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When some investment managers talk about their process it can sound like they’re living in fantasy land. They tell you they’re looking for companies that operate in industries with high barriers to entry, where the regulator is a few steps behind or asleep at the wheel, where the business model is based on unique IP that can’t be snatched away, where the company is poised to ride a tidal wave of new consumer trends and behaviors, and where they can scale to the sky. Did I mention it also has to come at a good price?
It turns out the recipe for investing success is simple after all: just find high-quality businesses that have no competitors, can grow to infinity, and can be bought up cheap. How many of these stocks have you found lately? Could you send me the ticker? The reality of investing is very different. Sure, there are companies with huge growth potential, but you pay for that growth. There are companies playing in industries where regulation is yet to catch up, but it always does eventually. There are companies with a great business model and brilliant IP, but happens when other companies start doing the same thing? Then there are those that were just at the right place at the right time. What happens when their product goes out of fashion and consumers find something else to obsess over?
We can’t afford to indulge fantasies when we invest. Markets are intensely competitive and prices are struck based on the analysis and opinions of millions upon millions of investors. We aren’t the only ones with a view. But we can make sure that the view we have is as rigorous and disciplined as possible, and find investments that can meet our objectives. It all starts with three simple yet critical questions that every investor, regardless of their age or experience, should ask themselves whenever they are considering an investment.
When we come across a stock we like, we start thinking about all the ways it can make us money. What we should be doing first is asking: How can this company lose us our savings? You can’t overestimate the importance of this question. The purpose of due diligence is not to look for arguments that justify your decision but to find arguments that go strongly against your instincts. Find the analysts who are most bearish on the stock and read their analysis. Find people who are down on the entire sector and learn why they think it will come under pressure. Find the major risks that could lead to losses and steel-man the arguments. Then, once you’ve identifies the valid risks, you can look for ways to manage them as best you can.
Every company faces risks to its business. These include company-specific risks: thinks like poor management, mishandled issues, or misallocated capital across the organization. Maybe the company is facing lawsuits that are not widely known. Look into these issues before you go charging in. Then there are industry-specific risks. These include the demand and supply trends affecting the company’s operating environment, such as technology changes, shifts in fashion, and regulatory developments. These things affect all companies in the industry, albeit in different ways. Market risk refers to the behavior of financial markets more broadly. Every stock is subject to the risk of a secular downturn in company values, maybe due to a rise in interest rates or inflation, or a sharp selloff due to exogenous economic factors, a financial crisis, or a pandemic.
Think carefully about your personal risk preferences and whether this company can deliver steady gains or is dependent on a strategy that may or may not come to fruition.
Some investors enjoy the thrill of the ride, while others prefer a safer climb. There is not right or wrong way, but you need to understand what you’re looking for and identify investments that fit your style.
As part of this process, you also need to look at the current holdings in your portfolio and determine how this stock will either add to risk or possibly balance out some of the risks you already have exposure to. Understanding the total risk of your portfolio is critical. Maybe you’re looking to invest in a technology company, but you already have significant technology exposure. This is something you will need to manage, and this can be done in different ways depending on the asset.
For example, a real estate investment will be most exposed to interest rates, because mortgage interest is the biggest expense. This can be managed by locking in an interest rate with fully amortized financing, or through the use of non-recourse financing, which can help limit your total losses should one property fail. If you’re investing in bonds, be careful where you’re investing along the risk curve. High-yield bonds can generate high returns, but there is a greater risk of default and non-performance. Lower yields from high-quality companies with strong balance sheets might be a better option depending on your risk appetite.
The purpose of your portfolio is not just to maximize your potential returns. You need to carefully manage the trade-off between returns and risk. What defines a great investor is their ability to make consistent returns through all market conditions by controlling losses and making disciplined decisions. Some assets offer the possibility of high returns, but there is always a catch — they will tend to be more volatile, meaning the price is liable to move up and down more frequently and to a greater extent than assets that promise lower returns but deliver them more consistently over time.
The price of some stocks can fluctuate significantly as investors take in information about the long-term prospects of the business. Sometimes these can be highly uncertain and contingent on things like the successful trial of new technology or drug, the implementation of new production processes and efficiencies, the popularity of the product or service, and the ability of competitors to join the market and start offering similar products for a lower price. Amazon is a great example of a business that has its fair share of bullish proponents and bearish detractors. Amazon’s ability to leverage its platform, develop more efficient warehouse logistics with robotics and other technology, and continue to gain a foothold in a wide range of markets and regions, is dependent on a whole number of factors. How investors view these factors and how they impact the company’s revenue and costs can change — sometimes dramatically — resulting in sharp price movements.
If this is the sort of asset that fits in your portfolio and supports your objectives, then buy it. But you must first be clear about what your set of objectives is. Are you targeting growth or income? Are you looking to accumulate your portfolio over a long period of time, or will you be making a large drawdown in a year or two? Are you looking to support particular businesses and industries and avoid others? Are you looking to gain exposure to certain factors like momentum, size, or value? Do you need to protect your portfolio from large market falls, or manage tail risks to prevent your capital from being wiped out? All of these questions should be carefully considered and answered with respect to your own tolerance for risk and your future wealth and income needs. You should never add an investment to your portfolio unless it lowers your overall risk or increases your expected return. Preferably, it should do both.
Everyone needs an exit strategy. Over the course of your investing life, you’re going to make some wrong calls. Even when you’ve put in the work and looked at the business from every conceivable angle, things can still go wrong.
Log on to Twitter and check out some of the more flamboyant hedge fund managers. You’ll see an endless stream of tweets talking about the great calls the fund has made. You won’t hear about the bad calls, but you’d better believe they’ve made them.
An investor who never loses money on any of their investments is like a lawyer who never loses a case. Either they are incredibly selective about the cases they take on, or they’re not being completely honest.
Assuming you will make losses on some of your investment decisions, you need to have an exit strategy in mind. It helps to decide ahead of time when to sell an asset to avoid letting your emotions get in the way. Don’t ever marry your investments. Be explicit about the conditions under which you will sell before you put money in. What could happen that could undermine the company’s business model? At what point does it become clear that the growth story is unlikely to eventuate? What are the critical milestones the business has to reach, and what will you do if it misses them? Be clear, and then be prepared to sell when it’s time.
No investment is forever. I know someone who owns Verizon shares because he was gifted them by his dad, who in turn was gifted them by his dad. There’s nothing specifically wrong with Verizon — it offers a nice dividend and it’s a secure utility-like business — and in this case, maybe it has some sentimental value. But your portfolio is a living breathing thing, and sometimes it needs to be properly pruned of its losing assets.
Selling and rebalancing is all part of the journey. You should monitor your portfolio and always refer back to your original thesis. Markets change, and so do your investments. Sometimes a stock that used to be a good fit is no longer appropriate for you. Maybe you believed strongly in the company’s potential but now consider the stock to be overvalued. Now might be the time to take profits. Be prepared to sell, conserve capital, and move on to the next strategy.
There are plenty of different theories about investing, which can make it confusing for anyone starting out. But investing is largely a learning-by-doing exercise. By making investments and thinking carefully about what could go wrong and how risks can be managed, we start to gain a deeper understanding of the theory and an appreciation for the art as well as the science of investing. By getting exposure to markets, we start thinking clearly about our personal objectives and how our portfolio can support them. We think about our investments in terms of likelihoods, rather than buying into the most appealing narrative.
Investing is about learning and adapting to changes in market conditions, the economic cycle, or individual business models. The more we do it, the wiser and more experienced we become. But we’ll never stop asking these three questions.