Rufus: Portrait of an anti-investor.
The story of Rufus the amateur investor and how he was so wrong by being so right. You need conviction to make money. Volatility is a constant in the financial markets.
Investors nowadays aim to achieve investment success by trying to jump on the next hot trend that the markets may throw at them, without really doing the work to assess whether it’s an opportunity or a trap. The primary motivator of their investment interest seems to be price action and not fundamentals.
Besides the well-known human emotions (fear, envy, greed etc.) that enter the mix and “push” participants to buy at ever-increasing prices and sell at ever-decreasing prices, one could also argue that investors just don’t care about value considerations. The immediacy and urgency to make money trumps all.
Contrary to public opinion, research reports by investment banks and the like do not serve to increase sensibility in markets. Instead, they too surrender to the whims and fancies of stock market participants. Look no further than the recent example of research analysts proclaiming the mea culpa of their previous Tesla convictions and throwing in the towel.
Unfortunately, their change of conviction was not marked by corresponding changes in fundamentals – but rather due to dramatic changes in the share price! It seems that the tail is wagging the dog and not the other way around.
If reputable research analysts change their assessments of a security simply because the stock market is disagreeing with them – then I would argue that they are completely unreliable as investment indicators and can only be utilised as contra-indicators.
Granted, the reasons why research analysts are not as “perfect” as one would expect them to be are several and range from general political dynamics within the investment business, to pressures from investors to issue research that actually performs in the short-term. This structure leaves research analysts jumping from trade idea to trade idea, investing for the next quarter and hoping to catch a good one and keep punters happy.
This leaves a massive gap of opportunity for the investor willing to do the work and deploy capital with conviction. The market is so quick to discount security prices due to any sort of fear or worry that may grip markets or specific companies from time to time.
Your job as an investor is to figure out how much of that worry is true (if at all), and then allocate your capital accordingly. Your job is to undewrite the risks that the market prices in, by exchanging your cash for a given security at a given price.
There are times when the market’s underwriting mechanism (i.e. the valuation engine), breaks down and misprices a security enough to give you – the prudent investor – an opportunity to invest with a sufficient margin of safety. When that isn’t the case and the market’s valuation engine is overly optimistic of the future or just plain foolish, you are better off staying put until further notice.
Trying to guess where each stock or trend is going to go is like rolling dice.
But you ask, what if I get lucky and hit a home-run?
The problem with getting lucky is that you will most likely believe it was skill and not luck that gave you the result. That is dangerous territory to be in. This is what typically happens in a prolonged bull market.
The average investor manages to double or quintuple his money someway or another, and he never shies away from boasting to his friends about it. “I bought So & So at $30 a year ago and it’s now at $100!”, he shouts with excitement. “You could see the company was going places with all these stores they are opening.”
His friend Rufus cannot help but get a bit envious of his success, and ask, “Do you think it’s going higher?” – “Oh Yes!” he proclaimed, “It has a lot of room to go”.
He considers investing as well but decides not to as he doesn’t know enough about this company to invest, until after 3 months later when they meet again and his investor-friend asks with please, “Did you buy So & So?”. Rufus replies negatively.
He erupts nervously, “Are you stupid? I told you to buy! It’s up another 100% since then!”. At this point Rufus’s cognitive and impulse control functions fail completely in the face of his friend’s scolding and the easy profit he has seemingly achieved.
Rufus goes home to his wife and announces to her that they would be making a substantial investment in a high-quality business with a lot of room to grow in the future. That investment would be shares in So & So.
She gets excited about the tremendous prospects for profit and can’t wait to boast to her friends that they would be investing in SNS at $200 a share. When they ask the reasons, she basically replies that it’s a “sure thing and it’s going up”.
They all move in to invest considerable amounts of their savings at $200 and enjoy profits as the price goes to $240. They become extremely pleased with their investment process and acumen in arriving to the conclusion that they should invest at $200, while getting a bit overconfident as well. “Honey, I think I’ll buy some more SNS, there’s no point in having our cash just sitting there with no return whatsoever”.
He doubles up at $240, taking his average price to $220. Why shouldn’t he? The stock market has proven to him that this is a good company and that he is a good investor. Besides, a top-tier investment bank initiated a BUY rating on the company with a target price of $600.
In the following next quarters, the stock continues to do well as more and more of their friends decide to buy shares in SNS, until one day shares peak and start to turn south. The share price drops 30% in one month. Apparently a research analyst somewhere published a report that stated that the company was using aggressive accounting to prop up its bottom line.
Shareholders disregarded the news as low quality hearsay and decided to hold on for the bounce back to higher highs. Another month passes by and the share price is another 30% down, many people are now underwater on their investment – and they are starting to get jittery.
Analysts that issued a buy on the company are now starting to feel the heat from their clients and the market’s swings – quietly they start to lower their price targets or take back their buy ratings.
“What’s going to happen with SNS?”, Rufus and the others start to ask around. “Oh, it’s going to go bankrupt”, someone replied. They impatiently enquired as to the source of this information.
“A banker friend told me”, was his reply. They decided to sell en masse and save what they could from the tragedy that was about to unfold. They all called their brokers hurriedly and offloaded their shares, causing a further drop in the share price in the process.
Meanwhile the company had to take action about the analyst report that contended they had been engaging in aggressive accounting to cook their books, as indeed they had been. They decided to take an impairment charge of a material amount and start afresh. They announced this a few days later amidst a continued share price drop. For some reason the share price bottomed on the day of that announcement.
The recently departed shareholders took no note of this as they had gone back to their normal, non-shareholder lives. A year later, Rufus saw a newspaper article entitled, “SNS hits new-highs”. He grabbed the newspaper forcefully and quickly turned to the relevant page – he discovered that SNS had continue to expand its business and earn more money. In fact, SNS initiated a buyback and bought some shares back on the cheap during its bad spell, creating more value in the process.
He was flabbergasted. He thought SNS was a sinking ship. He called up one of his non-shareholder friends that followed him on the stock tip to tell him the bad news. “I bought that stock at $200, sold at $100, and it’s now at $350” he cries. “How could we have been so unlucky?”
His friend replied,
“The fault, dear Rufus, is not in our stars but in ourselves, that we are underlings.”
What did Rufus and friends do to deserve this?
They acted on stock tips with no prior research or knowledge of the security in question or even of the person making the tip (when they bought).
They continued to transact in the security while they remained themselves uninformed of the details of the investment (when they sold).
Slaves to their emotions, they bought and sold shares at the worst times.
They had developed no investment strategy or mindset before making the investment.
They looked to price action as a guide (both on the way up and on the way down).
They looked to trade a company’s stock to make a quick buck rather than seeking to become a long-term investor in a company.
They followed guidance by investment banks and other institutions with interests misaligned to their own.
Awesome post! That really resonates, you absolutely have to do the research yourself in order to get the conviction to hold through volatility to achieve significant returns.
That said, nothing goes up forever and it's difficult to know when to sell, especially if a position is a multi-bagger success. Even more so if it is a group of stocks all within the same sub-sector (e.g. oil stocks at the moment). How to detect a regime change and differentiate it from normal volatility? That is the question I am currently thinking about.
excellent post :)