Many people think that limits and discipline box you in and, well, limit you. Nothing could be further from the truth. By limiting the entire universe of investments and narrowing things down to just high and sustainable return on capital companies, you limit the universe of investment possibilities down to a much narrower list, true. But by doing so, you can focus on becoming an expert at a particular type of investing that can allow you to meet your financial goals, and after all, isn’t that why we invest? All of the greatest investors demonstrated incredible discipline and were generally focused on a subset of the investing world (investing in stocks that were high quality and at favorable valuations), so there must be something to this practice.
The same should go for you in your investing practice. You should become focused on the particular area of investing we outlined (high quality and good value stocks) to cut down on the noise and infinite potential which is too much for you to keep track of. In this manner, you can see deals and signals from the narrower focused list of things of which you do keep track.
I also want to suggest that as you get into star list investing, that you limit your list of overall companies. I recommend limiting your list of companies to about 100. This does a number of things. For one, it is difficult to truly track 1000 or more companies and understand them well. It is just too much information and signals for you to be able to sort through it, keep track of news and earnings, understand any changes that come along, etc.
For another, you don’t want to put mediocre companies on your list just because you want to fill it out with lots of companies. This is not about quantity, it is about quality. Diversification is nice, but “diworsification” is not good. So don’t just diversify for diversification’s sake. And if you are very choosy about your list like I am, there will only be at most a couple hundred companies in the investing universe that fit the bill of businesses with truly sustainable returns on capital over the long term. Most companies, even if they have high returns on capital now, will gradually fall back to earth as competition moves in on these lucrative areas. Further, for my star list of companies, I want only companies that I feel fairly confident will still be around in 50+ years (meaning I am fine if they split or spin off businesses, and ceased to exist in name, but I am not fine if they cease because of bankruptcy and thereby wipe out the value of my investment). I want these to be companies that if the stock market closed for 20 years, I would be perfectly fine owning them.
Finally, limiting your star list to 100 companies forces you to choose only the best companies to put on your list. If you find a great company, and your list is full, it forces you to remove one of the worst companies from your list and then improve the overall quality of your list. If you have to start getting rid of things you really like, it forces you to think long and hard about making any changes.
This is akin to what Warren Buffett is doing when he says to business school students, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime.” If you only have 20 punches on your investing ticket, then you are going to make darn sure they are the best investments you have seen, and you will not compromise and lose one of your ticket punches.
Further, I would say you do not want your star list to be too small. If you only have 10 companies on your list, it will be the case that you may not find anything trading at undervalued or fair valuations. While investing in the top-of-the-top companies at mild overvaluation is not the worst thing in the world, we would prefer to get good valuation for high quality companies. Several super-investors have turned small amounts of savings into huge fortunes investing in only 3 or 4 stocks. But there are definitely more than 10 of these kinds of companies out there, so why not have them all on your list, since investing in better values will give you a boost in returns. Diversification is ok, as long as there are true gems to diversify into. “Diworsification” is what you want to avoid – that is adding things to the list that are not good, just so you can have a large number of investments. My guess is that you want, at a minimum, 50 stocks on your list or so.
Usually, I suspect people will have the problem of adding too many stocks to their star list than too few, but you should strive for a minimum of 50-100 stocks on your list total. I would recommend you shoot for around this number when building your list. It will keep you focused and force your list to be of the highest quality. It will also be a large enough number of stocks that you will virtually always have a decent deal or two valuation-wise on your list from which you can purchase each month. This will happen even if the market is over-valued, since individual stock valuations, although tied to the market, can still behave somewhat independently of the market.
Most importantly, discipline is a practice. If you don’t implement it now, you won’t suddenly be able to start practicing it perfectly later. You cannot turn this on like a switch when you want to any more than someone could just start playing the piano well in a week. You become what you practice every day. So, make sure to maintain your ethos of investing discipline as you work your way to wealth and your financial goals.
Now, go out there, and get started building your star list of outstanding companies. The best way to learn how to do this is to just start. As you learn from experience, you will really internalize these good investing practices.
Leave a Reply