A few basic questions

In stormy seas, it’s good to revalidate what our true North is. One way to do this is by asking ourselves basic questions on how we think about investing & what that implies for how we should act now.

Investing is simple but not easy. Especially in times like this when it’s easy to forget the simple stuff. A sea of red, both real and marked-to-market, messes with our minds.

One way to revert to simple is to explicitly ask ourselves the most basic questions about how each of us thinks about investing. Each of us has an investment process that hopefully (a) gels with who we are, and (b) works over the long run. Revisiting tenets of that process can help clear the mind in murky times and strengthen conviction to act on the implications of that process.

I’ll illustrate through my own process, as if I am thinking aloud in Q&A format. If this is vaguely helpful, try the same exercise with yours. The same questions will likely hold but answers will be different, as each of us operates under different contexts, constraints and preferences. What matters across our answers isn’t correctness but internal consistency.

What am I trying to do?

I am trying to indefinitely own safe and good businesses purchased at reasonable valuations.

(Since no one says the opposite, this is unhelpful BS. Let me elaborate on key parts of my answer.)

What, specifically, am I trying to do?

Safe means that I avoid ruin. Say, bad people or bad neighbourhoods. Or where I just can’t figure it out. I’d rather avoid than price big risks.

Good is partly quantitative. My primary metric is return on capital. Over 20% for over five years is my rough bar. I’m not fussed about growth, but I’d like a business that has strengthened competitive position within its industry. Qualitative part involves a construct where goodness is likely to sustain.

If I am right about safe & good, my consideration set is limited to above-par businesses. Buying these at near-par or modestly above-par valuations seems reasonable. To gauge what is par without getting into false sophistication, mathematical chicanery or decimal points, a useful reference is that an average business has historically been valued at mid to high teens multiple of earnings over the long run. Valuation discipline is to avoid disastrous outcomes when I am wrong or shit happens.

What am I not trying to do?

I’m not interested in unsafe or below par businesses at any price.

Within what’s safe and good, I’m not:

·       Looking to pay any damn price just because I really like a business.

·       Waiting for an unreasonably cheap price either.

Where does current environment leave me on what to do and not do?

Everything’s fallen in price but a lot of it isn’t actionable.

Bad businesses getting beaten down doesn’t help me (e.g., bad bank below book).

At the opposite end, 80 PE falling to 50 PE for a ‘great’ business doesn’t help me either.

Valuations for my consideration set are mostly ‘less outrageous but too high for my comfort’.

In the middle, a (small) sweet spot of safe enough, good enough, reasonable enough is emerging.

Where do I spend my time?

All my focus is on that sweet spot. I revisit each business that’s near buyable, trying to make sure I haven’t missed anything on risk and quality. Since my process makes buying opportunities relatively rare, I also explicitly check if I am being too cheap. In times like this, it’s easy to lapse into “I’ll buy if it falls 15%” and then repeat the same line after it falls 15%. I am trying to be fully prepared with a price that strikes a balance between losing money and missing opportunity.

What will happen in the short run?

Anything. Any damn thing. I have no clue about short-term results of what I do and not do. Some of what I buy will surely fall (a lot) more. Some of what I held back on will take off like a rocket making me feel even worse. All I can do is to keep revisiting my basic questions at every price level for my consideration set. I don’t know of any method, mine or others’, that can reliably deliver good short-term results. I also believe that aiming for good short-term results jeopardizes good long-term results.

One side benefit of sticking to safe and good is that one is less likely to question business fundamentals just because price tanks. In weaker businesses that periodically require kindness of strangers, reflexivity complicates life.

What will happen in the long run?

Across decisions, I hope for outcomes that are more good than bad, with wipe-outs being rare. In aggregate, I hope for satisfactory returns, both absolute and relative. But it’s far from certain and there’s a decent chance it won’t work out at all. My only assurance is a vague comfort drawn from history and experience. Even if it works out, long run can turn out to be painfully long.

What will I miss?

A lot. I will not catch every great opportunity of the coming decade. I’ll not even come close. There will surely be shitty banks and dodgy unicorns among tomorrow’s rockstars. Many a 50 PE will look cheap in hindsight, like in those cherrypicked back-tests. I’m not aiming to capture every likely winner. I’m aiming to do my best within what works for me.

More generally, focus is central to any sensible method. We have to zoom in on a subset of opportunities that fit into our way of thinking. What’s left out is usually way larger than what’s in. Straying outside our focus area implies that we either don’t have a method or will implement it poorly. Living with FOMO and envy is part of our job description.

How do these questions help?

Reassurance.

Everyone knows what to do. Problem lies in sticking to it in scary times. If we’re at peace with our chosen approach, we’re less likely to lose our nerve or try to become someone else. Explicitly going back to basics helps me be more at peace with my chosen approach and act in line with it. I’m less likely to be consumed by immediacy and noise.

In stormy seas, it’s good to revalidate what our true North is. It’s still scary but we’re at least pointed the right way.

PS. Like with the rest of my essays, there’s nothing new here. That’s exactly the point. There’s nothing new about sensible investing either. It is just packaged common sense which has been eloquently articulated by a few greats over many decades. There is nothing to add. The trouble is that what’s timeless somehow doesn’t stick. It is said that investing is about remembering the obvious, not grasping the esoteric. This essay is just one more reminder of the obvious.