REPUTATION AND INTEGRITY
Reputation and integrity are the most important assets. A reputation is gained over years but can be lost in a heartbeat. Warren Buffett’s recommendation is to not do anything that you wouldn’t want to see on the front page of your local newspaper.
DON”T LOSE MONEY
This is the Number 1 rule.
Capital preservation is paramount and is maintained by employing the “Margin of Safety” principle. In other words, one shouldn’t drive a 19,000 kg truck over a bridge that is estimated to handle up to 20,000 kg.
STOCKS = BUSINESSES
Only think of stocks as part-ownership in a business rather than a piece of paper whose market price wiggles around from day to day.
Only buy great companies at rational prices.
TIMEFRAME
ALWAYS think long-term. When evaluating a potential investment in a company, predictability is the key element. If you can’t foresee what the company will look like in 10 years, then it goes into the “too hard to value” pile. This is a very important concept.
DIVERSIFICATION
Diversification as demonstrated by most financial advisers leads to mediocrity
over 95% of volatility is eliminated after the 12th stock in an equally-weighted portfolio.
Too many stocks/businesses tend to dilute any advantage of generating better than average returns.
GREAT BUSINESSES
Only buy great businesses with a durable competitive advantage that are easy to understand (how and why are they successful?).
Also highlight the quality of management because there will be periods when a great business is run by a less-than-great management team.
Avoiding speculative investments outright will prevent any delay in the power of compounding returns.
COMPOUND INTEREST
Compound interest truly is the 8th Wonder of the World.
Patience, discipline and common sense are required to take advantage of compounding.
PRICE
Price is important but not as important as being in the right business!
Buying 1000 shares of Wrigley in 1985 generated 20% annualized returns ($2.6 M gain on $59,000 investment!)
Buying 1000 shares in Wrigley 3 years later (at a much higher price) in 1988 still generated 15% annualized returns ($808,000 gain on $69,000 investment)
Buying 1000 shares of Xerox in 1985? 7.75% annualized returns ($152,000 gain on $38,000 investment)
COSTS
Avoid transactional and other frictional costs (a 2% Management expense ratio (MER) takes away 2% per year of compounding (and one can see the impact of this compounding when looking at the Wrigley example above).
Buy and hold also avoids impact of capital gains tax. Remember that all gains are taxed (unless under registered plans such as RSP or 401K).
UNDERPERFORMANCE
Underperformance versus a benchmark such as the TSX or S&P 500 will be inevitable over periods of months, quarters and even over 1 to 3 year periods.
Coming from a different angle, if the market were really efficient and out-performance was not attainable then NO OPPORTUNITIES would ever exist. These opportunities rarely get recognized after only one week, one month or even over a year or two. So there will be times of underperformance (see ADHD, James Montier).
INACTIVITY
Inactivity does not equate to not doing the “work”. Only act/invest when the odds are in your favour and with a sufficient amount of one’s portfolio to make a difference over time. It is inevitable that there will be periods of time (possibly quarters and even years) where no activity will take place due to there being a lack of opportunities. This is a natural occurrence for a portfolio of companies one buys to keep (to take advantage of compounding returns).
Too many decisions increase the odds of making mistakes…..we don’t want to be forced into too many decisions. In other words, buy stocks/companies with the intent of holding them indefinitely (unless the original premise for buying changes or the market offers an insanely overvalued price for your business).
FUNDAMENTALS
The intrinsic value of any business is the Net Present Value (NPV) of all Future Cash Flows from the business discounted at an appropriate discount rate.
Calculating NPV is somewhat arbitrary since it is challenging to estimate future cash flows and the discount rate estimate is much too sensitive.
Only buy businesses that generate high returns on capital. This sometimes occurs as a result of a company having some sort of competitive advantage. Some companies will have competitive advantages for a certain time but competition gets attracted to these high return businesses. As a result the competitive advantage will erode over time. Other companies have a DURABLE competitive advantage. These companies tend to maintain high returns on capital for much longer periods. The advantage tends to be derived from a certain characteristic of the business (i.e. Coke’s Brand Name and Distribution System).
The difference between Competitive Advantage and DURABLE Competitive Advantage are like night and day.
PSYCHOLOGY
Success over time has just as much to do with psychology as it does the fundamentals.
All of this stems from viewing stocks as a part ownership of a business. The psychological impact from the noise of the market will be minimized when one thinks in this way.
One of the keys to success is TEMPERAMENT. Having discipline, common sense and focus will increase the odds of outperforming over the long-term.
Don’t let what happens to the stock of a company in the short term determine whether buying or selling was “correct”. Paraphrasing Ben Graham: You are not right because the market says you are right but because your data and reasoning are right. Also paraphrasing Graham: the market is not there to guide you but to serve you.
Discipline is the key. Only invest when the odds are in your favour and be aggressive when the opportunity arises (what Buffett calls the “fat pitch”).
In summary, in order to take advantage of the miracle of compounding, one must:
Minimize disruptions (#1 rule is don’t lose money),
Think long term (overcome short-term noise of the market)
and be disciplined, consistent and focused.
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