that there are many, many opportunities.
Invest in business fundamentals
Unlike the simplicity of being a good fiduciary, fundamental analysis and security selection is a very long, detailed, and nuanced subject. The amount of work and difficulty in understanding the many important facets of a business cause many investors to take shortcuts. These shortcuts can often have the eventual effect that the business fundamentals themselves are forgotten. Decisions begin to be made based on the stock and its price actions, not on the business and its fundamental cash flow creation. Fundamental business analysis with an emphasis on future cash flow creation and growth involves an extensive list of issues related to industry dynamics, market growth, competition, capital allocation, cost structure, management, and more.
Understand the role of valuation in future returns
Understand the business and its future potential, but then understand the effect of the point in time that your investment is made and the valuation you choose to pay. An investor's valuation entry point and future additions and sales of the investment are paramount to the final return outcome. I have avoided the term value investing, because it can be defined by some as buying cheap stocks, which is simplistic and will not create superior returns (although it is better than simplistically buying expensive stocks). Part II will develop how to think about the predictive power of valuation and the importance of multiples and cash flow yields in creating superior returns.
Contrarianism
Superior returns are generally created by being a contrarian and finding opportunities where the market has punished good companies, sectors, or countries and you can see a different future. If you are correct in recognizing a future successful company, that is a stock market darling today and trading at very high equity valuations, you will only return the beta-adjusted cost of equity capital. We will look at some specific and subtle issues concerning contrarianism. Being a contrarian in today's market environment is harder than ever before.
Prices fluctuate more than values—so therein lies opportunity.
—Joel Greenblatt, investor
Time horizon
Fundamental investing and contrarianism take time. You have to be afforded the time to allow your thesis to play out. In many instances, the markets do not accurately reflect the value of a company's future cash flows at a certain point in time due to exogenous factors. This is wonderful for good investors, and one of the primary reasons outperforming the market is possible, but it means you have to have the time to allow the market to correct and your thesis to play out. If you are forced to be a short-term investor, a huge advantage in your ability to outperform has been lost.
Portfolio concentration
Analyzing companies and making good individual investment decisions can be very different than being a good portfolio manager. Understanding how to construct a portfolio to offer the opportunity to outperform, yet managing risk, is both quantitative and qualitative. Liquidity and volatility can be quantitatively measured, but an understanding of the real-life implications of those numbers and how it will affect your decision-making is experiential. Portfolio concentration, making significant investments as a percentage of your capital, is necessary to create alpha. The level of concentration is dependent on the alpha and volatility goals of the firm. The challenges of managing a concentrated portfolio are not dissimilar from the pre-financial crisis period, but again they are magnified due to the amplified role of global central banks and technologically driven disruption. In the 2010s, macro issues have overwhelmed individual company decisions, and risks not generally associated with an individual company have often dictated short-term performance.
Behavioral pitfalls
Understanding the behavioral mistakes that affect every manager is the first step in overcoming (or limiting) those mistakes. Selling winners too early, letting the market rule your emotions, and trading too much are only a few of the pitfalls that must be overcome through experience and analysis. Behavioral mistakes in portfolio management are one of the top reasons, if not the top reason, investment managers fail to outperform the market. The magnification of both the potential for downside risk and FOMO (fear of missing out) create pressure on the behavioral control necessary to be successful.
I must take care not to compound my error by reacting emotionally. I must adapt to changing circumstances.
—George Soros, investor
Process
Investment process is both the key to long-term development as an investor and to creating a firm that can grow without dependence on one individual. Success in the investment management industry is very hard to come by, but even harder to replicate. How can you replicate something that has so many different variables and potential outcomes?
Active investing is a discipline in which being 70% correct is a great track record and in which you can be wrong for the right reasons and right for the wrong reasons. A strategy can look horrible today only to look brilliant a year in the future. The only chance an investor has to honestly judge actions and learn from mistakes and success is to painstakingly create a process of investing that incorporates both security selection and portfolio management. A large part of this process is documentation in the form of an original investment thesis and then regular updates on events that affect the thesis.
To make it even more difficult your process cannot be 100% rigid and static. There are too many unique scenarios, and every investor continues to learn and markets change. The core investment tenets we are discussing may not change, but any completely static process is not growing and evolving. We will discuss where to draw the line between a process that can evolve and become better over time, as opposed to one that is ever-changing and has no foundation.
My conviction in the core investment tenets described not only comes from 20 years of portfolio management experience but also from the opportunity to watch and interact with some of the world's best managers. The investment business is somewhat unusual in that understanding which decision was an error, even in hindsight, is not always readily apparent. It is possible to make the right decision and have a poor result. It is, also, possible to make the wrong decision and be handsomely paid. Some might not call being handsomely paid a wrong decision, but it may be a decision that nine times out of ten will cost you money; you just happened to be lucky in the timing of the investment.
Which experiences are beneficial lessons and which are red herrings?
Individual investment managers do not get the opportunity to analyze a huge dataset of decisions, because there may only be a handful of major decisions made each year.
The conclusions take time to become clear. Major periods of market stress are not very frequent, so the dataset of events to learn from is not large. For this reason, I am very appreciative of having learned not just from my own mistakes but also from watching and talking to the hundreds of global managers that DUMAC has partnered with in the 2010s. My dataset of decisions to analyze and consider has been 100 times what it would have been if I were to have solely managed my own fund and been confined to my experiences.
The next two chapters delve into more detail on the current market environment and the two forces challenging investment decisions
