What Doesn't Work

One of my favorite ideas from Charlie Munger (Trades, Portfolio) is that of observing what works in life and what doesn’t work. Sometimes just observing is not enough; you also have to ask the question, "Why?"

Since most of us are interested in topics related to investing, for the purpose of this article, I will only discuss the application of this idea in the field of value investing.

As much as I am interested in what works in value investing, I’d rather talk about what doesn’t work because if we eliminate the approaches that don’t work too well, what’s left is what works. Just a little inversion.

First of all, let me start with a qualification. I don’t think I am qualified enough to write a great article on this general topic due to my limited experiences. A lot of things work and lot of things don’t work, and there is no guarantee that what has worked in the past will continue to work in the future. However, based on my observation, I am reasonably confident that at least in the current environment, the following styles of value investing are unlikely to work very well:

1. Buying lousy businesses cheaply. This may sound too obvious but I didn’t find this out early enough and I certainly didn’t know it well enough during the first two years of my investment journey. It seems that I am definitely alone in this camp. I have friends who still firmly believe in this approach and one of the most cited reasons is the definitive quantitative “intrinsic value” one can use in this approach. It is perfectly understandable. Ben Graham’s net-net value provides a shortcut for us to use. System 1 kicks in. We can make a quick decision based on the perceived value. The peril of this approach is that the value for a lousy business often evaporates faster than you think. Think about Radio Shack (RSH, Financial) and Kodak.
2. Over-diversification. In my opinion, over-diversification almost leads to guaranteed underperformance. It is hard to define what over-diversification i,s but I think it is safe to say that if some active fund manager holds more than 100 stocks, there is a great chance that he or she is over-diversified. I can even name a few gurus from this website but out of respect, I choose not to. Interested readers can conduct a study on how many stocks each guru holds and track his performance over a 5-year and 10-year period.
3. Failing to consider, or underestimate factors that influence the market price of the common stock of a business. In other words, the intrinsic value of the business may be much higher than what Mr. Market is saying but it may also be unrealistic to unlock the value. This point may be less obvious to the readers so let me illustrate with an example. There are many Chinese stocks listed in the United States. Some of them are frauds and some of them are actually decent businesses. Many of these decent businesses are being priced at very attractive levels. However, as investors “China-cleanse” their portfolios, many of these decent businesses got clobbered. Some management team of these businesses got tired of being “China-cleansed” and decided to take them private at very low valuation levels. Investors who put money in these businesses in turn got clobbered.
4. Paying more attention to the upside than the downside. To put it in another way, not enough discipline. You can argue that this point is also very obvious. However, when I looked at the population of the investment write-ups on Seeking Alpha or Motley Fools, I found 95% of the articles put a lot more emphasis on the upside with very little room left for discussion of downside. Let’s say you have a stock with a worst case of $2, fair value of $5 and sell point of $7. If you buy it at $3, your downside is a buck and your upside is four bucks.Your risk reward ratio is 4 to 1. However, if you buy it at $3.5, which still gives you 100% upside, your downside will increase to a buck and half and your upside will decrease to three bucks and half. Your risk reward ratio drops to 2.3 to 1. This is a pretty significant drop, but very few people think this way.

Of course there are many other things that don’t work. It will take me much longer to list every single one of them. My point is not to educate the readers what doesn’t work but to encourage them to actively observe what doesn’t work and think about why. You can observe your own past mistakes and better yet, the mistakes of your friends and other investors. By building up your reservoir of what doesn’t work, you cannot help but become a better investor.