During 2013 I’ve had the honor and luck to meet a few great investors, and one of the questions I always ask is, “How do you suppress your urge to act?”
The reason I ask that question is because my experiences have taught me that fewer but wiser bets will likely lead to better performance. All of us have heard of Buffett’s “20 punch cards” advice to investors, but how many of us have acted accordingly? Human nature pushes us to get active, not inactive. When our brain recognizes an opportunity for financial reward, it releases dopamine, which tells the rest of the brain to pay attention to that opportunity and get our greedy little hands on it before we miss it. Worse yet, our rewards system gets much more excited about a possible big win so it will motivate us to do whatever provides the chance to win.
In this article I share the answers I got from three great investors and how I have used their strategies to pass on ideas that initially got me excited.
1. Mohnish Pabrai (Trades, Portfolio) - It is widely known that Mohnish Pabrai (Trades, Portfolio) uses a checklist to minimize the number of mistakes he will make. While the checklist is a powerful approach, Mohnish said most of his ideas won’t even get to the checklist step before they are killed. Among the strategies he uses to kill an idea, discussing the ideas with his friends such as Guy Spier and seeking contrarian information will often make him less excited about the idea.
Case in point – Chinese banks: During 2013, I paid a lot of attention to a few large Chinese Banks because they were trading below tangible book value. I read the annual reports of China Construction Bank and Bank of Communication. My initial analysis made me feel that they were much undervalued. Before acting on the idea, I sent it to a friend who knows a lot about Asian banks and asked for his feedback. He responded to me with his detailed analysis of the Chinese banks, along with the comparison to banks in other parts of Asia. After reading his response, I did a lot more research and eventually I came to the conclusion that while the valuation is low, the risk level is too high to justify a position.
2. Arnold Van Den Berg (Trades, Portfolio) – Van Den Berg has an amazing track record. Since Century Management’s inception in 1974, it has only had four down years compared to 11 for the S&P. Furthermore, the losses were below 10% except for 2008. The most remarkable characteristic in Century Management’s portfolio since 1974 is the relative rarity of losers, compared to other asset managers. Century Management’s publications – The CM Value Investor is one of the best value investing publications I have ever read. You can find it here. If you read the CM Value Investor, you will find that their discipline is phenomenal. If the downside risk is too big, they will most likely pass on the idea even if the upside is appealing. By looking at downside closely and establishing a purchase price as close to bear case as possible, Century Management has been able to outperform the market consistently.
Case in point – Weight Watchers International: During November last year, I wrote an article on Weight Watchers International (WTW). Through my research and analysis, it looked like Weight Watchers International has had an inherently favorable business model and although the moat was narrowing, valuation looked attractive. Some big name investors such as Joel Greenblatt (Trades, Portfolio) and Jeff Auxier (Trades, Portfolio) took positions in WTW as well during the second and third quarters of 2013. What eventually prevented me from looking further is the downside scenario, which was 36% below where WTW was traded in late November.The downside was too high to justify a position in WTW. I told myself to take a look at WTW if it ever drops to the mid-$20s, which is much closer to the worst-case scenario.
3. Stephen Yacktman – In my interview with the Yacktman Fund (Trades, Portfolio), Stephen Yacktman told me one of the best ways to suppress your excitement with an idea is to force yourself to look for WTCGs (what can go wrong). Each WTCG will make you feel less excited about the idea and very often, before you list out all the WTCGs you can think of, the idea is not that appealing any more.
Case in point – Corinthian Colleges (COCO): I was looking for ideas in the for-profit education industry and there was an interesting article on Corinthian College on GuruFocus submitted as a value investing contest idea. The case for COCO looked compelling. It is an established institution with high margins and lots of cash flows. The stock was cheap at merely above $2.5 per share. The upside looked really good. My brain was telling me, “Don’t miss this, you gotta act.” I passed on the idea once I started compiling the WTCGs. One of the WTCGs I found is management’s lack of integrity may lead to eventual scrutiny by regulators. There was a public article on Corinthian Colleges' officials' engagement in a no-holds-barred campaign to drive down their schools' rates by pushing former students to obtain temporary forbearance and deferments on their loans. Another WTCG that really threw me off was COCO’s horrible cohort default rates, which are so bad compared to Strayer Education that regulatory non-compliance was a real concern.
Conclusion: Most of us are born to be frequent batters. Although we know that the future is unknowable and there is a downside risk related to every investment, our reward system often pushes us to act on the ideas that promise the highest rewards, no matter how big the downside risks are. Worse yet, we are often temped to buy stocks simply to avoid missing out on the action, especially during a bull market. Designing a personalized strategy to suppress your urge to act will benefit one investor in many ways. But most importantly, doing so will force you to pay more attention to the downside, and it has been repeatedly said by many renowned investors: if you take care of the downside, the upside will take care of itself.