Four Principles. Ten Rules
One of the reasons Warren Buffet has never written a how-to book is because he knows how short it’d be. The guidelines for successful investment are straightforward and intuitive and I’m going to sketch out my personal philosophy in the simplest terms.
Some of these points though, like the advice to buy-low and sell-high, are hard to apply in real world situations. This road map may thus be an ideal but rarely achieved reality; but without it one may as well be just throwing darts at a board.
The Four Principles
Principle #1. Return Asymmetry. Seek the biggest possible. To do this properly some calculation of downside is essential. Not losing money is one of the most important strategies in making it and if a potential investment has significant downside move on. As a rough guide I apply a 1:4 test i.e. if my potential loss is $1 then I need to be confident of $4 of upside to justify a position.
Principle #2. Flexibility. Every situation is different so try to avoid one–size-fits-all analysis. To the person with a hammer all problems are nails so it’s necessary to adopt the correct valuation methodology (P/E, P/B, PEG, GARP?) before proceeding. Above all a commonsense approach is the most reliable guide; and if you’re not ‘getting-it’ very quickly, again, move on.
Principle #3. Character. Have nothing to do with shabby operators; whatever the payoff on a trade could be. Preliminary analysis usually reveals these situations and this point is important as corporate governance is an evolving process in China so one has to rely heavily on the personal integrity of business managers. If you can’t get comfortable with the people that’s another sign to keep on moving along.
Principle #4. Time. It’s essential that it be on your side. Since the GFC many investors are scrutinized on shorter time frames than ever before. This produces sub-optimum results; nine pregnant women won’t produce a baby within a month. Time is perhaps the last real competitive advantage an investor can have because really good ideas never fructify quickly.
If you’re comfortable that the stock you’re considering has significantly more upside than downside, that you know the correct way to value your target, that the management are trustworthy and, above all, time is on your side then proceed to..
The Ten Rules
Rule #1. Start from the top. Fundamentally I’m a bottom up investor but the macro environment matters. Is the sector healthy? Does the government interfere and if so is it to the incumbents’ advantage? Where are we in the broader economic cycle? N.B. It’s axiomatic a value investor will want to commit when macro factors appear least supportive.
Rule #2. Non Linearity. Brace for it. This is an ongoing feature of markets. Rarely do changes, both in and against one’s favour, play out in a predictable fashion. As much as you can then plan for and expect the unexpected. Practically this means being able to hold on when big bad things happen. Or, as Mr. Buffet puts it, being willing to hold a position if the market shuts for the next five years.
Rule #3. Plan. Any activity that involves risk over time requires planning. If you’re buying a stock you have to have a plan on day one what you expect to make and over what period of time. You’ll be wrong and need to modify the plan as new data arrives but never lose sight of what you want out of a trade. Inactivity is a hallmark of value investing; except on the important and rare occasions it isn’t.
Rule #4. Concentrate. How many positions are ideal? Less is usually going to be more. If a saver doesn’t have time for the regular work that investing requires I’d recommend an index ETF; but to get better than average results you have to make meaningful bets. I have a 20-stock rule. There are so few really good ideas out there anyway this isn’t hard to stick to.
Rule #5. Informational Advantage. It takes time but it can be done. Never buy stocks on somebody else’s recommendation. The only way to get comfortable with a position is if you’ve done the research yourself. Markets are only scary places for people who haven’t done their homework so make sure when dislocations come you’re better informed than others.
Rule #6. Brilliant Ideas. Try not to have them. Whenever I wake up and just can’t wait to get a trade on I know can’t miss; I’m probably better off going back to bed. It’s hard to out-think other investors and as for out-thinking a market? Forget it. The only place success comes before work is in a dictionary. There are no shortcuts and I’ve discovered, to my cost in the past, I’m not an investing savant. Hard to accept; but the case nonetheless for most of us.
Rule #7. Uncommon Sense. It’s been noted that there are few things less common than common sense. Nowhere is this more so than in markets. People fall for the same scams time and again and I try to never lose sight of what makes intuitive sense. Above all, if you don’t feel you truly understand a situation then it’s not for you; and it’s that simple.
Rule #8. Timing. I can’t time the market so on the way in I tend not to mess about. On the way out things are different. Valuation is paramount as a reason for establishing a position but will always take you out of winning trades too soon. When I’ve made money in a stock I find the hardest but most profitable thing to do is nearly always nothing. It’s said it’s never wrong to take a profit. My experience is it nearly always is.
Rule #9. Cash is King. Cash is an option that allows you to buy any stock in any market condition; and that’s worth a lot. When the world looks bad try to have very little of it as it should be invested. When things look great though if you don’t have a healthy balance something is wrong. Unfashionably early is the best way to arrive at and depart from markets.
Rule #10. Being Human. With work at least I try, as much as I can, not to be. Our brains evolved for roaming the Serengeti not investing. I’m always on the lookout for the following ticks ; reacting to sharp price moves, fixating on time periods, approval seeking, trading, talking my own book, anchoring, regret and high (and low) spirits. In short; if the thought of what you’re about to do makes you feel good, or bad, it’s probably wrong.
In conclusion, I can and do regularly allow exceptions to some of these rules, which kind of echoes the second Principle of flexibility. However, without some guide it’d be just me, the board and a handful of darts.