Ten practices of a great investor
• A feel for figures, rabid reading and an open mind are some of the traits necessary for success
Last year Michael Mauboussin at Credit Suisse published a piece entitled Reflections on the Ten Attributes of Great Investors. To summarise, Mauboussin believes great investors:
● Understand numbers (and accounting). To be a successful investor, you have to be comfortable with numbers. There are rarely complicated calculations but a feel for figures, percentages and probabilities is essential. Accounting is one of the main languages of business [and] great investors are adept at analysing financial statements. The task has become more challenging as companies invest more in intangible and less in tangible assets. [But] this does not abdicate the responsibility to understand a business’s current economics and prospects.
● Understand value (the present value of free cash flow). The landscape of investing has changed a great deal in the past three decades. The average halflife of a public company is about a decade, which means that the investable universe is in flux. Conditions are always shifting because of unknowns including technological change, consumer preferences and competition. But one concept that is close to immutable for an investor is that the present value of future free cash flow determines the value of a financial asset. Great fundamental investors understand the magnitude and sustainability of free cash flow [as well as] the limitations of valuation approaches such as price/earnings and enterprise value/Ebitda [earnings before interest, tax, depreciation and amortisation] multiples. As Al Rappaport says, “Remember, cash is a fact, profit is an opinion.”
● Assess strategy (or how a business makes money). This has two dimensions. The first is a fundamental understanding of how a company makes money. Great investors have a grasp on the changes in the drivers of profitability and never own the stock of a company they do not understand. The second dimension is a grasp of a company’s sustainable competitive advantage. Michael Porter makes a distinction between strategy and operational effectiveness that executives and investors commonly blur. Strategy is about deliberately being different to competitors and making choices about what to do and not do. Operational effectiveness relates to the activities that all businesses need to do and does not entail choice. Great investors can appreciate what differentiates a company that allows it to build an economic moat that protects it from competitors.
● Compare (expectations versus fundamentals). Humans are quick to compare but not very good at it. Perhaps the most important comparison an investor must make, and one that distinguishes average from great investors, is between fundamentals and expectations. Fundamentals capture a sense of a company’s future financial performance. Expectations reflect the financial performance implied by the stock price. Most investors fail to distinguish between fundamentals and expectations. When fundamentals are good they want to buy and when they are poor they want to sell. But great investors distinguish between the two.
● Think probabilistically (there are few sure things). Investing is an activity where you must constantly consider the probabilities of various outcomes. This requires a certain mindset. When probability plays a large role in outcomes, it makes sense to focus on the process of making decisions rather than the outcome alone. The reason is that a particular outcome may not be indicative of the quality of the decision. Good decisions sometimes result in bad outcomes and bad decisions lead to good outcomes. Learning to focus on process and accept the periodic and inevitable bad outcomes is crucial.
Great investors recognise another uncomfortable reality about probability: the frequency of correctness does not really matter (batting average). What matters is how much money you make when you are right versus how much money you lose when you are wrong (slugging percentage). This concept is difficult to put into operation because of loss aversion, the idea that we suffer losses roughly twice as often as we enjoy comparably sized gains. But if the goal is grow the value of a portfolio, slugging percentage is what matters.
● Update their views effectively (beliefs are hypotheses to be tested, not treasures to be protected). Most people prefer to maintain consistent beliefs over time, even when the facts reveal their beliefs to be wrong. Further, we commonly expect others to be consistent. We all walk around with views of the world we believe are correct. The trait of seeking alternative views is called being “actively open-minded”, defined as “the willingness to search actively for evidence against one’s favoured beliefs, plans or goals and to weigh such evidence fairly when it is available”. The best investors recognise that the world changes and that all of the views we hold are tenuous.
● Acknowledge behavioural biases (minimising constraints to good thinking). Keith Stanovich, a professor of psychology, likes to distinguish between intelligence quotient (IQ), which measures mental skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good decisions. His claim is that the overlap between these abilities is much lower than most people think. Importantly, you can cultivate your RQ. Great investors are those who are generally less affected by cognitive bias than the general population and put themselves in a work environment that allows them to think well.
● Know the difference between information and influence. In classic markets for goods or services, prices are a highly informative mechanism. [But] Investing is an inherently social exercise. As a result, prices can go from being a source of information to a source of influence. Take the dot-com boom as an example. The crowd is often right, but when it is wrong you need the psychological fortitude to go against the grain.
● Understand the importance of position sizing (maximising the pay-off from edge). Puggy Pearson was a gambling legend who won the World Series of Poker and was one of the world’s best pool players. When asked about his success, Pearson said, “Ain’t only three things to gambling: knowin’ the 60-40 end of a proposition, money management and knowin’ yourself.” Great investors take to heart all three of Pearson’s points, but money management is the one that gets the least attention in the discourse on investment practice. Success in investing has two parts: finding edge and taking advantage of it through proper position sizing.
● Read (and keep an open mind). Berkshire Hathaway’s Charlie Munger said, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time – none, zero.” Great investors generally practise a few habits with regard to reading: they allocate time to it; take on material across a wide spectrum of disciplines; and make a point of reading material they do not necessarily agree with. “Reading is particularly important for investors who must synthesise a huge number of inputs into actionable ideas,” Mauboussin says.
WE WALK AROUND WITH VIEWS OF THE WORLD WE BELIEVE ARE CORRECT… THE BEST INVESTORS RECOGNISE THAT THE VIEWS WE HOLD ARE TENUOUS