What Works in Investing

We want to begin to understand what works in investing…and what doesn’t.  This will help us to develop an investing system that can generate value.  The authors are value investors at heart, and we will make the case for a particular kind of value investing that we believe will earn substantially better returns over time.  At its heart all investing is value investing in the sense that you are trying to underpay for an asset which you believe will return you more in net present value at some point in the future through cash flows, price appreciation, generation of new value, and the like. This includes any investable asset from bonds, real estate, and privately owned businesses to publicly traded companies. However, we will focus on publicly traded investments.  In this space, you can try to buy “cigar butts” with one last puff as Benjamin Graham and Warren Buffett (in his earlier days) did. You can try to buy great companies at low prices. You can even try to buy growth companies at high prices with the idea that they will outpace even the most optimistic projections.  Some of these strategies are far better than others, and we want to distill it all down to the things that work.

There are many ways to make money, and far more ways to lose it, so we need to develop a set of guiding principles and a discipline to follow with investing. While this narrows our field of ways to invest from many to just a few, it allows us to focus and maximize the potential of that strategy and become skilled at using it vs. scattering our concentration across too many things. So what should our discipline look like? We need something that the vast majority of us can replicate. Things like investing in biotech stocks might be good if you have a lot of access to information and deep understanding of the space, and can spread your investments across many, many bets. Or if you are an absolute math genius like Edward Thorpe who can derive a better options valuation strategy, you can use that to exploit markets to make bundles of money. But for most of us these paths will be inaccessible and counterproductive. So what kinds of advantages do we have? It turns out we have a few – patience being one of the most important. Many funds and large institutions are beholden to investors who have short timeframes and this forces them to make suboptimal decisions. This goes similarly for many small investors who are not really investors but rather speculators or gamblers.

I have read number of case studies over the years of successful investors.  As I was reading these, I always tried to distill their investment styles and techniques down, in the hopes that I could discover what works consistently and could further be applied by ordinary people.  When I discuss these examples with others, they will often point to flash-in-the-pan, get rich quick types as arguments against this.  And there are a number of these examples.  Some more recent examples are Keith Gill (GME guy on wallstreetbets), and the infamous Sam Bankman-Fried a once Bitcoin billionaire.  We have yet to see how Keith Gill will fair, but Sam Bankman-Fried has crashed and burned and is now facing a long time in prison.  In years past, there was Jesse Livermore who made and lost several fortunes day trading back in the early 1900’s, and who seemed to have a knack for understanding market behavior.  And yet, his huge risk taking both made him wealthy and lost him everything, eventually leading to his suicide.  The suddenly striking it rich types overall don’t provide great examples.  I don’t observe any consistent variables there that can be exploited.  They were in the right place at the right time by chance and struck it big.  Usually, they don’t quit while they are ahead and lose it all back to the house at the casino and then some. Also importantly they never developed a discipline before they were rich, and it led them to fall prey to their lack of disciplined training once they were.

On the other hand, there are legendary investors like Benjamin Graham and his acolytes like Warren Buffett and Walter Schloss as well as other great value investors like Peter Lynch.  There are also a great many cases of obscure, ordinary, working class people, who, only after death are identified as having amassed huge fortunes.  Investors like Sylvia Bloom, a legal secretary who left $6.24 million to a local charity, or Ronald Read, a janitor who built an $8 million fortune.  The book, “The Millionaire Next Door” also provides a lot of good profiles of these types of people.  These super-investors’ fortunes were not the product of one-off events or even short term lucky streaks because they were able to outperform for decades.

Sounds impossible to be a super-investor?  The concepts are easy to understand.  The implementation is hard, because it requires patience and, you guessed it, discipline.  In reading all of these investors’ case studies, I have found these were some of the common factors:

• They have a core ethos of value investing and/or investing in extremely high quality companies.

Most were strongly aligned with value strategies or with buying a basket of the highest quality companies regardless of what the market was doing or what the news said.  Having a set of guiding principles which you follow entirely serves as a compass to guide you when doubts creep in and times get tough.  We want to select a core ethos that has worked in the past and that we can stick to through good times and bad.

• They followed their own discipline rigorously. 

One of the most difficult behaviors to overcome that I have observed in people, is the ability to watch your neighbors and friends getting “rich” in the latest boom like bitcoin and watching it pass you by as others brag about their newfound wealth.  What you don’t see coming is the bust.  Usually, most people get in on these booms near the top, and promptly take the elevator straight down when the bust hits.  It can be difficult to watch reliable, stodgy value stocks underperform for years.  This ties in to the point above about having a core ethos which is adopted entirely.  It allows you to maintain the discipline necessary to follow through on what works along the long road of your investing lifetime.  If you don’t develop your discipline now, you will stray from the path at some point.  Remember that a huge component of successful investing is having the right psychological mindset.

• They didn’t invest in things they didn’t understand. 

That might’ve meant they missed things like tech stocks during the tech boom, but they did just fine, nonetheless.  New things when they work are absolutely great and push society forward.  However, the fact is, most new things fail, are bad ideas, or are supplanted by even better more refined versions of the idea.  Unless you really understand the particular niche it is best to stick to what you know.

• They had a buy and hold mentality. 

Extremely low turnover is a hallmark of successful investors.  By the way, index investing also employs this strategy to great success.  All of them made their fortunes over many decades, not just a few years.  The most successful investors of all time sometimes never sold a stock and only purchased stocks.    Some of these people even had stocks go bankrupt while continuing to hold them, but their winners far surpassed their losers.  Even the “losers” that went bankrupt were often winners.  For example, many people think that because Kodak went bankrupt, owning it from, say, 1950 until bankruptcy in 2012 was a losing bet.  Nothing could be further from the truth.  If you calculate all of the spinoff company shares you received and all the dividends paid, you actually would have made a sizable return on Kodak over the years, despite its eventual downfall.  One can minimize this less desirable outcome by buying extremely high quality companies and coupling this with a buy and hold strategy.  If you are investing on anything less than a 10 year time horizon, you are a short term investor – a suboptimal place to be.  Any money you need within that timeframe should be invested in shorter duration instruments like CDs or treasuries.  When you buy stocks, you should be in it for the long haul.

• They didn’t try to time the market.

Data has shown consistently that time in the market is much more important than timing the market.  You do not have the ability to reliably decide when the market is due to go up or down.  There is a limited ability to determine if the market is overvalued or undervalued, but this does not translate into any ability whatsoever to time the market at all in the short term.  In any case, there are always opportunities to invest in particular undervalued companies whether the overall market is overvalued or not.

• They saved diligently and put the money to work in the market.

This not only gives them more dry powder to fire off at stock purchases, but it also speaks to their ability to implement a discipline and stick to it.

• They didn’t spend excessively.

Again this shows more evidence of discipline, as well as the ability to accumulate more capital to invest.  They especially minimized investing expenses by, for example, using buy and hold to minimize tax expenses, and using DRIP investing in years past when stock trading commissions were high to keep commissions low relative to amounts invested.

• They didn’t gamble, day trade, invest in the latest fad, or get fancy with their investments.

They used tried-and-true methods of investing.  Leave the fancy stuff to the institutions.  Every few years even some of these institutions will self-destruct, despite having armies of the smartest PhD mathematicians to make them money and manage risk.

• They kept a large proportion of their investment in stocks

There are far fewer super-investors that invest in bonds, options, futures, or commodities.  Here we should mention that we exclude private business owners and real estate investors which have also generated large successes.  These require specialized knowledge, and a different skillset, and we will keep our focus narrowed on investing in publicly traded entities.  We will not even discuss derivative instruments here, but of particular note should be bonds.  Over the very long term, the data shows that these debt instruments are not very good investments relative to stocks, since returns are fixed and therefore eroded by inflation severely.  On short term time horizons, volatility converges with risk and stocks are the more risky short term investment vs. bonds.   However, on long time horizons, the situation reverses, and bonds are actually the instrument with greater risk.  It is no accident that the super-investors had most of their net worth in stocks for a majority of the time the investments were growing.  Bonds and the like have their place for short-duration needs, however.  If you plan to buy a house in 5 years, the money for the down payment should not go into stocks, but instead into a 5 year treasury note or CD.  The time horizon is simply too short for stocks.

• They were properly diversified.

If they bought individual companies, they usually owned at least a handful.  They didn’t necessarily need to buy 50 companies, but they usually didn’t bet all of their fortunes on just one company.  Few investors owned less than 3-5 companies with the notable exception being several highly successful Berkshire Hathaway investors, who pinned their fortunes to Warren Buffett.  However, Buffett himself managed a properly diversified set of investments for his investors.  We will look more deeply into diversification later, but it looks like having at bare minimum 5 high quality companies in which to invest is advisable.  On the upper end, there is more debate – some fall into the school of mass diversification being good and some fall into the camp of wanting fewer good companies vs. numerous companies to spread capital over.  The authors fall into the camp of fewer, higher quality companies, but we will discuss this more in the future.  If you practice buy and hold, over time it tends to be hard not to accumulate a number of different companies, however.

• They fall into 2 groups – financially savvy in the sense of being able to dissect a company’s financials and understand the story, or not financially shrewd in this respect – and this distinction differentiates their styles of investing to an extent.

Of those that are financially savvy, they can invest in a variety of value stocks from “cigar butts” to undervalued gems, or utilize more advanced value strategies.  One example of an advanced Ben Graham type of strategy is investing in a basket of less good companies in a down industry that is recovering, such that their higher cost structure and/or more leveraged balance sheets lead to greater stock price changes relative to the better companies in the industry due to the greater improvement in earnings with recovery.  Of those investors that are not able to dissect company financial statements and understand the company deeply, they have stuck to the much more simple strategy of investing in very high quality businesses that generated lots of free cash flow such as blue chip stocks. Interestingly, it appears as though one can do far better in high quality stocks regardless of whether you are financially savvy or not. See for example Warren Buffett’s performance and reasons for conversion from “cigar butt” types of investing to instead purchasing high quality stocks after being persuaded to do so by his partner Charlie Munger.

• They mostly kept things simple.

Usually, they did not engage in many different and complex strategies.  Their strategy could often be articulated simply and in many cases could be followed almost automatically or without much thought (DRIP investing, automatically investing a percentage of each paycheck across a pre-determined allocation of stocks, only investing in high quality companies, etc.).  This allowed the strategy to almost become a habit.  It also likely prevented mental fatigue and mistakes that come with a complex strategy.  If you are going to implement a strategy for decades, you need to set up your system to make it easy to do so, or you will probably slip up.

I think most of this recipe for success can be boiled down in its essence to 1) having a set of guiding principles that work, 2) having the discipline to stick to those principles, and 3) having patience to see things through over decades.  These three essential principles are easy for most people to grasp, although admittedly, it can be hard for people to apply these practices or more investors would be doing so.

As we build our investment strategy over the next few posts we are going to bring these common ideas to bear.  In the next post we will turn to indexing and its strengths and weaknesses.  Indexing, interestingly enough, allows common investors the psychological framework to be able to follow many of the behaviors outlined above which they would otherwise have trouble following were they investing in individual stocks. Index investing will be the first line in our strategy.  If any of you, dear readers, feel that you lack the skill or desire to go further in your understanding of investing, you can always fall back on index investing as a reliable method of generating wealth for you and your families.  We will of course take you beyond index investing to strategies that can earn you extra return if you are willing to put in the work, but that will take several more posts and some discipline on your part to build.  These principles outlined in this post are the beginning foundations for all of our strategies, pulled from reliably consistent examples of people who have generated fantastic amounts of wealth with levels of intelligence, resources, and wage earnings that are decidedly average or below average, and therefore accessible to most of us.