“There is a certain relief in change, even though it be from bad to worse. As I have often found in traveling in a stagecoach, that it is often a comfort to shift one’s position, and be bruised in a new place.”
- Washington Irving
A reporter interviewing A.J. Muste, who during the Vietnam War stood in front of the White House night after night with a candle, one rainy night asked, "Mr. Muste, do you really think you are going to change the policies of this country by standing out here alone at night with a candle?" Muste replied, "Oh, I don't do it to change the country; I do it so the country won't change me.”
I was recently speaking with my co-worker John Dorfman at Dorfman Value Investments and we were discussing changes in our investment philosophy and stock picking criteria over our investing career. It occurred to me that not only had I proactively changed in a positive manner (meaning I chose to adopt new thinking), but I have changed in a negative manner (meaning I chose to reject certain thinking) as well. Looking back, I believe the ideas I have rejected have an equally important role in making me a better investor as those I’ve adopted. In the words of Muste, not allowing Wall Street to change me has been just as vital in my investment success.
There have been several major issues that have evolved in my thinking where I have worked hard at adopting them into my investment methodology. Some have been by commission (where I have actively cultivated an approach or strategy) and some have been through osmosis (a more gradual and less conscious adoption). The following I would put in this adoptive bucket:
Think like a business owner
When I first started investing I really had no idea how to run a successful business. More importantly I didn't know some of the measures that define long-term success and value creation. Over time, running a successful management consulting firm has made me a better investor. Conversely, being a value investor has made a tremendous impact on how I think about managing and overseeing my business. None of this was a light bulb going off but a gradual understanding of the symbiotic relationship between corporate management and value investing. When Mark Twain commented about cats (“A man who carries a cat by the tail learns something he can learn in no other way”), he could have been talking about someone who owns and manages a business – you can learn some things in no other way.
Quality creep
As Warren Buffett (Trades, Portfolio) learned from Charlie Munger (Trades, Portfolio), quality matters in investing. Overtime I have evolved my investment criteria to reflect what I consider extraordinary businesses with high ROE, ROC, no/little debt, high FCF/revenue, and significant competitive moats. This learning hasn't been as linear as some of my other education. The Market Crashes of 2000-2002 and 2008-2009 have greatly affected my thinking in this area. The “creep to quality” – as my friends refer to it – has been a byproduct of my next learning – investing not to lose.
It’s not about winning but about not losing
When I began in this industry, my eyes were always on the Peter Lynch ten-bagger and looking to achieve extraordinary returns. Over time my thinking has inverted on this subject. I recognize now the odds of finding and selecting a company that will return 1,000% is infinitesimally small. Rather, by focusing on certain things in my control (trading costs, turnover, stock selection) I’ve found the returns will take care of themselves. I have been extraordinarily lucky (and let’s call it for what it is – luck) in having several companies in the portfolio (FDS and MANH come to mind) that have allowed for significant outperformance. But equally important has been sticking with the simple block and tackling that has prevented truly egregious losses. By not swinging for the fences I’ve always allowed myself to stay in the game.
It’s not about IQ but about EQ
Graduating from a prestigious school, belonging to all the right clubs and joining all the right firms has always been perceived as a leg up on Wall Street. I don’t discount this entirely. But I’ve found some of the best investors aren’t extraordinary geniuses. They are smart – no doubt about it. But over time I’ve realized my worst enemy is not a normal IQ but a poor EQ. The ability to control your emotions, be dispassionate in your actions and be driven by the data is equally important, if not more, than having a considerable intellect. Each market crash and genius hedge fund failure has solidified my thinking in this area.
As I mentioned earlier, it hasn't been proactive choices alone that have changed over the years. There has been an equal amount of rejection of theories on my part. This negative response to common wisdom (if you can call it that) has stood me well over the years by avoiding hot trends (tech stocks, RFID companies, nano anything, etc.) and general sheep-like behavior. Some of these include:
Short-term thinking
Boy, did I learn at a young age how short term thinking can kill you. I remember purchasing a stock in high school (now long since gone – a shoe manufacturer if I remember correctly) that I purchased on a Friday and sold the following Tuesday for a 7% gain. So excited at this I bought it again on the following Thursday and promptly lost 27% in three days. And I sold it the next week to only see it go up 18% the next week. It dawned on me I was playing a fool’s game and clapped a stopper on this behavior going forward. As much as Wall Street will try to convince us that every day there is some extraordinary gain to be made by acting now (kind of like those Ronco potato peelers), I’ve learned that short-term thinking is the graveyard of so many unhappy – and poor – investors.
Value doesn’t matter
There are so many ways to ascertain value for value investors – whether it’s using low P/E like my friend John Dorfman to conservative DCF calculations like the Nintai Charitable Trust. Many successful long-term investors use a means to calculate value and then buy at a discount to that assessment. I haven’t seen many long-term wealthy investors who trade on momentum, market trends or individual stock technicals. As much as Wall Street wants us to believe the house casino can be beat by letting the dice fly high, the bottom line is you are purchasing a piece of a business that is worth something. The simple trick is knowing that value and waiting for your opportunity to buy at a discount.
The trend is your friend
No. The trend is not your friend. If you expect to beat the markets, then you have to be different. Putting all your money into tech stocks in 2000 or financials in 2007 might have been the trend, but they sure didn’t make you rich. Over time I have become far more adamant in my opposition to following the herd and seeking gratification from the overall market. Being contrarian may not make you the talk of the cocktail circuit, but it will most assuredly give you a better shot at outperforming the general markets.
Conclusions
Most of the great investors I’ve had the pleasure to meet or read about have been knowledge compounding machines. Their ability to identify, sift and accept/reject potential learnings is a vital development in their investment success. Much like good value investing, it is vital to prevent poor intellectual theories to infect your thinking. Knowing what to accept – and reject – can make or break your short and long-term investment returns. In any event, change is important if for no other reason than to refresh the mind and provide new tests for our intellectual and emotional frameworks. Develop your own thinking, rigorously test your ideas and constantly assess your current models. Doing this will make your chances to outperform all that much stronger. Otherwise, much like Washington Irving’s coach passenger, your largest pain may be in your posterior.
