1. Invest in Businesses, Don't Trade Stocks

  • Allocate capital to businesses, rather than just "buying shares." Know and understand what you own.

Many market participants are not actual investors. They buy and sell stocks without regard to what they're actually owning. Many mutual funds, passive investments, trackers, quant funds and even traditional mutual funds do not fundamentally know anything about the underlying companies in whose shares they transact.

Remember why the stock market came into existence- it was to allocate capital to businesses. That is how we think about investing- we make decisions based on which companies we want to be part owners of. As capital allocators, we want to know and understand what it is that we're buying.

INVESTING VS TRADING

When you invest, you participate like a business owner. You analyze the fundamentals of the company: what are its products, what do its markets look like, where are the strengths/ weaknesses, what is the competition doing etc. These are all things that we can genuinely analyze and establish an opinion on.

When you trade, you are buying an asset without paying attention to what it is you’re buying. As a result, you don’t really know what it’s worth. How can you if you don’t know what it really is? Instead, to generate a return you’re reliant on someone else being willing to pay more than you did for it. And so you are relying on being able to judge and predict the sentiment and emotions of thousands of market participants.

2. Think Long Term, Don't Try to Time Markets

  • Market inputs are impossible to predict consistently, both in terms of what will happen and investors will react.

 

In the short term, the market can and does misprice stocks. Short term market movements are based on emotions, sentiment, weather, politics, company results, management changes, wars, diseases, fashion changes and a million other variables. No human nor any computer can simultaneously predict all of these variables, as well as interpret how thousands of individuals will react to them. Many investment managers and pundits will make predictions on market direction- but these predictions are just noise. They should be looked through, so we can ignore the hype, media, fearmongering, overexuberance and clickbait that is all around us.

Whilst no- one can predict prices in the short run; in the long run, prices are determined by underlying company earnings. Nobody can predict short term sentiment, but patient, careful investors can predict long term earnings.

The simplest and easiest way to stack the odds in your favor is to invest with a long term horizon. Based on the history of the S&P 500 since 1950, with a ten-year horizon you had a 93% chance of positive returns.

3. Be Concentrated, Don't Overdiversify

  • Over-diversification is incredibly destructive. Exceptional investments are rare, so don't dilute great investments with average ones.

 

There are two main forms of stock investing:

  • Passive: own all the stocks in an index (such as the S&P 500) rely on the whole index going up to generate returns

  • Active: select a small number of individual stocks to buy, based on company and stock analysis.

 

The explosion of passive investing over the past decade has largely been destructive in our opinion.

 

Passive managers often claim that “less than 50% of active managers outperform their benchmarks”. That statistic is enormously misleading. Remember two things:

  • Most active managers claim to be ‘active’, but in reality they are actually passive. Funds aren’t active if you own more than 50 stocks. If you own more than 50 stocks your returns will largely track the index anyway. You will find mutual funds claiming to be ‘active’ are in fact simply expensive passive trackers

  • If you own a passive investment you are guaranteed average returns at best. Its simple math. If you own all the good stocks and all the bad stocks, then your returns can’t be any better than  the market itself (which is the average return). In fact they’ll typically be slightly worse, as you’re still paying a fee

There are many active managers who have demonstrated that it is possible to outperform the market over a long period of time. Great investments are rare- so when we find them, they should be decisively backed. Diluting great investments with poor ones will result in average returns.

HOW CAN ANYONE BEAT THE MARKET?

1) Markets are driven by humans. Humans are not rational, nor efficient. For passive investing to work, we must believe markets are efficient- what is known as the Efficient Market Hypothesis (EMH). For this to be true, market participants (people) must act rationally and respond to news flow and information in a logical manner. We know neither of these things are true. We have seen thousands of examples historically of wild asset mispricing driven either by fear or by greed, and we will continue to see many more in the future. Think tulip mania, or the dotcom bubble, the financial crisis or even bitcoin. 

2) The market is an aggregation of all share prices and therefore the average of market participants. Investing passively, you will at best earn those average returns. Careful and prudent investors hold a concentrated number of great investments without diluting their portfolio with poor or average ones. In this manner it is possible to outperform consistently. 

4. Use the Market, Don't Rely on It

  • Market prices only reflect opinions- not underlying value. Markets are emotional, irrational and therefore provide opportunity.

 

Remember that market prices only reflect the market’s ‘opinion’ about valuation- they don’t tell you anything about genuine underlying value. Short term market movements are driven by sentiment and investor flows, while over the long-term share prices will track closer to genuine underlying value, as the impact of earnings growth (or declines) outweighs sentiment. The market can only be exuberant about a company for so long before that company has to actually deliver and generate some earnings (think 2000 tech bubble), and conversely, the market can only be negative about a company for a short period if that company continues to grind out excellent earnings growth (think the S&P recovery since 2009). At some point, the market has to accept reality. This is why we, as investment managers, are happy to maintain positioning even when the market or ‘styles’ may be moving against us. Over the long term, those features become irrelevant.

As a result- prudent investors should look to the market to provide them opportunities to transact in certain assets, but not look to the market to provide them with any reliable information about valuation.

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