So you wanna be an investor?
Know what it takes. Be prepared. The rewards are massive.
Being an investor is not as easy as it seems. Sometimes it feels like the weight of the world is on your shoulders. Like you are an athlete training for the olympics. In fact that is the best way to think about the life of an investor, like that of a professional athlete.
There are certain hard-earned skills and talents required in the path of a successful investor. The paradox is, it doesn’t seem that way.
Excuses & Easy Money
When markets are going up, it’s easy. You don’t need to do anything special to make money. The markets are going up and everyone is making easy money.
When markets are crashing, everyone asks “How low it can go?”. All you hear are excuses, pessimism and doubt.
When your positions are underperforming while overpriced speculative stocks are doubling every 6 months, all your hard work seems irrelevant. Reason and logic seem pointless when “degenerates” are making money hand over first.
You can always find excuses and rationalizations for not doing the required investment work. This is why most choose the path of easy money, but success turns out to be elusive.
“Take the high road, it’s far less crowded.”
Warren Buffett
The Retrospectivity of Returns
But when you look back at the performance of successful companies bought at reasonable prices, you won’t hear any excuses or doubts. Any past price drops will be regarded only as opportunities to buy more, no matter how scary the price drop.
All you will hear is the envy of those who did not benefit, with suggestions that they look forward to replicating that success. They are now hellbent on replicating that success.
No matter what they say, only few will manage to do so. But if you really want to be an investor — the following are an absolute requirement.
Take Pain
You have to be willing to accept volatility. You cannot optimize your long-term returns if you are not willing to see your positions fluctuate. Volatility is not risk, no matter what they say. Share price movements will never tell you what you need to know about a business.
And if you think the pain of volatility and massive P&L swings is the worst you have to bear, think again. Everyone will taunt you in your path as a great investor. If you haven’t bought the recent trend, you will be mocked. Have the discipline to avoid jumping on bandwagons, it’s a trap.
If you buy and hold something while it goes nowhere, you will be laughed at. No one will care about all the work you have done and your experience as an investor. They will take jabs at you and disrespect you, and it will hurt. You will question your whole existence and your future. But if your holdings still make sense, you have to be patient.
Boredom and waiting is also painful. But you have to be willing to wait for a fat pitch. While others around you are basking in the recently got short-term profits, you are just sitting there with nothing. If you have any investors, they will bully you because of it. Mostly because their friends are bullying them. It hurts looking at the market go up and up, while you just sit there.
“All of humanity's problems stem from man's inability to sit quietly in a room alone.”
Blaise Pascal
And if that were not enough, it’s important to remember that investing is like poker. Even if you hold the best cards, you can still lose money.1
Be an Independent Thinker
The market will never tell you what you have to do. Talking heads and news flow is mostly noise. A true investor focuses on the signal and ignores the noise. Being independent is notoriously difficult, but it pays the highest rewards.
“The payoff of a human venture is, in general, inversely proportional to what it is expected to be.”
Nassim Taleb
More than 99% of market participants make decisions reactive to the market’s movements. That makes them the market, even if they think they are something else. This notion is supported by how investors increase and decrease their exposure pro-cyclically.
“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.”2
But that price action will eventually reverse. How do you know when to buy and when to sell? For long-term compounding, random price action is not superior to intelligent business decisions.
Buzzwords like disruption, innovation or even disruptive innovation have nothing to do with the intrinsic value of a company. What’s intrinsic value?
“Ultimately, the value of a business is the present value of the cash it generates over its life. Even if the cash flows are disrupted in the short-term, if they are greater in the long-term, values will be higher.”
Bill Ackman
When the market is hot, you are paying a high price due to FOMO. When the markets are crashing and sentiment is ugly, securities are discounted due to FEAR.
The implication is that when you are jumping on the bandwagon of FOMO, you are paying expensive prices. As the trend of the time reverses, your profits will reverse into massive losses.
Be a Business Analyst
Equity investing is about buying businesses. You might think you know a business by looking at its recent price performance or reading a few articles — but don’t let that fool you. You have to do real work to understand a business.
You have to see yourself as a businessman and an investor. That means not being afraid of business, but loving it - as well as its ups and downs.
Business is all about value creation, and to understand the value creation chain you have to understand a company’s business model. Not all business models are made equal, so the best way to learn about businesses is to start studying them.
The only way to assess the intrinsic value of a business is to have an approximation of its future cash flows.
What kind of margins does the business earn? Do you expect that to change in the future? How much capital does the company require to maintain its current operations or for growth? Is it a capital intensive or a non-capital intensive business?
Does the accounting show the true economics of the business or is there a divergence? Is the business expected to have a stronger or weaker competitive position in the future? What longevity do the products or services of the business have? Can disruption kill this business or severely damage it?
Being a business analyst is as much about qualitative factors as it is about numbers. These are just some of the questions that need to be answered before assessing intrinsic value.
Sure, you don’t need to be accurate in this calculation and use discounted cash flows or mathematical models. But if you are not approximately right, you are liable to suffer material losses on your investment.
This is why a back-of-the-envelope calculation of a high quality is much superior to an elaborate financial model with low quality assumptions and inputs.
“It is better to be roughly right than precisely wrong.”
John Maynard Keynes
The consequence of that is that a good business man does not invest in anything and everything. If he is not able to establish a rough approximation of the future cash flows of the business, then he should stay away. There are situations when the price of the business is so low that you don’t need to know much about its future, but that is for another post.
Rounding it up
Looking back at the returns of solid investing, everyone feels like they want to replicate them. But only a small percentage of those willing replicators actually do the required work.
Formulas for success seldom exist but if I had to provide one it would be this:
GOOD INVESTOR = good business analyst + independent thinker + high pain tolerance + discipline + patience.
Molto bene!