Developing an investment philosophy

There are clearly numerous ways to make money in investing. There are successful growth investors, momentum investors, value investors, buy and hold-investors etc. For me to succeed as an investor, I think it is very important to find the style of investing that suits me personally, a style that I feel comfortable enough with that I can confidently execute it over the long term, even when the markets seem to disagree with me and my valuations.

My investment philosophy is still very much a work in progress. Because of that, this post might not be perfectly coherent and structured, instead it will contain som random thoughts on how I think about stocks/businesses, and what businesses I even care to look at, for the time being. This post is not only meant to provide my ENOURMOUS following with an understanding of my investment mindset, it is just as much a way for me to clarify my thoughts and make sure they make sense by putting them into print. All of this is highly subject to change in the future as I grow more competent, confident and evolve as an investor, and as always, any feedback is greatly appreciated!

As I mentioned in my previous post, I have read a bunch of books on value investing over the years. The idea of buying something for less than what it is worth is very logical to me, and is central to the way I think about stocks. As such, I will not buy a stock solely because I think someone else might be willing to pay me more for it in the short term for some reason that is not rooted in company fundamentals. However, I don´t really want to label myself as strictly a value investor, as I don´t want to slap a label on myself that might (consciously or unconsciously) prevent me from exploring ideas that might not be considered traditional value cases. I want to be open to all kinds of ideas that I can wrap my head around, and take whatever spots I deem to have the highest expected value. For the time being though, the caveat of me being able to truly understand the situation is a pretty big one in most industries, and I will likely stick to fairly straight forward situations in companies that are relatively easy to understand.

Being a data analyst and a huge fan of the work of Daniel Kahneman and the behavioural economics field as a whole, I want my investment strategy to be evidence based. Even though the knowledge of certain biases doesn´t seem to eliminate said biases, I have made a point out of asking myself before buying any stock, what different biases might be affecting me in my evaluation of the company, and how. The notion of an outside view (how do companies such as this generally perform over time) as well as an inside view (how will this particular company perform over time given its idiosyncratic characteristics) is also critical in how I think about the future prospects of a company. I suspect that the overall tendency of many market participants is to focus a bit too much on the inside view, as this is what is most natural for us as human beings, though I also suspect that in some industries, people aren´t focusing enough on the inside view, but instead treat all companies as pretty much the same when in fact, they are not.

Being evidence based, I am also very careful about extrapolating massive growth, particularly profitable growth, far into the future. As shown by Michael J. Mauboussin in his paper ”Death, Taxes and Reversion to the Mean” (and in several other studies), the ROIC for most (not all) companies tend to revert towards the mean over time. It is also shown that forecasts as a whole are generally too positive. These are in my opinion, things to be wary of when valuing a company. It doesn´t mean that I don´t like growth, on the contrary, profitable growth is great and a vital component of any valuation of a company. I am just not very comfortable assuming large growth numbers at a huge profit for a particularly long period of time, unless I am very confident that a company has a huge moat that it will be able to capitalize on for a long period of time and as such, belongs to the roughly 4% of companies that Mauboussin found doesn´t seem to suffer from mean reverting returns on invested capital. I did read Microeconomics 101, after all 🙂

Given that I am in the relatively early stages of my development as an investor, I don´t think there are many industries in which I am better than the next guy (or more importantly, the market as a whole) at judging what companies will enjoy sustainable high ROIC:s over time and as a consequence of that, I am rarely going to be paying high multiples for any of the stocks I buy if that means I have to assume fast paced growth many years in to the future, which it usually does. Given that regression to the mean also works for companies that are currently doing very poorly, a very good case could be made that it would be best for me to focus on these businesses instead, trying to find companies that currently have poor returns that I expect to regress upwards towards the mean in the future. This strategy is more of a deep value strategy, similar to the one being executed by Tobias Carlisle who also makes the podcast ”The Acquirers Podcast” that I greatly enjoy.

That is not the path I have chosen. The reason is mainly a psychological one. Even though there is ample evidence that such a strategy is likely to outperform the overall market if you use the right metrics (at least it was in the past), I don´t think I would execute it very well. I don´t trust myself to be able to hold on to really iffy looking companies when the times get rough, and I don´t really think I would be very good at knowing when to dispose of companies that really are going to sh*t and when to hold on to companies that are actually turning the ship around. In short, I don´t trust myself to be mechanic enough to just hold on to companies that look terrible even if the strategy insists I should, and I don´t think I´m good enough at deciding which terrible looking company is going to turn good, and which one is heading for bankruptcy.

Instead I have chosen to try and find good, or preferably great, companies that for some reason are trading cheaply. Ideally, I´d like a non-cyclical business with predictable earnings and cash flows, a high amount of recurring revenue, low debt, great management that has significant skin in the game and a wide moat surrounding the business. Sounds familiar? Well, that´s probably because more or less every investor out there inspired by Warren Buffett is looking for exactly that, and as a consequence, those companies are rarely cheap. To try and uncover a few hidden gems, I rarely look at closely followed large caps or the companies that everyone is talking about. Instead I mostly focus on small/micro caps, spin offs, illiquid stocks or other situations that for some reason hide the actual quality of the underlying business. The reasoning is simple, I just feel like the probability of a mispricing occurring should be much greater in companies that are operating in these areas of the market and that have less analysts following them. Again, I don´t want to limit myself by imposing strict rules on what I can and can not do, so if a gigantic company for some reason would become very undervalued in my opinion, I will definitely be open to investing in that area as well, but since there are way more companies out there than I have time to analyze, for the most part I won´t even be looking into huge companies unless I really feel that there is a very valid and realistic reason that the market to misvalue them. I do feel like the market tend to exaggerate and extrapolate both positive and negative news, which might make for interesting opportunities when the market decides that an entire sector is out of favor and drag all the companies in that sector down for a while.

I laid out some desirable characteristics for the businesses that I am most interested in a couple of paragraphs above. In reality though, there´s likely to be some compromising on my part with regards to these characteristics as it is incredibly hard to find businesses that tick every single box (especially for a low price), but I genereally look for businesses that I would deem as above average, selling at below average prices. I also focus quite a bit on downside protection. If I can identify situations where I think that the risk of actually losing a large chunk of my investment is very small, then most other outcomes are fine.

With that said, I am looking for investments where I expect to make at least 12% a year for at least five years, given conservative assumptions. If I dont´t expect to return more than the average market return, I should obviously just buy an index fund (but how fun would that be?!), and over time I hope to be able to move my goal up to making 15% a year. Given that I want to make 12% over at least five years, this naturally means that I want businesses where I can make some reasonable assumptions about what the business will look like in five years, or preferably longer than that. Generally I don´t expect to hold a stock for five years, but if I am right that the stock will return 12% a year over 5-10 years, either I will make those 12% a year and be fine with that, or the multiple will expand to a point where I no longer deem it undervalued and I sell off, likely making more than 12% a year (this reasoning is blatantly stolen from Geoff Gannon at https://focusedcompounding.com/ who also co-hosts my favourite investing podcast, Focused Compounding Podcast ). Obviously I will make mistakes and not every stock will return 12% a year, some will for sure have a negative return, but the hope is that some will yield a lot more than 12%, so that on average, obviously with a ton of variation along the way, I will make 12% a year.

No discussion on investment philosophy is complete without touching on diversification. Empirical studies show that diversifying beyond 30 stocks is sort of pointless as it doesn´t reduce volatility much, if at all. For me, having 30 would be rather unpractical as I do have a day job. Following 30 companies, plus all the companies I might be interested in adding to the portfolio would consume a lot of time, given that I want to know a lot about the companies I own. More importantly though, I struggle to see that the expected value of investing in the company that is my 30th favourite is even close to the EV of the company that is my favourite holding, or even my fifth favourite holding. I also think that I would struggle to find 30 companies that meet my strict investment criteria, that I also would feel like I understand enough to own long term. In the future, as I hopefully improve as an investor, I can see myself owning as few as 5-6 stocks, but right now I think that a portfolio of roughly 8-10 equally weighted stocks is a nice balance for me, hopefully not diluting my returns too much while simultaneously giving me some protection against my own ignorance and the inevitable mistakes I undoubtedly will make on occassion. The choice to concentrate also has to do with the type of businesses I´m looking at. If I had chosen the deep value approach touched on earlier, I would definitely be looking to have around 30 positions, but as my holdings will hopefully be of higher quality, more predictable and potentially a bit less volatile (at least on the downside), I´m hoping that 8-10 holdings spread out over a handful of sectors, hopefully not strongly correlated with each other, should provide enough diversification to reduce the risk of ruin to a very, very low number.

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