Price focus is the best protection. Investments, we believe, become riskier as their valuations rise. So, the original price you pay for an asset, relative to its cash-flow, is the most significant factor guiding future rates-of-return.
2. Investing is Not Gambling, If You Give It Time
We acknowledge that investing is a gamble—in the short run. Less than 10% of stock market price movements in any given year is a rational response to changing company fortunes. Sentiment is responsible for the other 90%.
In the long run, however, investing is not gambling. Investments have an underlying value based on the cash-flow being produced. Investment prices will ultimately reflect how well that value performs over time.
3. We believe the source of investment returns is derived from a company’s internal value creation.
This may seem obvious, but practitioners of other investment strategies disagree. Momentum investors, market-timers and adherents of Modern Portfolio Theory look to the stock market as the source of investment returns. This is an important distinction because it affects how you think about stock prices which will, in turn, affect your investment behavior.
We believe security prices can potentially tell us one thing only: Is the asset priced to produce an adequate return? That is why cash flow is so important. It allows us to compare a company’s yield against our own requirements.
If, on the other hand, you look to the stock market as the source of returns, as is common, then security prices have great meaning. The practical effect is to wait until ‘things are better’ before buying stocks, and to sell them when it seems financial Armageddon is imminent. It can lead to a cycle of buying high and selling low.
4. Your own temperament is the greatest factor in achieving a successful financial life
Everyone wants to be successful with their money. Many believe rarefied financial knowledge is key; failing that, having the best money manager is critical. They are wrong.
There is no evidence showing finance professors are better at investing than other intelligent types. If simply hiring managers with great records were the answer, the typical investor would not underperform the actual results of those managers, which they consistently do by a large margin.
So, here is the truth. Your own temperament is the greatest factor in achieving a successful financial life. You may be highly intelligent and a star in your chosen profession, but unless you have the right temperament, those attributes are of no help. That is why plenty of smart and successful people are terrible investors.
We all have ingrained tendencies that are detrimental to achieving investment success. They include thinking we know more than we do, being anchored by past decisions, and, most important, being impatient. Successful investing requires we bypass this hard-wiring. Controlling your emotions can be a ‘competitive advantage’ for an investor.
5. The Paradox of Investing
Paradox and investing go hand in glove. Some of the highest returns can be achieved from low risk investing. The best time to buy is when everyone’s gloomy. Worrying about your investments only makes sense when things look great. Investing is simple but not easy.
The biggest paradox of all, however, is related to behavior. No one wants to die soon. No one wants to outlive their money. Every investor is therefore a long-term investor. Yet most investors act like traders, particularly when markets decline.
Unlike other investment paradoxes, managing long-term funds to short-term concerns is a self-imposed one. This paradox drives many investors to act as traders, not as business owners. And this creates frustration and anxiety and bad behavior. It can be wealth destroying through unnecessary tax bills and loss from premature sales.
Unlike other investment paradoxes, managing long-term funds to short-term concerns is a self-imposed one.
6. We focus on owning individual businesses
Our focus on individual businesses runs to the heart of value investing. It allows us to avoid popular and overvalued assets, concentrating instead on companies that meet our yield requirements.
We believe the current mania for so-called passive strategies, as evidenced by the popularity of ETFs, will eventually disappoint participants. US stocks, in aggregate, are priced to deliver paltry long-term returns simply due to elevated valuation levels. ETFs reflect this reality.
ETFs have an inherent flaw with many implications. It is related to an implicit promise of liquidity which, in practice, means an ETF is only as good as its least liquid component. ETF manufacturers in practice subordinate all investment decisions to liquidity considerations and has some weird implications.
As long-term investors, the focus on liquidity is an anathema to our philosophy which considers valuation to be the linchpin.
7. ‘Predictive attributes’ are a powerful long term tool
‘Predictive’ behaviors and factors are time-tested actions and attributes shown to produce long-term outcomes. An example outside the investing realm is the idea that eating properly, along with daily exercise—though no guarantee—will lead to a healthier life, as opposed to a diet of junk food and persistent inactivity.
Investment success, like everything else in life, can be postponed or eluded by unknowable factors and events. There are no guarantees, but by focusing on ‘predictive’ factors, we can create probabilities in dealing with uncertainty, thereby improving our chances for success. As we add factors, we increase probabilities and further our odds of a desirable outcome.
Staying with the healthy-life metaphor, add a history of longevity, meaningful work, moderation in all things, a smoke-free environment and a happy social circle to the factors of proper diet and exercise, and the odds the person will indeed be healthy are increased.
‘Predictive’ factor investing works the same way. Not liquidating your stocks after a severe market decline, or viewing your holdings as pieces of operating businesses, or taking stock-market predictions with a grain-of-salt are examples. ‘Predictive’ factor investing can be used in implementing strategies such as paying attention to the Capital Cycle, or they can be the basis of an investment checklist in identifying suitable companies to own.
Without revealing too much of our secret sauce, we consider paying a fair price for a business that has consistently made money, earns high returns-on-investment capital (ROIC) versus its weighted average cost of capital (WACC), enjoys a modest debt profile, and has plenty of money-making reinvestment opportunities to be ‘predictive’ factors.