The Seven Secrets of Successful Investors

People with many letters after their names and much pseudo-scientific evidence will contend that a new paradigm has occurred, that ‘what was’ is no longer and ‘what is now’ will be so forever.

  1. This time is never different
  2. Be patient
  3. Be contrarian
  4. Always insist on a margin of safety
  5. Risk is not volatility, it is the permanent loss of capital
  6. Be afraid of leverage
  7. If you don’t understand it, don’t invest in it

This time is never different

Sir John Templeton, a ‘Hall of Fame Investor’ was asked to name the most dangerous belief an investor can have.

He replied

“this time is different.”

An example of the dangers of the idea of a new normal, is what lay at the root of the US financial meltdown; the assumption that because house prices had been stable or upward for the previous 30 years this would continue indefinitely. It was believed that prices could not fall, that lending criteria no longer mattered and that securitising loans in such a way as to make sub investment grade appear triple A was the new, better way.

This same assumption of a changed normal can be identified in the late 90’s internet bubble, and all other booms, bubbles and fads of history.

People with many letters after their names and much pseudo-scientific evidence will contend that a new paradigm has occurred, that ‘what was’ is no longer and ‘what is now’ will be so forever.

As asset prices rise they must be justified; if they increase far in advance of their long term trend values this must be validated and there are many who will oblige.

When the next boom arises, a new transformatory technology occurs and markets price companies at extraordinary levels, listen for the tell-tale call of those proclaiming the end to established truths and know they know for an investors “this time is never different”.

Be patient

This is a tale of a fickle and changeable man; “Mr Market”.

Mr Market is employed to provide a price for goods. All shares, Bonds and Commodities are given to him to value each and every day.

Most of the time Mr Market is in mildly optimistic mood, he sees some blue sky and some cloud, the future is uncertain, could be sunny, some rain may fall, during these periods he asks a full price.

Occasionally he becomes very positive, he sees only blue skies and believes they will stay blue, and he asks high prices.

However there are occasional dark periods, he becomes depressed, he sees clouds and storms and he can’t see a future when the sky will be blue again, at these times he offers low prices, occasionally very low.

Understanding and profiting from the mood swings of Mr Market is to know that whilst it is his job to offer prices daily he will do this every day; there will be periods of depression with the prices being much lower; all that’s required is the patience to wait.

To put this into a baseball analogy, the batter (investor) does not have to swing at any pitch (price) Mr Market throws, they can wait until a big fat easy pitch is thrown (when Mr Market is depressed), these are the ones easiest to hit and that produce the ‘home runs’.

Be contrarian

The successful investor will utilise a number of skills but as Warren Buffett says, successful investing is not a factor of IQ, it is a combination of intelligences, one of the most important being “emotional”.

A key ingredient to becoming a skilled investor is to practice the emotional control necessary to overcome the natural human reactions to periods of stress and loss.

The human brain is an amalgam of different elements including strongly imbedded programming (instinct) from our distant past. As an example the human craving for sugary things is an evolutionary leftover from the times when in nature these were only available in short periods (in autumn mostly before the lean time of winter).

Human programming in the West has not caught up with the year round availability of sweeties so they are eaten constantly with negative health results.

In the same way humans are hard wired to seek consistency of positive results to become confident that something is safe (this is self-evidently sensible, if something is consistently safe then this is a good thing). However this logical and self-protecting analysis of risk in everyday life DOES NOT WORK when applied to investing.

It leads to watching an asset price rise consistently over time which creates the confidence and ultimately the desire to buy it.

Conversely watching an asset value fall over time and having an increased desire to sell.

These reactions to actions are why the majority lose money.

The smart investors know that when an asset falls in value it becomes (if the asset is fundamentally sound) more attractive not less, greater value can be purchased at a far lower price.

So they use the faulty emotional bias of the majority to profit.

They practice Contrarian Investing:

“Be greedy when others are fearful and fearful when others are greedy” – Warren Buffett.

Always insist on a margin of safety

A cornerstone for the “Value Investor”.

To understand the value of an asset and be able quantify something is actually worth (the intrinsic value).

They calculate this in various ways including:

P/E Ratio: The multiple of a share price to profits earned (the lower the better)

Price to Book: The total value of the shares as a percentage of the actual value of the assets of a company (again the lower the better and ideally lower than one when shares in issue are valued at less than the actual assets of the company)

To add to initial price and value calculations the “Value Investor” will then analyse amongst other things:

  1. The predictability of future profits and profit growth
  2. The costs of production; does a company have to reinvent its products, which is expensive and unpredictable. Is it a company with a large ‘moat’ such as Coca Cola which has a wonderful franchise with no creative destruction (a more predictable future) or is it a Motorola or Nokia where creative destruction rendered them obsolete
  3. What is the break-up value of the assets of a company, if it’s greater than the total value of shares in issue plus debt this is referred to as a “net net” by value investors. (If the cost of a share is less than the value of the assets then this is the margin of safety, it can be liquidated at a profit)

Identifying companies with resilient franchises, strong balance sheets and predictable future profits at a price that underestimates true worth is rare but when it occurs investors pay only 40, 50 or 60p for a £1 of value, this is their margin of safety.

Risk is not volatility

It can be emotionally draining to invest in assets which have volatile prices; the values swinging around far more than the index average (a high beta stock).

But the assumption of many is that greater price volatility means greater the risk, this is not necessarily the case.

A consistently successful investment practice is buying assets which have suffered from a negative period; have fallen heavily in price but are crucially fundamentally sound. The volatile price when at its lowest has lessened the risk of loss not heightened it as the asset can be acquired at a lower cost to intrinsic value.

Conversely a share which has risen consistently over a protracted period can often be unrewarding as it has become priced for “perfection” (any mishap will then result in a significant negative rerating).

The key is identifying the intrinsic value of an asset and to use volatility of price as an advantage. If the price has fallen to a level significantly below book value, the risk to buying the asset is low and attractive although this is difficult for many emotionally.

The risk that should concern all investors however is that of a “permanent loss” of capital.

If a company becomes insolvent this is a permanent loss which can’t be recovered, by comparison if the price is depressed for a period this is not a permanent state, it can be an opportunity and how market beating gains are achieved by value investors over the longer term.

Be afraid of leverage

Leverage is another way of describing borrowing. The amount a company borrows can have a positive effect on increasing its profitability but conversely it can be its road to financial ruin.

The attraction of leverage.

Example:

If a company has £1 million of capital and makes a return of 20% the profit will be £200,000.

The temptation for a company is to ‘juice’ the profits by borrowing another £1 million, paying 5% interest and creating an additional (net of interest) 15% profit taking them to £350,000 (i.e. an increase of 75%).

The attraction / downside of leverage (and everyone with a mortgage uses leverage) is illustrated by the metrics of purchasing a house.

No Leverage Positive Leverage
£100,000 house £1 million house
No loan (so £100,000 own money) £900,000 loan, £100,000 own money
25% increase in price 25% increase in price
£25,000 profit (25%) £250,000 profit (250%)

The same amount of money is invested in each scenario (£100,000). The returns are ten times greater with leverage.

But

It works equally the other way.

No Leverage Positive Leverage
£100,000 house £1 million house
No loan (so £100,000 own money) £900,000 loan, £100,000 own money
10% fall in value 10% fall in value
£10,000 loss (10%) £100,000 loss (100%)

When leverage works it produces outsized gains, when it stops working and becomes negative it bankrupts over leveraged companies.

If you don’t understand it

Some investors decline to invest in certain sectors or companies because they simply don’t understand them.

They can’t accurately predict the likely future for a company so even if performance is stellar they decline to own their shares.

Of the many investment truisms.

“If it looks too good to be true it probably is.”  Is one which continues to be validated.

The identification of a great company is fundamentally straightforward.

The company’s business is understandable; it demonstrates a great franchise, great management and unfailing commitment to shareholder value and has future predictability of a good to excellent increase in sales and profitability.

It is assumed by many that successful investment is comparable to quantum physics; requiring ‘rocket science’ intelligence to succeed.

This is not however the case, successful investing fundamentally requires the practice of common sense, emotional control and the patience to first wait for great opportunities and then to stick with them.

 

 

NOTE: This is written in a personal capacity and reflects the view of the author.  The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

 

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