Conviction

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Conviction
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One of my favorite quotes states that you can borrow someone’s ideas, but not their conviction.

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Q3 2021 hedge fund letters, conferences and more

Mohnish Pabrai On Value Investing, Missed Opportunities and Autobiographies

Mohnish PabraiIn August, Mohnish Pabrai took part in Brown University's Value Investing Speaker Series, answering a series of questions from students. Q3 2021 hedge fund letters, conferences and more One of the topics he covered was the issue of finding cheap equities, a process the value investor has plenty of experience with. Cheap Stocks In the Read More

It is a great quote, because it deals with a problem that many investors face. Some of us may be taking tips from others, and may be investing money in companies, without really doing much research. This is a dangerous position to be in, because you are outsourcing everything to another person. You need to get to a point where you have an adequate investment plan for action. Thus, when things change, you would know whether to hold or to fold.

I tend to spend time looking for ideas, either through screening, reviewing my investable universe, reading and interacting with other investors. However, I always try to put each idea and filter it in a way that makes sense for me. That way, I can take personal responsibility for my actions, and take the next step of learning and growing as an investor from there.

I have been investing in Dividend Growth Stocks for about 15 years now, and have learned to try and devise my own set of guidelines that would do the heavy lifting for me. One such guideline has been to review my own investments that I have made. I believe that the ability to review historical transactions is very beneficial for investors, because it can help identify gaps, and improvement opportunities.

Flexibility And Adaptability Vs Conviction

In my analysis of my own investments, I have noticed that I cannot really tell in advance which specific company would be the best performer in terms of total returns, or future dividend growth over a set period of time like ten years for example.  I have looked at some ideas I posted about in 2008, and then the list of aristocrats from 2011. I did not know that one of the best companies would be Lowe’s for examples. But, by owning a diverse portfolio of companies, I had a fair share of winners that compensated for the losers. I did ok, even if I made some mistakes along the way, such as selling perfectly good companies and replacing them with cheaper value traps. Of course, I do try to pick many quality companies, and hold on to them for as long as possible which helps. Hence, I am a fan of diversification, and dislike concentration. I do not know what my top 10 ideas would be, though I presume they would be in my diversified portfolio of 50 – 100 quality securities. Based on my experience, my best performing ideas turned out to be outside my top 10 or 20 convictions.

Analyzing past actions is a very humbling experience, because it shows me that we can have all the information in the world, but that doesn’t mean that we would be right all the time. Hence, I do not believe in having conviction in investing, because it may potentially lead me to overconfidence, stubbornness and inflexibility. I believe that apart from having a few principles, conviction can be dangerous for most investors. It is good to have conviction to hold through the hard times assuming that they do turn, but you also need to know when the situation has changed and you need to move on. I believe that flexibility and adaptability are more important than conviction. That’s because if I am convinced of something, I risk ignoring contradictory information, so I may end up just being plain stubborn and lose money. That’s the risk I am trying to avoid of course.

In general, I assume that my investing universe would likely have a group of outstanding companies that would deliver outstanding returns. I just have to ensure I include them, and then hold on to them. I just don’t know which specific company would be the best, and which would be the worst. The goal is to just follow my strategy, letting winners ride, and keeping losses relatively limited.

This means I should not invest based on my opinions, but follow my strategy into long term trends.

It also means that I don't micromanage businesses, or create narratives. I should simply follow the performance of the business, not my opinion of it. In my case, it is as simple as just sticking around for as long as the dividend is growing, and not being cut. On average, this has been a winning strategy in the past. You won't be right on every investing decision, you may be whipsawed, but as long as you keep losses small and maximize winners, you stand a chance to make a profit.

This goes along with my favorite quote from Buffett:

Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. 

Minimizing Losses

Actually, I believe that to succeed in investing, one should start with the mindset of risk management and try to look for ways to minimize losses, rather than shoot for the stars. In other words, I believe that the upside would take care of itself, but it is my job as a portfolio manager to manage downside risks.

The first way that I manage risks is refusing to risk more than a certain percentage of total portfolio value on a given position.

I believe in diversification, which means not putting all my eggs in one basket. I also do not believe in concentrating my portfolio in my best ideas, because I do not know which of my ideas today would turn out to be best ideas in 2031. I have a rough estimate, but I also want to assume that I may make mistakes, that the world is uncertain and more difficult to understand than previously believed. This is how I come up with a list of 30 – 50 companies at the very minimum. This means that I shouldn’t really have more than 2% - 3% allocated in a given company.

If a stock goes to zero, the most I would lose is 2% - 3% of portfolio value. However, I am still in the game, and I hopefully have the other positions to carry their weight, and overcompensate for losses suffered with their gains.

I often hear the rebuttal that Buffett liked to concentrate their portfolios, and succeeded. Of course, I am not Buffett, and I would argue that you are not either. Today, Berkshire Hathaway is very well diversified, with a stock portfolio consisting of 44 individual holdings, as well as an operating business that consists of more individual businesses. I would much rather have slightly lower returns, but compound capital and income for decades, than earn more but at a higher risk of losing a large chunk of my portfolio on a concentrated bet. It’s insane to risk what you have for something you don’t need.

While Buffett may have been more concentrated during the 1950s and 1960s, he still held at least 20 - 30 investments. Most importantly however, he diversified into several investing strategies such as generals (undervalued stocks), workouts (M&A, spin-offs, liquidations) and control situations (activist investing). (source)

Following Long-Term Trends

The second way that I manage risks is by following long-term trends, and exiting when they end.

As a Dividend Growth Investor, I buy companies that have a certain track record of annual dividend increases. My idea is that a body in motion would stay in motion until something changes. I buy a stock, believing that certain business conditions exist for the business ( moat, competitive advantages, you name it), and the rising dividend is an indication of it. I then hold on to these companies for as long as possible, through thick or thin. I follow the companies, but would keep holding for as long as the dividend is not cut. I would consider adding to a position that is below my 2% - 3% cost threshold, for as long as it is still raising dividends, and those dividends are supported by strong fundamentals. But, if that company freezes dividends, I would not add to such position. This is basically a yellow light, a warning sign that things may not be going as well as what my initial thesis told me. It means I need to research further what is going on, but not take any action yet.

Once a company cuts dividends, that shows me that my original thesis was violated. I bought a company, expecting that the good times that generated its track record of annual dividend increases would continue. When the music stops and the dividends are cut, it is a good wake up call that things have changed. Perhaps this is a short term situation that would be resolved, or perhaps this is the beginning of the end. I sell and put the money elsewhere, because conditions have changed. It is very likely that I am selling at a short-term bottom, and the stock would double or triple from there.

That doesn’t matter.

I make my money on businesses that grow and keep delivering. I make my money on businesses that I do not need to micromanage. I don’t make my money on guessing whether the stock price would go up or down in the short run.  In a given portfolio, most of the gains would come from a small portion of companies. That’s why it makes sense to identify strong companies, and then to hold them, through thick or thin.

A rising dividend payment means that things are going ok in general. I will keep holding, through dividend rises. My goal is to follow long-term secular trends, that may last many years and hopefully many decades. The goal is to get on the elevator, and just stay on it, not second guess it on every move.

Investors generally have a hard time holding on to winners for various reasons; could be because the stock looks “expensive”, they are told it is a bubble, some other company may look cheaper, some temporary weakness is blown out of proportion, the stock price may not go anywhere for a few years, etc etc

The mental model of just sticking to a position while the dividend is still growing is very powerful. With this mentality, I can afford to focus on the evidence of growing dividends, and keep holding. While some companies may end up cutting dividends and I will end up selling them, a portion of them would end up in the portfolio for decades. These will be the winners that would cover for mistakes and losses, and hopefully result in a profit. Oh, and selling those companies early for no good reason would be the difference between making money and not making any money.

Focus On Fundamentals

Third, I focus on fundamentals when I buy companies. In general, I tend to look for several factors, playing together.

  • Rising earnings per share over a period of 5 – 10 years
  • Dividend increases that outpace inflation
  • Dividend payout ratio that is sustainable and mostly in a range

If a company can grow earnings per share, it can afford to pay rising dividends down the road. If it doesn’t, then it is likely that the business may not be a good fit for my portfolio for the time being. I tend to also look at valuation. However, I do not have a formula for it. I look for P/E and dividend growth, and I compare existing opportunities in my opportunity set. I also look at the stability of earnings, cyclicality and dependability.

I believe that even if I may overpay a little for a good company, rising earnings per share would ultimately bail me out. On the other hand, if I buy a company with declining earnings, even at a low P/E it may turn into a value trap.

Building Positions Slowly

Last, I tend to build my positions slowly. I tend to buy a starter position, then add back a little later. I have done this, because built my net worth slowly and over time. I saved a portion from each paycheck I ever earned, and invested it.

The downside of this approach is that in a raging bull market, I would usually end up paying higher and higher prices. This shouldn’t be a problem, if the business also grows over time.

The upside of this approach is that I have time to react to changes or to information that shows me that my original analysis may have been wrong.

Today, I discussed a few simple ideas on how to survive and thrive in the investing game.

I believe in a few principles, that are helpful:

  • Diversification
  • Not risking more than a certain percentage of portfolio value on a given company
  • Managing risks by following long-term trends
  • Focus on fundamentals when reviewing a business
  • Building positions over time
  • Being adaptable and flexible

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