The renowned investor Howard Marks, widely revered for his investment memos, was once asked about the reason behind his investment success. “An effective investment philosophy” was his answer. The answer made me curious about my investment philosophy.
I worried about not having one. If I do have one, what is it? I do believe I have one. But I would flutter if I had to explain it. Although I believe most of my investment decisions are guided by principles gained through years of experience (most of it painful) in the market, they remain obscure.
I know what I do, but why I do it is quite hazy. My investment philosophy is an amalgamation of these guiding principles. This post attempts to bring those guiding principles out of obscurity and thus bring much-needed clarity and brevity to my investment philosophy.
Risk and Valuation
Managing risk is the most important of these principles. Investment risk resides in the asset’s market price, whether stocks, bonds, real estate, or precious metals. Hence, valuation is the most critical step in the investment decision-making process.
The present value of an asset is the sum of the cash flows the asset is expected to generate over its useful lifetime, discounted for the time value of money and the uncertainty of receiving those cash flows. At any time, an asset’s market price reflects the market participants’ expectations of those cash flows.
The actual cash flows might deviate from those expectations. But those deviations don’t necessarily have to impact the asset’s market price. Market prices change according to the changes in the expectation about future cash flows – not changes in the actual (or present) cash flow.
Suppose that a stock with high expectations of future cash flows reports a lower present cash flow. This development will negatively impact its market price only if the lower present cash flow causes market participants to soften their previously high expectations about future cash flows. If not, the lower present cash flow fails to make any meaningful impact on the stock’s market price.
What causes market participants to change their expectations about future cash flows is unpredictable. Basing our investment decisions on such capricious factors would be self-defeating. We need to pay attention to what truly matters, instead of vainly dabbling in market expectations.
And what truly matters is an asset’s earnings power and how much we should pay for it. Operating profitability, capital allocation, and a sustainable competitive advantage are major determinants of a firm’s earnings power.
The information gained through the analysis is then used to estimate a fair value for the stock. Buying when the market price is closer or lesser than the estimated fair value seems appropriate – both from a risk and return perspective. As the fair value of an asset is determined by its future cash flows, and as the future is uncertain, estimating the fair value is not an easy task.
Firstly, to do so, we need to make certain assumptions. These include assumptions about the stock’s future operating profitability, investment rate, and dividend payout. Our natural inclination is to extrapolate the current trend. But that would be, most likely, erroneous due to the cyclical nature of earnings and investments.
For most of us, estimating the exact fair value is outside the purview of our skills. Hopefully, we don’t need the exact fair value of a stock. All we need is an approximate estimate of the fair value just enough to make an effective investment decision.
The final answer we seek through this process is whether a stock is under-valued, fair-valued, or over-valued. We could buy a stock if it is under-valued, or even fair-valued, and at the same time, sell an over-valued stock.
Unfortunately, estimating the fair value of a stock from its past and present information has many limitations. Different methods or slight changes in certain variables might throw out widely varying fair values. Such outcomes bring more confusion than clarity. The analyst/investor should use his discretion in deciding which outcomes should be considered or ignored.
Catalyst
Towards achieving superior returns from stocks, the biggest dilemma I have faced is on the earnings front. I think it is true for most of the investors. We all know that it is high earnings growth that leads to superior stock gains. However, waiting until high earnings growth becomes visible has caused me to lose out on most of the stock’s potential gains.
Self-doubt and uncertainty compel me to wait for clear visibility of high earnings growth before committing to an idea. Unfortunately, it is a counterproductive strategy.
To achieve superior returns, investment must be made before the emergence of high earnings growth, that is, during a low earnings growth phase; that is, near the trough of business activity rather than near the peak. Then valuation would be attractive too.
However, our investment will fail to deliver, if the low earnings phase continues indefinitely or much longer; that is, the decline is structural rather than cyclical. Nevertheless, we investors lose out in both scenarios – the dilemma I was talking about. Hopefully, there is a way around this dilemma.
We need two favourable conditions to achieve superior returns from a stock. Firstly, the stock must be going through a low earnings growth phase (the trough). Secondly, alongside that, it should have a high probability of elevating to higher earnings growth in the near term.
The first condition being in the present is simple to identify. However, deciphering the second condition is complicated as it concerns the future. The presence of a catalyst can resolve this dilemma, at least to a certain extent.
The catalyst makes the elevation to a high earnings growth trajectory more probable. It could come in various forms: deleveraging and increased dividend payout are my favourites. Expanding gross profit margins could also be a reliable catalyst.
I seek a catalyst in every of the investment ideas I pursue. It is one of my guiding principles: the presence of a catalyst. But a catalyst can’t go on forever and deliver results. It would eventually get exhausted after a period, consequently, diminishing the stock’s prospect. Hence, like every other parameter, the catalyst’s evolution and extinction need close attention.
Competitive Position
Massive wealth from stocks is made over the long term. Stocks with such huge prospects, though very uncommon, do exist. However, spotting such opportunities at the right time needs high diligence. These stocks achieve their feats through high earnings growth and superior profitability over an extended period.
But in a market economy, once a stock attains high earnings growth and profitability, it soon attracts competition from both within and outside the industry. The consequent increased competitive intensity puts downward pressure on earnings growth and profitability. Therefore, achieving and maintaining high earnings growth and profitability over long periods is onerous, but not impossible.
One thing that insulates a stock from the ill effects of increased competition is a strong competitive position (or a durable competitive advantage). In possession of a strong competitive position, it is now plausible for a stock to sustain its high earnings growth and profitability for longer periods.
In the authoritative book “Competitive Strategy”, Micheal Porter states cost leadership, product differentiation, and focus as the three generic strategies companies employ to achieve a strong competitive position.
A strong competitive position is another guiding principle that makes up my investment philosophy. On this front, we investors have two tasks. One is determining whether a stock possesses a strong competitive position. The other is determining the source of the competitive position.
Larger Macro Context
Individual stocks don’t exist separate from the larger financial ecosystem. Everything is correlated. Therefore, for effective decision-making, it is essential to make sense of the greater macro context in which individual stocks operate.
These include the general market valuation and sentiments, business and economic cycles, fiscal and monetary policy, interest rates and inflation, currency movement and external balances, among others.
However, these factors are so humongous that keeping track of changes in each of them is unfeasible. Even if we do keep track, at least, of a few of them, still, we could still go wrong in interpreting the market significance of those changes.
However, it isn’t hopeless either. As per the efficient market hypothesis, the market reflects all relevant information concerning its prospect. The market prices change to incorporate any new information as soon as they happen.
So, interpreting market price action is the best way to understand, comprehensively, the larger macro context in which individual stocks operate. However, there is one caveat to this possibility. Although market prices reflect all relevant information most of the time, there are occasions when they don’t.
During periods of speculative frenzy, due to excessive greed and optimism, market prices might reflect less of their underlying fundamentals but more of the mass hysteria engulfing market participants. Apart from those rare occasions of deviation, interpreting market price action is instructive in making sense of the larger context in which an individual stock operates.
Challenges
Despite all these efforts, we investors still face two major challenges in our investment journey. They are self-doubt and uncertainty. The former is intrinsic while the latter is extrinsic to us. Either way, they are cause for anxiety and lead to decision paralysis.
Their elimination or avoidance in any way is impossible. Every attempt at that only makes us more conflicted. The problem is not them but our beliefs about them. The belief that they are something to be eliminated is a wrong one. Instead, we should rather be concerned by their absence in various situations.
Self-doubt and uncertainty are present on any path to progress. It should not be their presence, but their absence that should be concerning. The right approach is to get comfortable with them, accept them, and learn to live with them if your goal is to progress in your endeavours.
Reframing them as possibilities rather than hindrances would help in dealing with them effectively. The mere existence of self-doubt and uncertainty in our path reassures us that we are on the right track. If we have done our work, we should act despite the self-doubt and uncertainty, rather than succumbing to inaction under their influence.
Self-Doubt
Once we have identified a stock worthy of investing through our research, the next obvious step is to buy the stock. At the beginning of my investment journey, however, I used to hesitate at this step. I would instead google up to see what other investment professionals have to say about the stock and its prospects.
There is nothing wrong in collating our perspective with that of other professionals. But I wasn’t doing that. The cause of my hesitation was self-doubt. The underlying belief behind those actions was that if many others hold similar perspectives as mine, then I might be right. Thus, I would gain enough confidence to act.
I wasn’t aware of this counterproductive belief at the time. It is counterproductive because, by the time a perspective is widely shared, most of the prospective return from the stock would have already accrued. For successful investing, being right isn’t enough: you need to be right before everyone else. It is holding a contrarian perspective and being right that leads to a superior investment outcome.
However, self-doubt always accompanies such conditions. We are inclined to view self-doubt as an obstacle because it puts strong resistance towards our forward journey. It causes us to ruminate and procrastinate, rather than take meaningful action.
However, dealing with self-doubt by working towards more confidence is ineffective. Rather, self-doubt should be dealt with courage. The first step is being aware of it as it happens. Next is reframing it in a good light – as a possibility –instead of antagonising it. Acknowledge its ubiquity in any path towards progress.
Finally… we acquire the courage to act by convincing ourselves that… we have done the necessary work… but despite that… we could go wrong… if so… we should utilise that as a learning opportunity… rather than becoming despondent.
Self-doubt appears not just at the buying phase. It makes recurrent appearances post-investment too. It pressures us to get out of investment positions, during such appearances.
Hence, staying invested is the hardest part of investing. It requires overcoming the strong impulses, triggered by self-doubt, to tamper with our investment positions.
One way I deal with this problem is by reviewing my investment positions only once a year. This is the general case – sometimes exceptional circumstances may warrant a genuine review much earlier than a year. Otherwise, once a year review policy is a good defence against self-doubt.
Usually, it is a disappointing stock price performance or earnings growth that strengthens or brings to the open the self-doubt within us. However, stock price and earnings growth performance, particularly in the short term, are trivial when it comes to a stock’s long-term prospects.
Core fundamentals (competitive position, capital allocation, operating profitability) and valuation are what truly matter. So long as they are intact, tampering with the investment position is unnecessary. Convincing us of this truth would be fruitful when self-doubt is trying to be a damper on our investment journey.
Uncertainty
A stock’s future price movement is determined by how much it will earn in the future, not by how much it earns today, or how much it had earned in the past. Historically, humans have a disastrous record of anticipating the future. It is ridiculous that the disastrous record hasn’t in any way dampened human confidence in their prediction skills.
Despite the massive progress made by humanity, when it comes to the matter of the future, the only thing we are sure of is that it is uncertain. Since a stock’s investment prospect is determined by its future earnings, it surely is subjected to high uncertainty. Uncertainty is a cause for fear and anxiety that leads to decision paralysis.
Swindlers and fraudsters leverage this fear and anxiety to lure naive people into fraudulent schemes with exorbitant promises. The principal reason why many fall to such deceitful schemes is because they all come with the (false) promise of certainty. The success of these schemes proves how much the general populace detests uncertainty.
Uncertainty is unsettling for me too. But I have learned there is no way around it. Being comfortable with it, exploring it, and reframing it as a possibility is how I try to deal with it. But how far I have succeeded at it is arguable.
The future unfolds in the most unexpected of ways. Preparing for it is unfeasible because we can prepare only for the known, not for the unknown. But we can prepare for uncertainty by ensuring that we are not wiped out when the bad happens, and at the same time, make large gains when the good happens. In other words, this means getting the odds in our favour.
Our investment portfolio could be buffered against the crippling effects of uncertainty through preventive measures. ‘Not paying too much’ (a fair valuation) … ‘avoid putting all your eggs in a single basket’ (reasonable diversification) … ‘recognising the limitations of our knowledge’ (humility) … and a ‘willingness to learn from our mistakes and make changes’ (belief adjustment) … are a few such preventive measures that can be useful in dealing with uncertainty effectively.
Conclusion
This post began as an earnest attempt to clarify my investment philosophy. We discussed ‘managing risk’, ‘presence of a catalyst’, ‘competitive position’ and ‘understanding macro context’. We also discussed how ‘self-doubt’ and ‘uncertainty’ could play spoilsport in our investment journey and how to deal with them.
To be truthful, it was a disorienting experience. The intended clarity never materialised. The effectiveness of whatever has materialised is doubtful either. Maybe, an effective investment philosophy itself is a delusive concept.
Effective means the ability to produce desired results. But how sure can we be that it was our investment philosophy that brought about the desired results? It might just be favourable economic or financial conditions, or else, just pure luck: nothing to do with our investment philosophy.
I am not questioning the essentiality of an investment philosophy. There should be some guiding principles, but the idea that it is fixed and knowable is unconvincing.
I prefer an adaptive investment philosophy.
‘Adaptive’ because conditions are ever-changing; what works today might backfire tomorrow; what works for one situation might not be suitable for another. It is comprised of several principles, including the ones we discussed, but not confined to them only.
Most of them are imperceptible, hidden in the deeper realms of our minds, but are active contributors to each of our investment decisions. The permutation of principles involved in each decision is different, chosen as per the demands of the situation.
I have been analysing and investing in stocks for the past 17 years. I too have my share of good bets and bad bets. If I am asked how and why I chose those bets, I would say: “I don’t know… I do things… and things just happen… but… most of the time nothing happens… “
Society will find the answer rude. To appear polite and win respect… if that’s our intention… then… we may have to come up with a reasonable, interesting, and convincing theory or explanation.
If I get myself in such a situation, I will choose the ‘adaptive investment philosophy’ explanation and put forth some of the principles discussed in this post as some of its guiding principles.
Otherwise… It is… Just see things as they are… Just do things… Keep Moving….
Now it’s not that disorienting… I feel liberated…
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