Readings: Week 21 - 27 Aug 2017

Charles Ellis on “Winning” at Investing

I’ve pulled some highlights from what I read that help describe what Ellis believes investors need to do in order to “win” at investing.

On what investors should care about.

That’s what investors should really care about: Don’t lose. Don’t make mistakes. They cost too much. Most of the destruction of investment value occurs in small private, anguished experiences, that are never discussed and never recorded, because people were doing things they never should have done.…In investing, losing means taking decisive action at the worst possible times — being driving by your emotions precisely when you need to be the most rational. Trying too hard to win eventually means losing. Long-term investment success really depends on not losing — not taking major losses.

If you avoid large losses with a strong defense, the winnings will have every opportunity to take care of themselves. And large losses are almost always caused by trying to get too much by taking too much risk. If, as investors, we could learn to concentrate on wisely defining our own long-term objectives and learn to focus on not losing as the most important part of each specific decision, we could all be winners over the long term.

On being defensive.

"Honestly, I don’t know. But I do know one thing. Just about the time you think there’s never going to be a horrific negative surprise, one comes barreling along. I may be too careful. I may be too protective. I may be too defensive. Though knowing history, I think it’s probably a pretty good idea.”So when the horrible experience came slamming through, it wasn’t that he was really prepared for that specific one, but he was well prepared for real difficulties.

On the best time to be bold.

"If you’re buying something, wouldn’t you rather pay less for it than more? When stocks get cheaper, how can that not be good news for long-term invetsors? There are very few times when you should be bold, and history shows that those times are precisely when it seems you should be most afraid. It’s absolutely cockamamie crazy to sell stocks after they drop. Instead, you should say, “Today, there’s first-rate bargain and I’m buying.”

On avoiding mistakes. Knowing how to be selective, you avoid the mistakes.

On “winning” at investing.

The powerful message: Each runner had achieved his or her own realistic goal, so each was a true winner and fully entitled to make the Big Y and run the victory lap.

If, as investors, we each thought and acted the same way — understanding our capacities and our limits — we could plan the race that would be right for us and, with the self-discipline of a long-distance runner, run our own race to achieve our own realistic objectives. In investing, the good news is clear: Everyone can win. Everyone can be a winner.

13 investing insights from Seth Klarman

  • “Great investments don’t just knock on the door and say ‘buy me.’”

  • “It is easy to find middling opportunities but rare to find exceptional ones.”

  • When buyers are numerous and sellers scarce, opportunity is bound to be limited. But when sellers are plentiful and highly motivated while potential buyers are reticent, great investment opportunities tend to surface.”

  • “Rather than buy from smart, informed sellers, we want to buy from urgent, distressed or emotional sellers.

  • “A bargain price is necessary, but not sufficient for making an investment, because sometimes securities that seem superficially inexpensive really aren’t.”

  • Institutional constraints and market inefficiencies are the primary reasons that bargains develop. Investors prefer businesses and securities that are simple over those that are complex. They fancy growth. They enjoy an exciting story. They avoid situations that involve the stigma of financial distress or the taint of litigation. They hate uncertain timing. They prefer liquidity to illiquidity. They prefer the illusion of perfect information that comes with large, successful companies to the limited information from companies embroiled in scandal, fraud, unexpected losses or management turmoil.”

  • “We pursue opportunity largely off the beaten path, sifting through the debris of financial wreckage, out-of-favour securities and asset classes in which there is limited competition. We specialize in the highly complex while mostly avoiding plain vanilla, which is typically more fully priced. We happily incur illiquidity but only when we get paid well for it, which is usually when others rapidly seek liquidity and rush to sell.”

  • “When you have been doing this for a while, you start to become more proficient about where to look, which rocks to look under. The rocks we look under tend to have a few things in common.”

  • You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.”

  • “Market inefficiencies, like tax selling and window dressing, also create mindless selling, as can the deletion of a stock from an index.”

  • These causes of mispricing are deep-rooted in human behaviour and market structure, unlikely to be extinguished anytime soon.”

  • “Investing is, in many ways, a zero-sum activity in which your returns above market indices are derived from the mistakes, overreactions, or inattention of others as much as from your own clever insights.”

  • “Typically, we make money when we buy things. We count the profits later, but we know we have captured them when we buy the bargain.”

A common theme is that cheap stocks appear in cases where the majority of investors either don’t want them or want to know about them. It’s counter intuitive, but although it feels good to be in agreement with lots of others, wider market interest simply raises competition for returns. A key part of the hunting process is choosing where to look, and Klarman points to market downturns or companies experiencing turmoil as instances of reduced competition.

Bulls Eye Investing

Every hunter knows you don’t shoot where the duck is; you shoot where the duck is going to be. You’ve got to lead the duck. Bull’s Eye Investing simply attempts to apply the same principle to the markets. In this book, I hope to give you an idea of the broad trends that I believe are at work now and will persist for the remainder of this decade. Then I’ll help you target your investments to take advantage of those trends.

Understanding the environment and investing accordingly are critical to your success

The essence of Bull’s Eye Investing is to focus on absolute returns. Your benchmark is a money market fund. Success is measured by how much you make above Treasury bills.

Price is less significant that valuation. A stock that cost $500 can be “cheap,” just as a penny stock can be “expensive.” Value has to be measured relative to something—such as earnings, revenues, cash in the bank, or accounting book value.

Mauldin recognizes that markets go through long cycles of expanding and contracting valuations.

After all, stocks “always” generate 7-10 percent returns over the long term.

Mauldin writes that “our emotional forebears invested without the wisdom that we now possess. They didn’t understand that markets will go up eventually and that all you need to do is buy and hold and not worry about corrections and other transient phenomena.”

As Mauldin makes clear, emotion drives the stock market. The biggest factor driving stock returns, in Mauldin’s view, is not earnings growth or underlying economic conditions. It is investor perception of these.“

The essence of Bull’s Eye Investing is quite simple,” Mauldin explains. “Target your investments to where the market is going, not to where it has been.”

Mauldin has a couple recommendations:

  1. Go for a deep value approach. Invest like a Benjamin Graham by systematically buying companies that are priced so cheaply they can be cut up and sold for spare parts at a profit. This requires time, research, and patience that many investors may find too onerous, but you simply are not going to be able to generate decent returns in a value strategy by buying and holding a mutual fund.

  2. Whatever your trading strategy, “cut your losers and let your winners ride.” Set stop losses on your positions, and stick with them. You should also have an exit strategy. Set targets for profit takingbefore you actually invest. And naturally, “do not fall in love.” The stock will not love you back.

  3. Consider dividend-paying stocks as income vehicles…but only if you are reasonably confident that a broad market crash isn’t around the corner. During bear markets, dividend stocks fall less than the broader market. But they still most certainly fall.

  4. Actively trade. On this count, Mauldin is a little harsh, saying that only about 1 percent of his readers are really traders at heart. “Any of the other 99 percent who venture in will be their cannon fodder.”

  5. Investigate alternative investments, and particularly absolute returns funds. On this count, select your managers very carefully and be sure to do your due diligence.

Finally, Mauldin’s best advice, as a confessed “serial entrepreneur,” is to consider starting your own business if you have a good idea and have the endurance to see it through to the end. Even in a low-growth “muddle through” economy, there are new opportunities. It is simply a matter of finding them and exploiting them.

The Fear of Losing Money

Brilliant people continue to fail at trading the markets because of their emotions, not their intelligence or their work ethic.

Fearful investors base their entire system, thoughts and style of investing on a negative thought process or a negative mental attitude.

Successful investors, whether it is stocks, real estate or businesses, always develop strategies to protect from the down-side by focusing on the reward versus the original risk. Successful investors develop systems with expectancies that allow them to negate emotional fear by knowing what can happen if the investment fails. Successful investors are emotionally prepared to handle the side effects of losing money.

Unsuccessful investors think about losing the initial investment and more often than not, pass up on a potential golden opportunity.

Two remedies exist for the fear of a bad loss: a bankroll that can withstand a few bad beats and a strategy that capitalizes on hands with high odds for potential winners.

The same principal holds true in investing and in life. The people that assume the risk and calculate the odds of success are typically the ones that come out ahead with larger bank accounts. They don’t focus on the losing aspect of a deal and never blurt out the words “what-if”. To repeat, they don’t ignore possible failures as they prepare for the worst and expect the best.

Stock Trends for 2017

I could search for the “next hot thing”each year but why make investing more difficult than it already is when certain trends, technologies, products, services and companies continuously work.Many investors fail in this world due to their fear of losing money.

Investing in the stock market should not be exciting or a path to get rich quick, rather it’s meant to moderately grow our existing capital over longer periods of time.

By investing (longer term) in low cost index funds and an assortment of stocks that have proven their worth, my returns have consistently outperformed social media stock pickers, active managers and mutual funds.

“All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.”

Sam Zell on Global Growth: “Where’s the Demand?”

“Opportunities are completely connected to Demand, I’m a student of demand and when demand is there, I look at the cost of fulfillment.”

The fundamental law of supply and demand is one of Zell’s governing principles in his investment decisions, whether he’s looking at commercial real estate, asset-intensive industries like oil and gas, or manufacturing in developed or emerging markets. He keeps an eye out for supply-and-demand imbalances and likes situations where supply is shrinking or nonexistent. In his recent book, Am I Being Too Subtle? he says that “much of my career has been about understanding and acting on this basic tenet.”

Investing Matters: To Companies And Countries

One of the little-appreciated facts about investing is how little the near-term matters to the value of a company. While the Wall Street banks and the media pundits try to tell you that a company beating or missing quarterly EPS estimates by a penny, the great majority of the value of a company is derived from the assumption that it will continue to operate as a going concern for many years.

When analyzing a company, we at Framework pay particular attention to the investments it is making in the present. We know that the investments a company is making now will influence the growth of profits in the medium-term – let’s say from 5-10 years from now...being able to assess the likely efficacy of a company’s investment program is essential to skillful investing.

The most worrying signs for a company in my mind are companies that are clearly squandering their owners’ capital in investment projects that are likely to fail.

The 13 Commandments of Successful Value Investing – The Art of Value Investing

Value investors typically:

1. Focus on intrinsic value—what a company is really worth—buying when convinced there is a substantial margin of safety between the company’s share price and its intrinsic value and selling when the margin of safety is gone. This means not trying to guess where the herd will send the stock price next..

2. Have a clearly defined sense of where they’ll prospect for ideas, based on their competence and the perceived opportunity set rather than artificial style-box limitations.

3. Pride themselves on conducting in-depth, proprietary, and fundamental research and analysis rather than relying on tips or paying attention to vacuous, minute-to-minute, cable-news-style analysis.

4. Spend far more time analyzing and understanding micro factors, such as a company’s competitive advantages and its growth prospects, instead of trying to make macro calls on things like interest rates, oil prices, and the economy.

5. Understand and profit from the concept that business cycles and company performance often revert to the mean, rather than assuming that the immediate past best informs the indefinite future.

6. Act only when able to draw conclusions at variance to conventional wisdom, resulting in buying stocks that are out-of-favor rather than popular.

7. Conduct their analysis and invest with a multiyear time horizon rather than focusing on the month or quarter ahead.

8. Consider truly great investment ideas to be rare, often resulting in portfolios with fewer, but larger, positions than is the norm.

9. Understand that beating the market requires assembling a portfolio that looks quite different from the market, not one that hides behind the safety of closet indexing.

10. Focus on avoiding permanent losses rather than minimizing the risk of stock-price volatility.

11. Focus on absolute returns, not on relative performance versus a benchmark.

12. Consider stock investing to be a marathon, with winners and losers among its practitioners best identified over periods of several years, not months.

13. Admit their mistakes and actively seek to learn from them, rather than taking credit only for successes and attributing failures to bad luck

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