Over the course of my 15 years of self-directed investing I have learned a lot. Some lessons were learned from investing legends such as Warren Buffet and Peter Lynch, while others were learned the hard way. I have tried to bring a growth mindset to my investing journey, avoiding the “know-it-all” ego in favor of a “learn-it-all” approach. Putting my ego in the back seat has allowed me to improve my returns over the years.
In this post I am sharing my nine principles for successful investing. These are the principles I follow in search of market beating returns with a margin of safety to protect my capital.
1. Maintain a long-term perspective
Achieving peak performance in any field or practice begins with the right mindset. The best golfers in the game know the most important factor in determining their success begins before they even step onto the course. It starts with having the confidence they are using their physical capabilities to the best of their abilities. Good golfers lean on this confidence when things start to go wrong, trusting themselves and their process.
Good investors also trust their process when the stock market goes south. The very human reaction to stock market drops is to become fearful, often leading to panic selling. If we have a long-term mindset, market dips are viewed as opportunities to buy companies we want to own at better prices.
The data bears out that having a long-term investing perspective pays off.
As we lengthen our investment horizon, the average annual rate of return over that timeline becomes less variable. Financial service provider Schwab studied the highest return, lowest return and average annual return of the S&P 500 over various holding periods from 1926 until present day. They found that as you move from a one-year holding period to a three-year, 10-year, and finally to a 20-year holding period, the number of negative returns experienced goes down. In fact, there has never been a 20-year period with a negative return.
This means that the longer the amount of time you spend in the market, the more likely you’ll be to receive the long-term average annual rate of return. Sure, investing in the stock market carries some risk, but by extending your time horizon as an investor you’re lowering this risk while stabilizing your return.
Investing for the long term, versus short term trading, will let you ride out the unavoidable ups and downs of the market, stabilizing your annualized return and mitigating the loss of capital.
2. Focus on major trends first to find the best growth stocks
“If you're looking for a home run -- a great investment for five years or more -- then the only way to beat this enormous fog that covers the future is to identify a long-term trend that will give a particular business some sort of edge”
- legendary investment manager Ralph Wanger
Spotting major shifts in the economy, technology or whole industries have brought about the best performing stocks in my portfolio. It is these mega trends that will create significant value over an extended period of time for the elite companies that are best positioned to ride the wave.
Picking the top one or two companies that compete in the transforming industry or which will benefit the most from an economic or technological shift is key. It is not easy. It is a tricky balance between not entering the theme too late when all the major gains have been realized and not being too early where you pick the wrong company because it’s unclear who will win. Before pouncing on the latest technology fad, I try to be skeptical and make sure all the elements of an investment ready mega trend are present. You do not want to be too early to the party left holding the loot bag with no loot.
To find the winners within a major technological shift I have honed my approach into a specific methodology for picking tech stocks that deliver wealthy returns.
But remember to first look for those mega trends that will create significant value over an extended period for the elite companies that are best positioned to ride the wave.
3. Look for opportunities where Wall Street has not considered the full story
There are certain stocks that Wall Street has a difficult time fully understanding. They might not fully appreciate the market opportunity, the company’s optionality, its moat or, as was the case with one of my most successful investments this past year, what business the company is in. As was the case with Roku, most investors did not understand that Roku is in the platform business. For a long time, Wall Street has believed Roku was in the hardware business. Roku built its brand on their digital media players and so this ignorance was understandable. Much of Wall Street was valuing them as a connected TV device manufacturer – a low margin business. Wall Street was missing the fact that Roku is a platform company that is being monetized through their accelerating advertising business. As more and more people caught onto the “true” Roku story the stock began to pop. There was an extended period where the market was mistakenly valuing them as a commodity hardware business when the signals were pretty clear that they had built a successful advertising operation that was ready to explode.
As individual investors, these Wall Street misunderstandings are some of our biggest opportunities.
Some clues I look for to identify misunderstood stocks include companies that are either in the early stages of a new, growing market or have pivoted to a new business that has not fully materialized in their income statement. For example, it was not until 2018 that Roku’s advertising business pulled ahead of its hardware business in terms of relative size. There was plenty of time to get ahead of Wall Street.
While it’s not clear if their pivot is going to be ultimately successful, BlackBerry is another good example. If you look at their recent annual reports, it looks like they are rapidly contracting. But if you go beyond the top line you will see that while their legacy mobile handset business has all but disappeared, they have a fast-growing security software business. It just takes some squinting and analysis to uncover these “diamond in the rough” stocks.
4. Have a hypothesis for each of your investments
You must understand why you want to buy shares in a company before you make the final purchase. “Because my friend recommended it” is NOT a good enough answer to why you bought a stock. An investment hypothesis is the reasoned justification for purchasing shares in a company. Having an investment hypothesis also helps you set the time horizon for when to sell a stock. You should only sell a stock when the hypothesis is realized, or when it’s clear the hypothesis is no longer achievable.
You might think a company is undervalued, or that a company is in a high growth industry that they are poised to capture. You may choose to invest in a company because it historically has grown its dividend payouts and you want the income stream in your portfolio.
One of the more successful investment hypotheses I had informed my purchase of a company called Western Digital. It was my belief the market was undervaluing the company. Western Digital develops data storage solutions, anything from flash drives, to devices, to large enterprise solutions. Many of the metrics used to help indicate if a company is properly valued or not - its Price to Earnings (P/E) ratio, Price to Book, and others, were all signalling Western Digital was being undervalued by the market. What was driving this discount was Wall Street’s belief the storage market was undergoing a major transformation from local storage solutions, which was Western Digital’s traditional bread and butter, to cloud storage solutions. What I felt Wall Street missed in its low valuation of Western Digital was that the vendors who were providing cloud storage services themselves needed the same storage hardware from companies like Western Digital to be able to provide these services at scale. As soon as Western Digital recovered to a more “fair” market valuation, I exited the stock and looked for other opportunities to invest my gains.
Our biggest losses in investing often come from selling too early and missing out on our original hypothesis being realized. How much is enough patience? For me, unless I see obvious signs that I was off on my thesis or I see signs of high risk, I will wait at least four quarters before selling a thoroughly researched and thoughtful investment.
5. Look for companies with a lot of optionality
The more options a company has to grow over the long run, the greater the likelihood they will become a Multibagger stock pick. Optionality exists when a company has a second and third act, potential for a new business or market that keeps the growth going beyond its original idea. You cannot expect wealth altering returns if the company is a one-trick pony.
A great example of a company with a lot of optionality is Amazon. We all know how Amazon got started, what started as an online bookstore quickly evolved to become the everything store. Since then, we have seen the behemoth generate new growth beyond their e-commerce core business, including cloud computing, advertising, devices, video and music services, and more recently the grocery industry. We are also seeing glimpses of what Jeff Bezos might have up his sleeve for his next act. Would anyone be surprised to see Amazon begin to offer shipping and logistic services that compete directly with Fedex or UPS? The company is also pushing into healthcare with its recent acquisition of online drugstore PillPack. It is no wonder Amazon has the astronomical valuation it does thru what amounts to an optionality premium.
I believe there are two types of optionality, both are strong indicators of future growth but one is a much bigger catalyst and quite rare:
Use case optionality: This kind of optionality exists when a company has a core technology that can be applied to various use case scenarios. A good example of a company with “use case” optionality is Splunk (NASDAQ: SPLK), a provider of software for making sense of machine-generated big data. It’s specialty is the real-time capture and analysis of big data generated by machines, not people. There are several use cases of it’s technology – for IT operations, improving security and to manage industrial operational data. Its technology is differentiated from competitors, it does what it promises really well and there are multiple use cases of its technology that will generate growth for a long time. I’m certain, just as they expanded beyond their original beachhead of IT operations, that they will find new use cases.
Mission optionality: For a select group of tech companies, mission optionality exists. This sort of optionality only exists for special companies with awe inspiring missions. “Be earth’s most customer-centric company”, “organize the world’s information”, “make the world more open and connected”, “empower every person and every organization on the planet to achieve more”. Any of these sound familiar? These are obviously very inspiring missions, being big and audacious enough that they present multiple ways for the company to achieve their mission. Take Facebook and their mission of making the world more open and connected. Their acquisition of Instagram and What’s App, and move into virtual reality and even their efforts with Project Libra are all about making the world more open and connected.
Both types of optionality can offer some really compelling investment ideas and I’m always searching for companies in both spaces. However, when I find that rare company that has mission optionality, and if I get in early enough, I am likely to hold onto the stock for decades.
Optionality leads to multiples (e.g., P/S, P/E) expansion, which leads to growth in the stock prices. Expanding multiples are a good sign that investors are beginning to realize the company has a lot of optionality.
6. Buy quality
“You get what you pay for”. Of all the things this expression is used for, perhaps investing is one of its most true to form. Quality is very subjective. There are three characteristics I study to determine if a company meets the quality bar I set for stocks I invest in:
Does the company have a defensible economic moat?
Does the company have strong leadership?
Does the company have a margin of safety?
Defensible Economic Moat
A moat is a long-lasting competitive advantage. When a company has a defensible moat, they can generate strong and consistent profits. There are many ways companies can create a defensible moat – a strong brand, a patent, a low-cost advantage, high switching costs, or a much better product that is hard to replicate.
Facebook has created a strong moat due to the network effect it has created. People are less likely to leave the social network because most of their friends and family are on Facebook. Google has a strong moat because its search engine is simply better than anything else out there. Google beat out a dozen competitors in the then nascent search market back in the late 1990s. You might not remember other search engines such as Excite.com, Lycos, AOL, Go.com, Yahoo, AltaVista, Magellan, Infoseek, Webcrawler, HotBot, Open Text and Ask Jeeves. They were all left in the dust when Google came out with its search engine that simply blew them away.
Strong Leadership
When you are investing in a company, you are also betting on the ability of the company’s CEO and leadership team to deliver strong results. Look for companies with experienced leadership that has a strong vision and a track record of driving growth and navigating through tough times successfully. I also prefer companies where management has a material equity position in the company themselves. You can trust them to be good stewards of the company’s financial position given their “skin in the game”.
The question becomes, how do you as an outsider far removed from the company assess the quality of leadership at the company? Watching their speaking engagements where they lay out their vision can be helpful, but let’s face it, dynamic speakers can easily be mistaken for good leaders. The best way I know to get some insight into the quality of leadership at a company is to go to the source. What are the employees saying about the leader? Glassdoor is a public site where employees write reviews of the company and rank the CEO and a resource I rely on when evaluating company leadership teams.
Margin of Safety
This is a really important factor if I ever where to manage someone else’s money. It’s one thing for me to own riskier companies if I’m satisfied with the risk/return quotient. It’s entirely different if the money I’m considering investing in a stock belongs to a friend or family member. I would be mortified if I ran up a large loss managing someone else’s money.
To protect capital I look for companies with a margin of safety, which is a built-in cushion allowing some losses to be incurred without major negative effects. It is basically a safety net for investing.
In practical terms, for each investment I ask myself: What are the chances that an investment in the company will result in a significant capital loss over the next five years?
I want investments that I am considering investing in to have a low likelihood of a significant price decline five years out. I can withstand short term volatility but will walk away from an investment idea if it feels like there is too high a risk of significant capital loss.
To assess the margin of safety for a publicly traded company, I start with the two characteristics discussed above - a moat and strong leadership. From there, I look for low (or even better, no) debt levels, diversification in the geographic markets the company competes in, customer portfolio and/or product breadth. A leadership team with a strong track record of capital allocation will also instill confidence that the stock is unlikely to crater.
Another proven way of creating a margin of safety when investing in a company is to find the right balance between not entering a stock too early or too late. I’ll let famed investor Peter Lynch explain. He was a big baseball fan:
“Enter early — but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the lineup is announced, you’re taking an unnecessary risk. There’s plenty of time (10 to 15 years in some cases) between the third and the seventh innings, which is where the 10- to 50-baggers are made. If you buy in the late innings, you may be too late.”
- Peter Lynch
How do you know when it’s too early or too late? You want to see that the company has a successful formula and room to grow. In the case of Starbucks it meant waiting until they hit 100 stores, if you were so lucky to spot them at such an early stage of their growth. For technology-based companies it might be waiting until they have conquered one segment of the market or industry, with a clear path to crossing over into new ones. Or, maybe it’s waiting for success in a particular geography. Shopify is a good example. They had achieved success in English speaking markets when they started expanding into non-English markets by localizing their platform, offering regionally specific payment methods, and letting merchants list products in multiple currencies. These expansion efforts signalled new tailwinds and created more growth for Shopify and its shareholders.
7. Valuation matters
We don’t buy stocks in a vacuum. What could be a great company may not be a great stock investment because of a high valuation. Academic research shows that there is a negative correlation between valuation and share price performance, meaning that high valuation leads to lower future returns and vice versa. This research looks at the stock market in aggregate, not specific companies, or industry sectors. It is important not to generalize as all stocks are not the same. A high Price/Sales (P/S) ratio for an industrial company might signal an over extended or high valuation of the stock, but if a tech company had that same P/S it would probably be considered a deeply discounted stock.
When I evaluate a stock I consider its valuation in context – relative to its competitors, historical averages, and current market valuations. Even tech stocks with enormous growth rates that seemingly can do wrong can be overvalued. While I don’t want to buy overvalued stocks I also don’t want to miss out on a stock that still has a lot of room to grow. How many times have you heard “I wish I bought that stock when I looked at it last year, but I thought the price was too high at the time”. Be willing to pay for quality companies but at a fair price or for a reasonable premium.
8. Let your winners run
Multibaggers, especially the higher return types such as 10-baggers, do not happen overnight. It quite likely will take more than five years. If you want wealth altering stocks in your portfolio you must be prepared to hold for a long time and resist the urge to “lock in” profits when warranted. As an extreme example, imagine you bought Amazon after its fall during the dotcom bust period of the early 2000s. If you started your 2001 new year off by purchasing Amazon at its then rock-bottom price of approximately $18 and only sold when it reached 10-bagger status of $180+ in late 2010, you would have missed out on an additional 19X growth between 2010 and current day April 2021. That means not realizing an additional $324,000 on an original $1,800 investment.
There can be good reasons to sell and take profit. For example, if you foresee the winning streak coming to an end. Just be strategic about why you are selling or why you are letting the winner run.
9. Know where you are in market cycle
Let me be clear, I am not suggesting you try to time the stock market. I’m no fan of this fool’s errand. I’m a big believer in buying and holding. However, we must not turn a blind eye to reality and to achieve alpha we must use the market’s current state to our advantage.
Famed value investor Howard Marks captures this sentiment the best:
"We never know where we're going, but we sure as hell ought to know where we are. Where is the market in its cycle? Is it depressed or elevated? When it's depressed, the odds are in the buyer's favor, and when it's elevated, the odds are against him. And it's really as simple as that. You should distinguish between markets that are high in their cycle and markets that are low. You should vary your behavior on that basis. You should take more risk when the market is low in its cycle and less risk when the market is high in its cycle."
- Howard Marks, OakTree Capital
I love a great party, but I also know when it is time to order an Uber and go home. When the market is clearly in a sustained period of elevation, I will take action to realize profit in highfliers that are clearly overvalued at the time. This does not mean I necessarily sell my entire position in these companies, but I will acknowledge when there is little hope of a stock outperforming the market at current, elevated levels. Conversely, markets and stocks get over sold, creating opportunities to buy companies you love at deep discounts.
I probably could have saved a lot of ink by just quoting the great Warren Buffet:
“Be fearful when others are greedy, and greedy when others are fearful”.
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