Allocate capital to businesses, rather than just "buying shares." Know and understand what you own.
Investing is about allocating capital to businesses, not just buying pieces of paper. As such we take on an owner’s mindset with each of our investments, asking ourselves which management teams we want to partner with in order to grow a business.
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.
We understand that stock prices are driven by two things: short term sentiment and long-term fundamentals. When we say, “long-term investing”, what we are really saying is to ignore the former and focus on the latter. The first is not predictable, the second is.
When it comes to short term sentiment, even if we could predict economic and geopolitical events with any degree of accuracy, we still could not predict how the market would respond to those events. The market can wake up sadder or happier on any given day than we think is warranted by the news flow – being driven at times by both extreme unfounded pessimism and extreme unfounded optimism.
But what we can predict are the economic fundamentals of the businesses we own (to varying degrees of certainty). If we think a company is going to compound cash earnings at 15% over the next decade, it doesn't matter if its multiple gets cut in half in any single year, our long-term returns will still track that 15% earnings growth. Trying to juice that return by jumping in and out of the market and predicting something that is unpredictable is no more than hoping to get lucky. We rather not rely on luck for our 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.
High-quality companies are rare. High-quality companies trading at attractive valuations are even rarer. If we forced ourselves to hold 50-100 positions despite this fact, we would likely end up with a portfolio full of a bunch of average investments.
We are not looking for average results. Instead, we seek to allocate capital where it can achieve the best long-term risk-adjusted returns. This means focusing our capital on a relatively small number of above-average companies. By doing this, we avoid the trap that many investment managers who are constrained in tracking a benchmark fall victim too – making investments in sectors and industries that aren’t conducive for above-average returns. We understand that concentrated strategies run the risk of short-term underperformance, but we view that as a necessary cost in achieving long term outperformance.
We also believe that a thoughtfully constructed concentrated portfolio is lower risk than one that may appear diversified by virtue of holding many stocks. Diversification is not protection against risk. We are taking less risk by owning 25 companies that we know in great detail, rather than 500 we know nothing about.
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 don't reflect underlying value. Markets are emotional, irrational and therefore provide opportunity.
Market prices only reflect an opinion about underlying business value and those opinions are prone to substantial errors in the short term. As such, we always reach our own opinion about a company’s value in isolation of what the market might think, and then we wait for the market to provide us with an opportunity to initiate or exit a position.