Occasionally, the opportunity to deliver a public outline of my portfolio methodology, at a conference, presents itself. Most investment conferences are an exercise in tedium, more often than not they represent an utter waste of resources. However, once in a great while, the process of appraising my work and distilling it into some basic bullet points, for thoughtful audiences, reveals a few important characteristics. At the conclusion of my recent multi-state, multi-country tour, here’s what I gleaned about my own work, over the past 18+ years of holding largely the same portfolio of securities.
1. I am excellent at waiting. It is my single best attribute and has served me far better, from an investment return standpoint, than my purported ability to select high quality securities. Selecting securities is simple enough for most people. It generally involves utilizing a series of investment criteria. Businesses are screened and researched for suitability; upon the determination that a business meets those criteria, a decision to purchase ensues. That’s the easy part. The HARD part is then the waiting.
Investors and managers, more often than not, fall prey to a host of confabulations and false choices. They fail to consider the full investment cost associated with the employment of incorrect advice. The SINGLE worst piece of advice that I’ve ever heard is the suggestion to take some money off the table when a winning investment presents itself. On the surface, the premise seems sensible enough: “recoup your initial investment once a predetermined profit threshold is reached and you’ll reduce your risk”. To me, that’s simply profit limiting. Drill down, ever so slightly, below the surface and an incongruity emerges; you are selling a winner and even selling a portion is still a liquidation of an ongoing success.
Once a portion of a clear winner has been sold, an investor has to reinvest said funds into yet another business. The odds are just 1 in 3 that this might prove out. Yes, a new investment might be superior to the business sold. It also might be equivalent and quite possibly could be inferior. The odds are stacked against one, when acting upon the oft-told adage; selling to purchase an equivalent quality purchase is a losing choice because of the taxable event that has been created from the sale. Divesting a portion of a winning business to purchase an inferior investment with the funds hinders the overall portfolio return. Accordingly, I never sell off my winners.
2. I average UP when it makes sense. Investment compliance departments hate individuals that average up; the perception is that buying more of an investment on the rise increases business risk, because when an investment falls in price, a winner can conceivably turn into a loser and quite possibly moves an entire position from the black to the red. Sure, that seems sensible prima facie. The opposite argument is that if you have picked a winning investment, one that is gaining investor traction due to the implementation of a sound business plan, then why not add to that position? I consider adding to a winning bet in the same vein that mathematicians favor splitting a pair of aces on a blackjack table; the odds of success are in your favor. It is also akin to making an additional bet on a horserace that is well underway, who wouldn’t wager more money on the horse that is not only far ahead of the pack, but is STILL pulling away.
3. I diversify only to the extent that I can find world class investments, featuring high sustainable EBITDA margins and that have secular tailwinds. Owning a bunch of average or subpar businesses, for no other reason than convention dictating the same, is a waste of resources. Bill Gates, Jeff Bezos, Sergey Brin, Larry Page, Larry Ellison, Mark Zuckerberg, Amancio Ortega; all of these individuals are counted among the wealthiest persons on earth. None of these individuals net worth can be classified as well diversified. In each case, one, sometimes two, business holdings generated colossal rates of return and their holdings are so top heavy that if they were not as wealthy as they are, compliance departments at the firms where their securities are held would be having conniptions.
There are fewer than 20 investments in my entire portfolio and that’s not by design; that’s just how it has evolved over time. If an investment under evaluation isn’t superior to what I presently own, then it doesn’t get in. No amount of haranguing, cajoling or marketing will persuade me otherwise.
4. I always invest with a tailwind. Some suggest a cautionary axiom “when you swim with the tide and the tide goes out, you are left naked”. My preferred tailwinds are pronounced, persistent secular trends; the global switch towards a cashless society, the global trend for international travel, etc. are just a few of the developments I consider worthy of investment. An important secular trend can be so impressive that the movement is akin to the flow of the Congo River; the current and volumes that flow from the Congo are sufficiently forceful that fresh, potable water can be had almost 100 miles into the Atlantic ocean from the mouth, regardless of tidal effects. Betting AGAINST such power seems to be folly and that is an important takeaway to be considered in terms of investment selections. Like the Congo River, whose fresh water can impact salinity and temperatures of an entire ocean, so too might a long term trend prove capable of impacting entire portfolios, for an indeterminate period of time.
A failure to differentiate what is a secular trend vs what is merely an arbitrary event represents the key risk which catches more than one investor off-guard. This is where it pays to be discerning. By way of example, consider global free trade. Is free trade a secular trend, or is it, more or less, a series of arbitrage policies that can be erased at the stroke of a pen? Those who bet on the rise of global free trade are completely taken aback at the possibility of a confrontational China bloc vs a US trade bloc with the remainder of the world sitting on the fence trying to play off both sides for a few hundredths of a percentage point advantage. Nations behaving in a mercantile manner blow apart investment portfolios set up to profit from a free trade society. On the other hand, businesses that assume free trade to be transitory might escape, more or less, unscathed, should things get more heated in the years to come.
5. I don’t invest for fun. The business of evaluating securities, buying securities and holding onto those businesses, through multiple market cycles, is the farthest thing from a thrill than can be imagined. Some talk up the notion of taking a bit of cash that can “be spared” for occasional speculation during economic upcycles. I consider this akin to growing zone 5 apples in a zone 3 climate; occasionally it works, for a bit, but the effort involved typically doesn’t provide an incremental return over time.
6. I set the bar high. Those who talk or write about being unable to outperform indexes over time might also have ulterior motives. Investors need to be aware that arbitraging individual securities, at the institutional level, is profitable when 90% of equity trading on an exchange is done via ETF bundling. Setting the bar low also provides a measure of cold comfort for those who have proven unable to outperform indexes over time. In my view, defeatism has no place in a modern capitalist economy.