On Being An Investor

Not everyone who buys stocks is an investor. In fact, there are few that are. What are the distinguishing markers?

  1. Style is defined by valuation method
  2. Personal factors
  3. Context
  4. Manage expectations

Styles and valuation methods

There are speculators, there are day traders, there are technical traders, there are quants, there are venture capitalists, there are short sellers, and there are investors.

Speculators are the ones who search for inventions, new products, new societal opportunities, and new industries. In recent times we have seen speculators buy positions in digital currencies, marijuana producers, gambling sites, video game producers, solar panel and windmill makers, and lithium miners. The motivation is to get in early and wait for the price bloom. Sometimes it works. More often not. A good idea by itself will not create a giant business. The best ideas soon attract competitors. Does the founder know how to evolve from a startup idea to a business?

Traders of all types use indicators of one kind or another. They are not buying potential growth or free cash flow, they are trading on news. They estimate they can understand the meaning before the other participants in the market. They will buy based on their research, their superior knowledge of human  nature,  and the tendencies of the others who play in the same space. Some traders use algorithms to find patterns in prices. Others trade across markets. Buy in London and 75 microseconds later, sell in New York. Some use the wisdom of charts. The very best make money. It pays handsomely to see the future just before your competitors. There are many examples of this kind of success. George Soros, John Paulson, and the people behind The Big Short. There are some failures too. Long Term Capital Management among the largest.

Venture capitalists are organized speculators. They look for ideas, and the people who can execute them. It is not random. They review hundreds of presentations to select one. They offer more than money. Management expertise is usually available too. There are immense wins. Facebook, Google, Shopify, and Netflix, are a few . There are hundreds of losses and some breakeven deals too. One venture capitalist told me it is like the wallpaper business. If you bring in five new lines, one will be spectacular, one will be a dog, and the other three will be somewhere between. Win big, lose small, is a valuable strategic method.

While it is a little counterintuitive, short sellers and investors are similar. Both need to understand two values and how they come to be.

  1. What is the intrinsic value of the business? Most use some variation of the present value of future dividends or free cash flow. Not an easy calculation in the present, and certainly not into the future. There are many metrics to consider. Quality of management, financial strength, ability to hold off competitors, cost control, innovation, market position, key people, are among the most important. Some of these are easy enough to assess, while others like key people and management ability are more difficult. There is a Yogi Berra thought on the subject. “A team needs deep depth.
  2. How the market assigns value to the stock. The stock market is an auction market. If many people want something the price goes up. If few, the price goes down. The market price is affected by the whole gambit of human emotion, and judgement. Fear and greed are powerful. Assessment and misassessment of macro economic factors like interest rates, a government’s monetary and/or fiscal policy, and the potential for a new product or competitor to do damage. If you brought in 20 people to survey how the future would play out for a given company, You would likely have little commonality of opinion, and ever one of them would have a “but on the other hand option.” You don’t need to know precisely, but you must understand market sentiment. How do people feel about the market and your target in particular.

Investors and short sellers understand both. Investors use their research to find things likely to go up. Short sellers look for ones that will go down.

Successful investors have personal characteristics that matter.

Patience and discipline the most important. Also important, they don’t think stock, they think business. A share certificate is just evidence of ownership of a fraction of the business. The business matters. The stock market is a big chaotic thing. If you think about stocks instead of businesses, you get a question that Charlie Munger claims is “Too hard.” Avoid too hard deals.

His partner Warren Buffet makes a good point. There is always another deal if the one you look at is too hard or too pricey. In his inimitable style, “The stock market is a no-called-strike game. You don’t have to swing at everything, you can wait for your pitch.  The combination of “too hard” avoidance and “no called strikes” means you will buy with a margin of safety. That’s where discipline and patience come in. There are not so many deals that fit your standards, but how many do you need? Ten in a lifetime would be enough.

Context

Successful investors know:

  1. Good investors expect paper losses. They invariably use intrinsic value in their calculations and use the market price to identify buying opportunities If Mr. Market wants $40 for a stock the investor thinks is worth $60,there will be a purchase. If Mr. Market is offering to pay $100 for the same stock there will be a sale. But that doesn’t account for the stock you already own at $60 and now Mr. market creates a price of $40. Do you have a loss? Not until you sell.
  2. The can assess when to sell. When Mr. market is offering more than you think the stock is worth. What about other times? It is not such a hard decision, once you know holding is the same decision as buying – a binary decision. You have the stock or the money. Only the order of events is different. If you have it now it is stock becomes money. A purchase is money turns into stock. There are tax and other considerations. You can analyze those independent of the fundamental. If you would not buy it at this price, you should not keep it at this price either. A  hold is just a disguised purchase.

Managing your expectations

Investing is boring. Except when it isn’t. And all of those exciting times happen on the downside. Sooner or later the market will take a hit. Warren Buffett says you should expect 50% down at least once in your career. I remember in March 2009 our investment people had a client who thanked them profusely when he found his portfolio was down 40%. The portfolio they were looking after was about half his money. The other manager was down 70%.

Have a reason to invest. What’s it for? If you don’t know, you will intuitively begin to manage relative performance. Like the client who was happy with down 40%. I recall a pension fund manager who on being congratulated on being down 8% when the market was down 15% said, “It has been my experience that you cannot pay pensions with relative performance.” Take that to heart. Try to have your investments deliver what you need.

The value of your portfolio is not money. It might be convertible into money by selling it, but that assumes a buyer and a price. That’s where the risk lives. Price relies on other people and is not knowable in advance. There could be transaction costs and taxes to consider. Stocks are not the same as cash and you will get confused if you equate them without thought.

The stock market is reasonably predictable. If you look at 4 year cycles and take three of them, you will discover it breaks down to three or so years better than the average, three or so years less than average and the other six around the average. If you look at very long time frames you will find the market is up on average 9.5% before costs. On a log graph it is very nearly a straight line.

How big a deal was the Crash in 1929 or the Great Depression? October 19, 1987 the market was down more than 20% down in one day in 19 of the 23 largest stock exchanges. Can you see it? If the chart was current instead of five years old, you would barely  notice 2008 either.

Did I mention discipline and patience?

Find the yield you need for your purpose. Your Goldilocks yield. Just right. The one with the right mix of manageable and predictable. Pay no attention to the ones who are pointing out their day to day wins. They don’t get it yet.

What you want is a situation like a client I had years ago. On the advice of his brother who had invested in the company, in 1954 he invested $5,000 at less than 20 cents a share. Twenty years later the income tax on the dividends was more than $30,000 a year. It won’t be like that very often but if you hold a respectable stock for 30 years you could reasonably expect the dividends to provide a very large return on your original investment.

The takeaway

Managing the investor is the hard part. Emotions. Surprises. Other people.

Know about reasonable expectations. The stock market has been predictable in the long run. Not so much in the short or intermediate term.

Pick a style and understand what it means

You need two things. How to decide intrinsic value and how the market creates prices.

Managing investments is easier than managing yourself.

You will learn how you behave matters more than how smart you are. Maybe behaviour is a form of smart.

The market is very good at what it does, but it doesn’t care what you want. Don’t expect more from it than it can provide.


I help people have more retirement income and larger, more liquid estates.

Call in Canada 705-927-4770, or email don@moneyfyi.com

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