Net Net Investing
Have you been to the casino lately?
I haven’t, yet I gamble with my entire life savings nearly every single day.
I’m not talking about online poker or horse racing – I’m talking about gambling with stocks. And, instead of buying the lottery-type stocks that you think I’m risking my money on, I’m playing a game of chance that I’m virtually guaranteed to win the longer I keep playing.
Let me explain…
Don’t Ignore Lady Luck
Investing is a game of chance. As an investor, you can dramatically boost your returns and limit your downside by playing that game well.
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Michael Mauboussin of Legg Mason says that you can order activities on a scale from those that have outcomes that are completely based on skill, and those that are completely based on luck. Building handcrafted furniture, for example, comes very close to being an activity with an outcome that’s totally based on skill. The way a carpenter holds his blade, measures the pieces for his cabinet, shapes the arch of the cabinet’s mantle, and layers the textures of wood within the final piece all have a major effect on the finished product, the outcome.
The outcome of playing the lottery, on the other hand, is nearly totally based on chance. There is little that you can do to influence the eventual outcome — unless you live in some crooked 3rd world country. It doesn’t matter what numbers you pick, what day you buy on, or even really how many tickets you buy — your eventual outcome is unlikely to change much no matter what you do.
Investing falls somewhere between those two extremes. Investing is definitely not purely a game of chance, since there are master investors who have beaten the market again and again over a large number of years. Accounting for their success as pure chance gets into absurd levels of probability.
On the other hand, investment returns are also somewhat divorced from the amount of skill you bring to the table. It’s just not the case that losses will stop completely if you bring enough skill to your investment operation. Warren Buffett is about the best investor in the world, yet he just recently lost close to $1 billion on Energy Future Holdings.
Luck, or chance, is a fundamental aspect of investing and one that you have to accept if you’re going to succeed.
Think you have the perfect investment thesis? Think again. Any number of unknowns could blindside you, derailing your gravy train to Profitville. It’s these unknowns, the things that you can’t control or anticipate, that prevents investing outcomes from perfectly reflecting investing prowess. Any of these unknown factors could, and often do, effect your eventual outcomes.
Focus on what you can control — like buying really cheap stocks — and ignore the rest.
Chance does not handicap your ability to make exceptional investment returns, however. You just have to have the right attitude towards investing.
Since so many things are outside of your control, you really have to spend your time focusing on the things that you can control that will have a big impact on your eventual returns. Understanding this fact and how to use it to your advantage is key to playing this game of chance well.
Focus on Controlling the Value Investing Process
Absolutely critical to your success as an investor is to stop focusing on achieving a high return. Your can’t control your eventual returns but you can control what you do to try to achieve those returns. Just focus on the investment process itself, and the returns will come.
If you set a goal to achieve return much higher than the market, on the other hand, then you could easily fall into a financially dangerous psychological trap. Suppose you aim hit a return that’s 5% above the market every single year. If you start falling behind the market, you’ll start to feel a psychological pull — a bit of self-induced pressure — to start taking bigger risks. You might not stick with companies that have low debt ratios, for example, or you might start placing bets on stocks the investment community thinks have a lot of promise. More risk, though, erodes returns over time. Instead of bring in that large windfall you expect you could see your invested capital cut in half.
I don’t think you should stop aiming for high returns. Just don’t make those returns your goal. Instead, your goal should be on improving, refining, and better executing your value investing strategy or process. In other words, aim to continuously refine and improve both your investment strategy and your process for picking stocks then let your excellence in those areas generate outstanding returns.
As a value investor, you know that there are a number of ways to implement a great investment strategy. But by far the best, in my opinion, is to fine tune a mechanical value investing strategy — buy a basket of cheap stocks and then hold those stocks until some sell criteria is met.
How to Gamble Your Life Savings Like a Pro
Why cheap stocks? Simple: Cheap stocks have been statistically shown to outperform the market over the long run.
The best gamblers in the world know how to exploit systemic anomalies. The best gamblers in the world can look at a system, see the weaknesses inherent in it, and then exploit those weaknesses through well-placed bets. A poker player, for example, has to understand the probabilities of getting certain hands and then act on those probabilities, placing sizable bets when he’s likely to be right.
He won’t be right all the time, however — that’s where the element of chance comes into play. But, he will be right more often than not… so the more bets he makes the more likely he is to collect his fair share of profit over time based on the strategy he’s using.
Bringing it back to value investing, investing in cheap stocks means taking advantage of a systemic anomaly in the market place. Cheap stocks, as a group, outperform their peers on average over the long run. So long as you invest in a large enough number of cheap stocks, repeatedly placing bets on cheap stocks will help you collect your fair share of profit from that market anomaly.
How to Improve Your Value Investing Process to Improve Your Returns
Cheap stocks provide great returns as a group, whether you’re looking at low price to PE, low price to book value, low price to cash flow, low price to dividends, or low price to sales. Any of these strategies will produce returns in the mid-to-high teens, which is a great deal more than the stock market indexes themselves have returned over the past 100 years.
To make sure you capture your fair share of those returns, or even push your average annual gains well above those figures, you’ll want to improve two key areas in the investment process: psychological biases and implementing your strategy.
You should be looking to eliminate any inefficiencies of biases in your investing process so you can actually achieve the returns associated with your particular strategy. Emotional and cognitive biases often trip up investors. Failing to invest in a falling stock due to fear, for example, is a great way to erode your investment returns.
Start eliminating your own psychological errors early because shaping your own temperament is not easy. One book that helped me tremendously was Daniel Goleman’s Emotional Intelligence. David Dreman’s books are also a great way to gain a large picture perspective that is invaluable during market turmoil.
The second area you should aim to improve is in your chosen strategy and how you implement it. If you pick the best performing investing strategy then you’ll achieve much higher returns. That’s why I’ve opted for Benjamin Graham’s classic net net stocks strategy — it’s the ultimate cheap stocks strategy. No other value investing strategy can match its long verified history of exceptional returns. While other strategies based on cheap stocks can yield returns in the high teens, Benjamin Graham’s net net stocks strategy is the only strategy I know of to consistently perform in the 25-35% per year range over the long run.
But even this strategy can be improved. While net net stocks in general have great returns, not all of them work out. To improve my own investment strategy, I’ve taken to using additional criteria to weed out the lower probability stocks, thereby cutting out a lot of the under-performers from my portfolio. What I’m left with is a group of cheap stocks that have a much stronger probability of achieving fantastic returns.
Take a look at what other factors have been associated with outperformance. Within the world of net net stocks, the stocks that are the smallest, the cheapest relative to NCAV, and have the least amount of debt in relation to equity have consistently outperformed. That’s why those stocks make up the bulk of my portfolio.
I’m constantly looking for other factors that help me distinguish the best of the best investments. You should be too if you want world-class investment returns.
Are You Gambling Your Way to Profits?
You should be — so long as you gamble intelligently by exploiting systemic anomalies. Since you can’t eliminate the impact of chance altogether from your investment returns, focus on the things you can control by fine-tuning your investment process, including your own psychological makeup. Investing is simple, and taking this route to investment returns will virtually ensure that your long term record is fantastic.
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