Wednesday, 5 February 2014

The two most useless (useful) investment tenets

Over the last few days, I've been thinking about my ever changing investment philosophy, in an attempt reach some clarity towards my current investment process. There are several schools and sub-schools in investing, and even the term "value investor" can mean a hundred different things. So to properly categorize myself within this maze I started to think about some of the folksy wisdom provided by great investors and two gems came to mind because they were completely meaningless to me when I had just started out investing, and now carry a great deal of influence over my decisions.

"Rule # 1: Never lose money; Rule # 2: Never forget rule # 1. "

When I first came across this advice, I thought well geez... "that's pretty useless, of course I don't want to lose money, but how do I make sure I don't lose money?" 

Now after looking at hundreds of different businesses, my investment process revolves around this vague folksy wisdom (this does not mean I never lose money). Nearly all of my time when looking at an investment is spent on how can I lose money in this investment / what can change in this business going forward? My usual reasons includes I don't understand the business (banks, pharmas, tech, resource based), too much debt, too expensive, too cyclical, too close to its cyclical peak, too big and complicated, and of course too competitive - when you have over 20,000 companies in North America alone, you can be quite liberal in rejecting investments.

Buffett himself has exemplified this philosophy better than anyone else - a 58 year investment career with only 2 negative years is simply mind boggling. Thinking about his investment process of - ultra-long-term time horizon or permanence, high concentration, buying quality, Saint-like patience - all are geared around avoiding losers, not buying multi-baggers although that may be the result, but first and foremost on avoiding losers. Even in his early days of buying cigar-butts and work-out situations, Buffet was doing just fine avoiding losers - in his 1963 memo titled "The Ground Rules", he reported his partnerships total realized gains to loss ratio over its  6-year existence to be "something like 100 to 1". 

"Use your [investing] edge."

Once again, when I first came across this advice I thought, hmm what is my investing edge? Am I smarter? Harder working? Copying smarter people? The first two are debatable.

But once again this advice has become a cornerstone of my thinking. Again let me use Buffett's folksy wisdom to explain - "If you have been in a poker game for a while, and you still don’t know who the patsy is, you’re the patsy." - I'm always looking for a reason why I believe this stock is cheap and why others are not taking advantage. It is very helpful in weeding out ideas. The most common (most important) edge is simply having a longer time horizon than others. But coupled with lets say undercovered companies that institutions can't invest in (too small, post-bankruptcy, spin-offs), misunderstood businesses (M&A, conglomerates), or out of favor industries, the opportunities can be enticing.

Other tenets could include:
"Price is the primary determinant of risk and returns"
"Investing is most intelligent when it is most businesslike."
"Learn from and copy success"

I think those are pretty self-explanatory.

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