Know the Right Thing

When did those trees turn green?

Anyways, I just finished One Up on Wall Street by Peter Lynch (download pdf here). It is a good book accessible to all levels of investors to read. I learned something from this book. If you are a beginner, it is quite dangerous to believe everything said in the book. Ultimately, you’d want to develop your own investment philosophy.

For example, Peter Lynch only likes businesses that have good prospects, which does not go well with my philosophy in that a company does not have to be great as long as there’s a comfortable gap between the price and the value.

Perhaps I’m still a noob because I found it hard to stick to my own philosophy when reading his book. I even tried to modify my investment philosophy. I guess the only way to avoid the conformism is to read more books written by different investors who have different styles so that you can concoct something for your own sake, something that works the best only for you.

It is helpful that Lynch has helped us categorize companies under six baskets:

  • Slow growers: companies in mature or declining industries that don’t have much growth potentials, but they probably have strong cash generation to yield dividends.

  • Stalwarts: think Coco-Cola. These are time-tested companies that have wide moats and still growing at a moderate pace.

  • Fast growth: as the name suggests, these companies might find a good formula that can be replicated to expand their business. I bet it’s hard to find a good bargain in this type of company. But we can value them by estimating TAM to see what the ultimate market share they can reach.

  • Turnarounds: might be undergoing bankruptcy or difficult operational challenges. It takes skills to bet on troubled companies. If companies can achieve turnaround successfully, then the reward should be quite satisfying.

  • Cyclicals: sadly, if you think we are near the top of the cycle, you’d have to wait for the decline. These would be companies that are affected by supply and demand and commodity prices.

  • Assets Play: real estate, TV businesses, cruise liners, or anything that generate cash from assets. Opportunities exist when people discount the stock below what all the assets worth. Or there might be hidden assets to be discovered.

The question is, should you look for all companies across these categories or just focus on a few categories? Note that Peter Lynch owns 1400 stocks, which is quite a contrarian approach for value investors. I personally favor concentrated investment strategy because I can dedicate more time and energy into each of the businesses. In the book, Lynch suggests that it takes only a few hours to research a company. If that’s the actual average amount of time he dedicates for each investment, no wonder that he can own 1400 stocks.

For some of us who love to learn everything about a company, it might take more than a week to get to know the company. So, on this ground, I still adopt a concentrated approach. However, here comes a dilemma. One can maximize profits using a concentrated investment approach through significant stake holdings or activism. Since you have all the time and energy for a few companies, why not just get involved in those businesses’ operations? But to do that, you have to have enough capital, which I don’t, and I doubt many of you do. If we hold thousands of stocks like Peter Lynch, it can be difficult as well because we are not professional stock pickers. We have 9-to-5 jobs that simply limit the number of companies we can research and invest in.

More, time has changed dramatically for our access to information. Now, good opportunities are rare because open data and the internet allow us to develop those fancy no-brainer screeners. And our financial services industry is more tolerant of smaller firms, too. We have so many independent research houses that do not have institutional limitations. So, it becomes hard to find a good company that has not been well-covered. We now spend more time on screening and sourcing ideas than on researching.

The upside, though, is that conformism still exists on Wall Street. A company covered by multiple analysts might still be a good opportunity if most of those analysts have misunderstood the company. Those sell-side analysts make money selling reports, not from investment profits. So they are not really incentivized to dig very deep into companies. And they are usually short-sighted. Because it’s easier to model short-term financials, and people love certainty. People love numbers. Many sell-side reports really just summarizing quarterly financials, and investment theses are basically a duplicate from companies’ IR presentations.

While it is reassuring that opportunities still exist, it has become increasingly hard to gain an edge. First, there are so many educational materials out there. Before Benjamin Graham, how many books about value investing are there? Now, even kids from elementary schools have heard of value investing. People are more educated on the topic than they used to. And business schools are designing value investing courses into their programs.

From a skillset perspective, our counterparties are much smarter. Think about those MBA grads and CFAs. They have probably devoured every value investing book, every Berkshire Hathaway letter, every Howard Marks memo, and most of the stuff accessible to the public. I guess a critical factor for success is temper. Like many legends have said, you don’t need to know everything about a business. You just need to know the right thing.

It sounds simple, but it’s tough to implement. How do you know that you know the right thing? And how do you know the right thing? Temper plays a big part. In my opinion, value investing is not just a style. It is a way of thinking in life. It takes patience, humility, open-mindedness, and persistence to succeed. You have to keep learning and reading different subjects to enrich your mental framework when it comes to analyzing companies. The more dimensions you have in your framework, the closer you are to the right thing.

Imagine you have a box on a table. If you just look at it from one side, you’d conclude that it’s a square. From a different side, you might say it’s a rectangle. But we can only know it’s a box when we have looked at at least three sides of it. And that’s just the bare minimum. What if one side of the box is hollowed out? And what happened to that hollowed side? Do you see what I’m trying to get at? If we only learn finance, we might be able to interpret accounting concepts. But everything’s connected in this world. By learning different subjects, we can look at the box from more perspectives. 

I’m not saying that you should know everything in the world. That is not possible, and it’s not the point. I’m saying that your mental framework must be developed by piecing different analysis methods from different subjects together. In science, we might start by coming up with a hypothesis and set up control and experimental groups, and so on. But in philosophy, we might have different ways to look at things. In music, everything flows and goes up and down like a cycle. Like breath.

We can only ask relevant and good questions when we know that we are looking at a box with one side hollowed out. If our narrow mental framework concludes that we are looking at a square, then we will never ask the right question. We will never find the right answer.

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