By: Greg Speicher

#7: Avoid Hot Industries with No Barriers to Entry

A Lex column in yesterday’s Financial Times, “Solar: the sun also sets”, is yet another stark reminder that a growing industry does not necessarily make a good investment.

The solar panel industry is expanding rapidly as measured by worldwide megawatts of solar panel shipments. By that measure, business is up approximately sixteen fold in the past five years.

In stark contrast, solar energy stocks, as measured by the Mac Solar Energy Index, are badly trailing the S&P 500. The problem is overcapacity and cheap products coming out of China. One casualty, Evergreen Solar, just filed for bankruptcy protection.

Investors are easily enamored with hot industries with seemingly unlimited growth opportunities. However, in many cases, the businesses in these industries do not have any durable competitive advantages. Competitors pile in and drive margins into the ground.

Society may be the ultimate beneficiary if competition drives down prices far enough for solar power to compete with fossil fuels, particularly if it can be done without subsidies. Investors in this sector may not be so lucky.

Steer clear of hot industries with no barriers to entry. Don’t invest in a business without a moat. Pay attention to whether managers gets this and what steps they are taking to strengthen their hand. This may be the single most important factor if you are a long-term investor.

#8: Have the Right Psychological Framework Regarding LossesIt is common in market downturns to hear and read about mounting investor losses. Pundits talk about the hundreds of billions or even trillions of dollars of wealth that have been wiped out. Of course, some real wealth is wiped out in market downturns as overvalued stocks come back to earth and when investors lock in losses by selling as a result of fear or a liquidity crunch.

Ben Graham taught us a better way in The Intelligent Investor. ”The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price speculation.”

To be a true investor has some requirements:

1) That you can reasonably value a prospective business before making an investment.

2) That you don’t overpay.

3) That you consider yourself a part owner in that business.

4) That you have enough cash from income or savings to not be forced to sell.

5) That you avoid leverage.

Perhaps most importantly, you need the right emotional framework to not panic when everyone around you is losing their head. There is no shame in feeling the pangs of fear when facing stiff quotational losses. We can’t undo the way we are wired. We can, however, choose our response to a given emotional reaction. As Steven Covey teaches, ”Between stimulus and response there is a space. In that space lies our freedom and power to choose our response. In those choices lie our growth and our happiness.”

#9: Cash is King!One of the realities that makes value investing possible and profitable is that market prices vary more – sometimes much more – than underlying business values. Joel Greenblatt is fond of illustrating this point by getting out the newspaper and showing his students the huge variances in prices between 52 week highs and lows. This, of course, is also the lesson of Graham’s famous Mr. Market parable.

To take advantage of these opportunities requires cash.

You not only need to have cash on hand to provide reasonable buying power when the market goes into a funk, but also you need to have enough cash on hand to never be in a position of needing to raise cash in a down market by selling your undervalued holdings. If you don’t have any cash, you won’t be able to profit from Mr. Market’s gifts. If you need to sell your holdings in a severe market decline, you turn your primary advantage as a value investor on its head and make it work against you.

There is no precise formula on how to do this but a few common sense principles should go a long way.

1. Have sufficient liquidity from income and savings that you can go three to five years without needing to tap into your equity holdings.

2. If one of your holdings becomes materially overvalued – thereby discounting years of the most optimistic expectations for progress in the underlying business – sell it to restock your cash position.

2. Maintain a meaningful portion of your portfolio in liquid form so you have buying power when opportunity presents itself. This is not to say that you should never be fully invested, but the bar should be set pretty high for you to part with that last 20% of your portfolio held in cash. The prospective investment should be screaming at you, and you should be fully cognizant of the opportunity costs of committing these funds.

3. As a complement to point 2, consider a meaningful investment in companies such as Berkshire Hathaway (BRK.A)(BRK.B) that have the ability to buy opportunistically on your behalf. For example, Berkshire has a huge cash stock pile of around $40 billion, annual earnings power of approximately $12 billion, ready access to funding, and – most importantly – the skills and attitude to put it to work when opportunity presents itself.