understand the business as well as key competitors. Often, a competitor may turn out to be an even more interesting investment opportunity.

- Screening for stocks is useful, although less than in the past simply because it is such an easily available tool which can be quite easily automated. Some search criteria could be valuation, returns on capital (Magic Formula website maintained by Joel Greenblatt), 13F filings (that track recent purchases of investors with superior track record), insiders' activity.


9. Position size. What share of your portfolio should you allocate to a company that meets your criteria? What share of your net worth is keeping in stocks?


10. Diversification. How many stocks should one keep in a portfolio, is it worth holding stocks from different sectors, countries.


11. Currency risk. In what currency does the company sell its products, what currency are its costs denominated in? What is the currency you measure your net worth, you make your most spending or plan to make in the future?


12. Opening a position. Should you open a full position once you have done all research or buy in stages?


13. Exiting position. When do you sell the position? Has the price of a company reached your fair value estimate? Have conditions in the industry or of a business change significantly compared to your original assessment? Have managers been selling or buying stock in the market?

III. Psychology

Two quotes from investment legends summarise the importance of psychology.

Ben Graham: 'The investor's chief problem—and his worst enemy—is likely to be himself. In the end, how your investments behave is much less important than how you behave'.

Peter Lynch was even more direct: 'In the stock market, the most important organ is the stomach. It's not the brain'.

Plenty of studies have proven that humans are not perfect in making rational decisions and in remaining consistent with decisions made.

In investing, it is crucial to keep this in mind. Our psychology can distort our decisions at every stage of the investment process: from choosing a stock for a possible addition to the portfolio, during the analysis phase, as well holding the stock and deciding when to sell it.

I see at least four causes for these shortcomings:

1. First act, then think. Humans have emerged in a wild world and quickly reacting to potential dangers was more important than whether the actual decision was correct. If our ancestors spotted something loosely reminding them of the ears of a lion, they would be far better off running away immediately, then taking extra time trying to confirm their initial guess. The downside from being wrong was some extra running, while the upside from being right – a saved life.


2. Social proof. In addition to living in a wild world, we also got used to being social animals preferring to live in a group than individually. We seek decisions that get social proof such as when buying popular stocks that everyone is discussing. It makes it painfully difficult to avoid those stocks and sectors when you see your friends and neighbours getting rich by holding the 'most obvious winners in today's economy'.


3. Look for order, avoid randomness. Somehow, our brains cannot handle randomness and seek to put things into order often looking for correlation and causations between events when there is none. This leads to various biases such as hindsight ('I knew this would happen'), 'illusion of knowledge ('the data and detailed analysis supports this'), overweight of 'experts opinions' and others. Our preference for certainty often makes us overpay for stocks with predictable and stable dividends. We also tend to buy stocks with clear 'stories' behind it.


4. We follow our emotions much more often than we think so. 'It is easier for us to say yet to people we like' is a famous advice from experts on self-improvement and relationships. The reason this advice works is that we often assess information not on its own merit but based on who we get it from. A well-spoken management can often 'sell' company's strategy and convince us faster even if reality is far more challenging and unclear.

We often assign higher probabilities to events that we can visualise better or which we just have experienced ourselves. Various studies show that people believe another natural disaster is more likely to happen if one just happened even if thousands of years lead to a different statistical probability.

Surprisingly at first, but even if the same information is presented differently – people tend to make different decisions. For example, studies show that individuals would likely choose to go ahead with some action (e.g. medical operation, construction) if they are told that 'there is 95% chance all goes well', while they are more likely to reject the decision if told 'there is a 5% risk of things going wrong'.

The whole field of Behavioural finance is full of various studies which have identified a list of all kind of biases and weaknesses in our decision making process. This list is worryingly long and includes some of the following ones:

- Loss aversion
- Anchoring

- Mental accounting

- Endowment effect

- Framing

- Over confidence

- Framing

- Hindsight bias

- Social proof and peer pressure
Various biases lead to all kind of problems like 'over trading', short-term investment horizon, focusing too much on TV experts, not doing enough fundamental research, over-paying for popular stocks with stable earnings and captivating 'stories', paying more attention to the final result rather than the process.

From my experience, the best books on this subject that are worth reading are:

'Thinking, fast and slow' by Daniel Kahneman and Amos Tversky

'Nudge' by Richard Thaler

'Behavioural investing' by James Montier (or a shorter version of it – 'The little book of behavioural investing')

'Fooled by randomness' by Nassim Taleb (as well as all his other books including 'Black Swan', 'Anti-Fragility' and to a lesser extent 'Skin in the game'.

I keep thinking on how we can overcome our human's weakness to get better investment results sharing some of my findings on this website. Some of them include writing investment thesis, having your own checklist, creating simple rules (e.g. having a maximum position size), avoiding 'hot' stocks and widely known 'stories', asking 'How I would allocate my savings if I had all of them in cash?' rather than 'should I stick to this or that stock, reduce / add?', checking stock prices less often.

Ultimately, perhaps the most important advice although the one which is probably the hardest to follow is to never stop learning especially through reading books to keep expand your circle of competence and accumulate knowledge.

Being mindful of your habits, practising meditation and having the 'right' circle of like-minded investors are also important steps to improve your decision making.
[1] A lecture by Charlie Munger given at The University of Southern California Marshall School of Business on April 14, 1994.

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