A snapshot of my current framework
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I started investing my own savings when I was in university studying engineering. I was blissfully unaware of what I was trying to do for years. Luckily, because I started at a young age, the impact to my financial well being was minimal and I think I learned a lot from my own stupidity. I had no real process, traded too frequently, chased names based on sentiment and single metrics like P/E ratios. I ended up doing okay (i.e. didn’t go broke) through sheer luck.
After a few years, I recognized SOME of my stupidity and tried to learn more about investing. I did so through internet articles, main stream media and a few books such as The Intelligent Investor.
“One of the basic rules of the universe is that nothing is perfect. Perfection simply doesn't exist.....Without imperfection, neither you nor I would exist”
― Stephen Hawking
Because of my focus on what I was generally good at in my academic background (hard science, math and engineering), the rational idea of traditional value investing was appealing to me intellectually. It was also generally agreeable to my stomach; or so I thought.
Of course, there are plenty of issues with this strategy. It isn’t that “traditional” value can’t work, but it certainly requires more nuance than I appreciated. Not all businesses SHOULD trade at similar ratios of earnings or book value. The price of 5x earnings for an oil company at peak earnings and top shelf oil prices is not cheap. The disadvantages of a capital intense zero-moat business with a commodity as a product doesn’t even mean you can’t make money investing in it. But it’s not something I can figure out.
My Investing Philosophy
Act Like a Business Owner
What I have come to realize is that there are many ways to make money in the stock market; what works for me is to think like a business owner. What’s a business that I’d want to own and what is a reasonable price to pay for said business. It is not: what do I think will happen to its stock price over the next week, quarter, or even year. This type of thinking would have me looking for what is about to be popular or what macro economic trends are doing.
I realize now that I need businesses that will survive and thrive through cycles. In order to do that they must meet the following criteria to be considered:
A durable moat is preferred but not 100% required. A business that delivers more value to its customers over time compared with the price paid. This can show up in high gross margins, high returns, pricing power and some other areas. Generally speaking, I want businesses that do not require a lot of capital to maintain their assets and can reinvest at good rates of return for a long period of time. I asked Twitter to define “quality in a business” and I got a lot of different but good answers.
Consistently smart capital allocation coupled with a focused alignment to long term shareholder value creation. Basically, they should be demonstrating that they will do what’s right. They will not chase growth of revenues at the expense of returns and will manage the balance sheet in conservative ways. They will seek to grow cash flows in ways that do not dilute shareholders while doing so at reasonable rates of return or better. The quote below about picking only winners who repeatedly win unfair fights is not necessarily fully aligned with what I own, but I like the sentiment and find it useful to think about.
“If you want to do truly extraordinary things in your life, you need to have a very high win rate. Genghis Khan only fought unfair fights… For most of the fights that he picked, his people weren't even within eyesight of the people they were conquering. Their bows literally had 30 to 50 yards more length to them. They didn't fight hand-to-hand… His number one general died on a farm at the age of seventy-three after conquering Western Europe… He didn't lose a single battle… The only way you do that with capital is you exclusively focus on unfair fights.”
― Yen Liow
Price Paid Still Matters
After I’ve decided that it’s a business that I’d like to own, I then consider what price is acceptable. It’s true that a P/E of 10 is too high for some and a P/E of 30 is a potential bargain for others. The fact that valuation comes AFTER consideration of the criteria for quality business and management is NOT a coincidence. My thinking on this has evolved over time. My current thinking is that while valuation matters, it should be done at the end. If I start with valuation, there are a couple of traps:
I don’t have the inputs yet to determine valuation properly
I’m likely to fall in love with the perceived cheapness of the business (see background section to find evidence of this)
Reduce Noise and Decisions
One of the benefits of owning a relatively small number of quality businesses is that it allows you to hold through volatility. Not needing to rely on sky-high growth rates for years to support the high price paid and needing unit economics to magically improve with scale to allow profitability to fund the business is another significant advantage. Said another way, it allows you to ignore short term market sentiment in favor of focusing on the long term trajectory of the business fundamentals.
I try to ignore main stream media such as CNBC for market news. Twitter can be another source of foolish market commentary if you aren’t careful. I take care to follow only certain people who tend to talk about businesses and not macro-economic predictions and market commentary or politics/ideology - “cabbages the brain” as Charlie Munger might say.
“Take a simple idea and take it seriously.”
― Charlie Munger
After having made lots of mistakes, the more costly mistakes have been when selling good businesses early for no good reason. “Taking a profit” has often resulted in missing out on another 2 or 3x gain. Focusing on a few decisions to buy right and hold on means that you will do the right amount of critical thinking up front. It also means being able to keep track of what you own. Then, the bulk of time can be spent finding the next better idea. In order to make it into the portfolio now that the portfolio is built, the next idea needs to meet the criteria above but also be MUCH better than the WORST current holding. This is because there is a strong tendency to think the new shiny thing you found is better.
Comfortable With Concentration
Diversification is more than a number of equities or asset classes. It needs to encompass lots of things:
Likely other things…
I’m currently holding less than 25 businesses and some are a high portion of the portfolio. My top 5 make up more than 60%. That being said, Constellation Software, Topicus, Alimentation Couchetard and Berkshire are in my top 5. All of these are diverse in themselves and (with exception of Topicus and Constellation) from each other.
I would point to this podcast by Trey Henninger as a good background that is similar in a lot of ways to my thinking about diversification.
Holding and Selling
What I’ve described until now has focused on finding and buying businesses. This is obviously important but what is missing is the period of holding and finally selling. So without droning on too much, I try to make the decision correctly upfront and buy well so that I can hold on for a long time. This should mean years and in some unrealistic scenario, forever. In reality there are rational times to sell and I would summarize them below:
The fundamentals of the business are deteriorating such that the future doesn’t appear to provide any reasonable return prospects. (i.e. industry decline leading to profit decline)
The management team is not addressing underlying cultural issues at the business that are harming stakeholders (i.e. Activision currently).
The management team is not showing smart capital allocation. (i.e. chasing unprofitable, low return acquisitions or investments for the sake of growth or diluting shareholders significantly).
The realization of a mistake. (i.e. if I were to buy something I don’t understand or I was wrong about.)
Egregious price to valuation. (i.e. If Berkshire were selling at 10X today’s price, I would admit that forward returns would suffer and move on.)
My philosophy is fluid. I’m sure there will be hypocritical things you could find on Twitter or elsewhere where I contradict what I’m saying here. To this end, I say, that’s fine. I need to be able to keep an open mind and not fall into tribal thinking. I don’t like putting myself into categories about how I invest or think. I will hopefully evolve and change going forward and hopefully for the better.
“I feel I change my mind all the time. And I sort of feel that's your responsibility as a person, as a human being – to constantly be updating your positions on as many things as possible. And if you don't contradict yourself on a regular basis, then you're not thinking.”
― Malcolm Gladwell
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