A year ago I posted a wire offering 6 pieces of advice rarely given to private investors and SMSF. This wire is a follow up to that article. If, as a private investor or trustee of an SMSF, you can take away just one piece of valuable information from this wire it will have served its duty.
1: Don’t Be Afraid of Taking Losses
Buffett’s number one rule is: “Don’t lose money”
And his number two rules is: “Don’t forget rule number 1.”
Good advice... If only it were that easy. I hate to be the bearer of bad news, but if you do this for long enough you are going to have losses.
Being afraid to take a loss can seriously impact your portfolio. Not only from potential further declines in the stock but in the opportunity cost of redeploying that capital elsewhere.
If a stock is going against you, don’t just sit on it. And don’t just assume the answer is to buy more.
In such a scenario the assumption should always be that you are wrong. You’ve missed something. Figure out what it is.
If you do the work and realise your thesis is still intact then hold strong. Perhaps, so long as it is justified, buy more.
But if you have indeed just gotten it wrong then don’t be afraid to take the loss. Don’t adjust your thesis to fit the facts that you initially missed.
And certainly don’t mistake the fear of taking a loss for a false confidence in your thesis or the company’s management team.
I have found that the best investors and traders despise losses, but they don’t fear them. There is an important difference.
The former drives you to do everything in your power to avoid a loss but will prevent you from irrationally holding on to losers when the right thing to do was to cut your losses and move on.
The latter leaves you holding a stock you should have sold long ago when the thesis was initially proven to be incorrect.
“Soros is the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade…he’s confident enough about his ability to win on other trades that he can easily walk away from the position. If you’re extremely confident, taking a loss doesn’t bother you.”
- Stanley Druckenmiller
2: Write Down Your Thesis
Writing down your investment thesis is one of the best ways to both reinforce and critique your reasons for investing in a company.
It helps answer a number of important questions.
- Does your thesis make sense?
- Do you genuinely understand what the company does and its prospects for the future?
- Are there any holes in your thesis?
- Most importantly, when you read it back, do you still want to be buying the stock?
It strengthens your process, tests the quality of the investment case and gives you an ability to look back and understand what you did well or could have done better.
It is a high quality filter for investment decisions. If you can’t write a compelling thesis for the stock it is unlikely to be worth investing.
Since the market is forward-looking, the story often drives valuation to a greater degree than the present day financials. A company’s ability to communicate their story and their outlook for the future determines the market's assumptions around growth rates, returns on capital, future profit expectations and, ultimately, where the stock trades.
So if you write down the thesis for investing in the company and the story doesn’t sound attractive, then the stock is unlikely to command a respectable multiple from the market anytime soon.
That is completely fine if you are a die-hard value investor willing to wait a few years but it is something to be aware of if your investment horizon is a bit shorter. It might help you filter out value traps.
You don’t have to be writing multi-page reports for it to benefit you. One or two pages will suffice. The best investment theses are very simple, so in some cases the shorter the better.
A useful structure to follow is a brief description of the business model, an industry overview, an explanation of where the company will go over the next few years and (most importantly) what the market is missing and why you have an advantage.
Valuation is important, but not critical, so long as your estimated value is significantly higher than your purchase price. Figuring out a more precise valuation becomes more pertinent when the time comes to sell and by then the facts will have changed considerably, meaning your valuation will have too.
If you can’t write a page or two on your thesis then you probably need to do more research. In some scenarios, and if you enjoy it, it is beneficial to do a deep-dive analysis on certain aspects of the company and that will take your note well above a page or two.
Most won’t do it because it takes a long time and pays no immediate or tangible rewards. But I can guarantee that writing down your investment thesis will improve your investment process. That will eventually lead to improved returns.
In this video from Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York University, he contends that stories matter, but only if they are connected with numbers. And numbers are empty, unless they are connected with narratives. In this talk, he looks at the process by which one might build narratives, check them against reality and convert them into valuations.
3: Favour Inactivity Over Activity
Activity simply for the sake of it is a major killer of returns, and not just through brokerage. Everything in your investing journey encourages activity. Your online share trading platform is designed to encourage you to trade more. Brokers put out buy and sell recommendations daily. Articles explain why stocks moved X% because of Y reason.
Even the mainstream news reports on the daily movement of the stock market as if it matters. So it requires an active decision to make inactivity the default. Have you ever found that when things are going well you are generally making very few investment decisions?
If you buy right and do the legwork in the beginning, the correct decision is almost always to sit tight.
This is one of the advantages you have over fund managers. Imagine reading a quarterly report that in essence stated “All is well. Still like our stocks. See you next quarter.”
That might be fine when things are going well, but what if the fund was underperforming? The redemption requests would eventually start flooding in. But you don’t have to deal with that.
Just like limiting your investment decisions is the best choice when things are going well, it is often the right choice when things aren’t going to plan. Figure out if the theses for your stocks still stack up. If not, don’t be afraid to take the loss. But don’t immediately redeploy the capital in an attempt to quickly make up for the damage.
- Be patient. Be selective. Go back to your investment process and wait for the right opportunity to present itself. Eventually it will and in the meantime you need to have the confidence to prevent activity for the sake of it, knowing that in time things will turn in your favour once more.
- Instead of sitting idle and watching stock quotes all day that make you want to trade, fill your time with productive tasks.
- Talk to companies. Scan for stocks. Write down your investment theses. Talk to other investors. Build your network.
- Be as active as possible when it comes to productive tasks.
But make inactivity the default when it comes to investment decisions.
“Money is made by sitting, not trading.”
- Jesse Livermore
4: Build Your Network
Building a trusted network can multiply the quantity of new ideas generated as well as improve the quality of your research process.
My preference in this regard is to build your professional network as large and diverse as you possibly can but to keep your investment network confined to a relatively small but highly trusted group.
The thinking is simple. You want to have quality contacts to call on from a broad range of industries as a part of your research process. As a generalist investor (as most of us are) having experts in each field to ask questions, run your thoughts by and get insights from is an enormous advantage.
But with other investors you may prefer to keep it fairly small. This is almost by force rather than choice.
The fact is that finding other investors who are really good at what they do but that you also trust to be rational and honest, rather than just talk their book, can be difficult. You may not find that many.
When you do you need to provide them with value. Share your best investment ideas and reasons for investing. Acknowledge when you get them wrong. Give more value than you receive as every so often it will come back to you in multiples.
If you can build a network of investors who are better at what they do than you are, then you are in a prime position to learn and improve quickly. This can be tricky but if you go out of your way to provide these people with value – stock ideas, research, notes, etc – you will often find the generosity is reciprocated.
If you don’t currently have much of an investor network and are a solo act in idea generation, then online discussion forums can fill some of the gap. But they need to be used carefully.
Without any intention to offend, 99% of users on these platforms should not be listened to. You need to figure out a way to filter out the average posters from those who are quality investors.
And while some like to bad mouth sites like Hot Copper, if you look closely, there are some really skilled posters worth following. Find them and then use their posts as a way to generate new stock ideas before doing your own research, the same way you would utilise a network of investors.
Livewire is a fantastic resource for this purpose. Find the contributors that fit your style and use their posts as idea generation. Read their thesis critically and look for holes, then go and do more of your own research.
Every so often you’ll find a big winner.
5: Pay Attention To Capital Flows
By 'capital flows', I’m referring to who is buying and selling. You never really hear this discussed with regards to successful investing, particularly for those with a long-term horizon, but it can have a significant impact on your average purchase price and hence the investment outcome.
It is easy to forget that on the other side of every transaction you make is a counterparty that has his or her own reasons for why you are wrong and they are right.
Why are they buying or selling? How many more do they have left to sell? Do you have an advantage over the counterparty, be it informational (you’ve done your research), emotional (taking advantage of panic selling), or simply a longer time frame?
The importance of this is exaggerated in small caps where one large buyer or seller can have a material impact on the stock.
If you are buying stock from a well-regarded fund manager or (even worse) a company insider, you might want to double check your thesis.
If you are buying off a forced or irrational seller, such as a fund experiencing redemptions, a large holder wanting out at all costs or during tax loss selling season, it might be worth swinging a bit harder to take advantage.
Occasionally it is really simple, as substantial holders and company directors are required to file notices of changes in their holdings.
Other times it requires a bit more digging. Look at the Top 20. Ask the company. Talk to brokers. Watch for any cross trades going through that might match up with the number of shares held by a large holder or signal that the selling might be done.
Often you won’t have a perfect answer. The selling might stop unexpectedly or continue for far longer than you assumed it would. This is part of the game and shouldn’t prevent you from making an investment decision.
But on the rare occasions when you can figure out exactly who is buying and selling and take advantage, it can be a considerable edge.
So don’t ignore capital flows, even if you are investing with a very long term horizon.
6: Stay Alive
Most of us have heard a story about an investor who picked a 10, 20 or 100 bagger and completely changed their life.
We are all looking for this type of opportunity. The risk is we force our hand in an attempt to find it, buying things we have convinced ourselves will be the next big winner when a more rational assessment suggests otherwise.
Here’s the thing. Finding the next life-changing investment requires great skill, but an even larger portion of luck.
Your odds of experiencing this type of luck increase the longer you stay in the game. In fact, if you play this game long enough you will almost certainly have a similar success story to tell.
Weimin Xie of MX Capital had a great wire on Livewire on the prevalence of 10 and 100 baggers. They happen. And they appear to happen more frequently than you might expect. It may not appear tomorrow. Or next year. In fact there’s a good chance this life-changing stock doesn’t present itself in a bull market but rather when the cycle has turned and everyone else is sprinting towards the exits.
Most of investing is playing defence so that when those rare opportunities to play offence come along, you can do so aggressively.
So don’t blow yourself up forcing your hand in the search for the next big winner. Stay alive.
Life changing investments are out there. But they present themselves very rarely. Be patient and selective.
And when yours finally comes make sure you have the capital to take advantage it.
Founder of Capital H Management and Portfolio Manager of the Capital H Inception Fund. Previously worked for Pie Funds and Bligh Capital.
Great post Harley. Well done! some very valuable lessons here. Once I started taking losses quickly and moving on, my returns seriously went through the roof. The way I think about is that when I am wrong I do not fight it, there are so many other opportunities on market so I just move onto another.
Thanks Alan, appreciate it.
Great stuff, "make inactivity the default" is so important. If your trading feels exciting and gets the adrenaline pumping, you are probably gambling! There is also some skill to riding a "lucky" 10-100 bagger IMO. The more big fish you hook, the more likely you are to land one. i.e. Hooking a monster fish is easier than getting it on the deck of the boat! We all have stories of the 'one that got away'.
Excellent post Harley.Beautifully explained.Taking control of/on emotions. I will read again to explain to my son who just started stock market life.
As an SMSF trustee of three years, I can appreciate the advice and wisdom in Harley's article. I'm not doing too badly in my bumbling way, but reading this, I've realised that my only exit strategy for any share I buy, is to sell losers to try to keep my portfolio at an "optimum" composition. Cash doesn't cut it day by day, so I am always fully invested in growth stocks. Then I measure success or otherwise, by frequently checking the bottom line, but really it's just a theoretical number! Food for thought! Thanks for a great article.
Thank you Harley for a great piece of advise. This is so much more practical than any others. I agree "Inactivity" is the most difficult task of all, and make it default would be even more challenged. Thank you for sharing with us once again.
Simple Advice and soooo true :) xx
Very reassuring Harley! As a newby to this game, your insights and lessons here are highly valuable to me, thankyou... I've picked my stocks for the long haul and whilst some of them are not too rosy at the moment, I'm reminding myself to sit tight. The stock market 'breathes' (fluctuates) up and down, up and down...
Great post, Harley. Thanks!
Bill, Venkata, John, Hanh, Cindy, Chris & David, Thanks everyone for the feedback. Much appreciated and glad you enjoyed it!
Half way through the year, this has got to be one of the most liked articles, so far. Great Read. Marcus Padley had 2/3 fantastically honest articles last year. This one is such an easy read and yet so important.
Appreciate the positive feedback Parth!