Admission Open: Value Investing Workshops – Offline (Mumbai) and Online
1. Offline Workshop: Mumbai – After a gap of 2 years, I am back with my live, offline Value Investing workshop. The first session is planned in Mumbai on Sunday, 22nd January 2023. I am accepting only 50 students for this session, and less than 10 seats remain now. Click here to know more and join the Mumbai workshop.
2. Online Workshop – Admissions are also open for the January 2023 cohort of my online value investing workshop. The workshop involves 22+ hours of pre-recorded, detailed lectures and Q&A sessions, plus a 3-hour live online Q&A session scheduled on Sunday, 15th January 2023 (tomorrow). I am accepting 50 students in this cohort, and less than 5 seats remain now. Click here to know more and join the online workshop.
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One of the first lessons I learned from my yoga teacher was that “yoga is not about rapid movements but long pauses. Slow down, calm down, don’t hurry, and trust the process.”
The thing about yoga — or any exercise — is that there isn’t a comfort zone. But if you have a sound process, and practice it diligently, over time it starts to work for you.
The act of investing your money, as I realize, isn’t much different from practicing yoga. A superior process and greatness often go hand in hand in yoga, and also in investing. For serious investors, thus, it’s wise to learn to trust the process that generates winning investment results.
I came across one such time-tested process framework while reading Michael Mauboussin’s “Reflections on the Ten Attributes of Great Investors.” Mauboussin is Head of Consilient Research at Counterpoint Global, Morgan Stanley Investment Management, and author of some amazing books like The Success Equation and More Than You Know. He is a highly successful value investor, and thus the process he has laid out in his note is a great help for any serious investor seeking a winning investment process.
Here are my reviews of the ten attributes Mauboussin has laid out in his note.
10 Qualities of Great Investors
1. Understand accounting and be able to work with numbers – Being comfortable with numbers is one of the most important attributes of a successful investor. And for that, one needs a grasp of accounting and an ability to analyse key financial statements. Of course, you don’t need to be an accountant to understand financial statements, but a feel for of the numbers is important. Numbers, after all, not just tell you about a business’s past or present, its advantage against competitors, but also where it is most likely to head in the future.
An eleventh-grade accounting textbook can be a good starting point for learning this language of business. You can then top it up with these books –
- Financial Statement Analysis ~ Martin Fridson
- Accounting for Value ~ Stephen Penman
- Financial Statement Analysis and Security Valuation ~ Stephen H. Penman
Plus, you may also take up my online Financial Statements Analysis Course.
2. Understand value – Successful investing requires an estimate of intrinsic value of the business. Without it, any hope for consistent success as an investor is just that: hope.
One of the undisputed rules of investing is that the present value of future free cash flow determines the value of a financial asset. This is true for stocks, bonds, and real estate. Now, despite the fact that valuation is a challenging exercise for investors because each driver of value – cash flows, its timing, and risk – are based on expectations. But you can make the process better by doing what Mauboussin suggests –
Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow. Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within its industry, barriers to entry, the economics of the business, and management’s skill at allocating capital.
3. Properly assess how a business makes money – Successful investors understand businesses they invest in, i.e., they can explain how a business makes money, what drives profitability, whether the business has a sustainable competitive advantage, etc. This is unlike most others who are more interested in seeking readymade tips than spending time and effort on understanding businesses they want to own.
All you need to do to understand how a business makes money is to answer the most important questions, like –
- Is the business simple to understand and run? (Complex businesses often face complexities difficult for its managers to get over)
- Has the company grown its sales and EPS consistently over the past 5-10 years? (Consistency is more important than speed of growth)
- Will the company be around and profitably better in 10 years? (Suggests continuity in demand for the company’s products/services)
- Does the company have a sustainable moat? (Pricing power, gross margins, lead over competitors, entry barriers for new players)
- How good is the management given the hand it has been dealt? (Capital allocation, return on equity, corporate governance, performance against competition)
- Does the company require consistent capex and working capital expenditure to grow its business? (Companies that have to spend continuously on such areas are like running on treadmills, which is not a good situation to have)
- Does the company generate more cash than it consumes? (Cash generators have a higher probability of surviving and prospering during bad economic situations)
While answering such questions, try to keep things simple. If you don’t understand how a business makes money, don’t expend your mental energies on it, and move on to the next business.
4. Compare expectations versus fundamentals – Mauboussin suggests what really separates great investors from everybody else is their skill at comparing a given company’s “fundamentals” (i.e., sales growth, profit margins, capital structure, etc.) with the “expectations” implied by its stock price. He writes –
Fundamentals capture a sense of a company’s future financial performance. Value drivers including sales growth, operating profit margins, investment needs, and return on investment shape fundamentals. Expectations reflect the financial performance implied by the stock price.
One way to do it is by performing a reverse DCF analysis, whose aim is to get the intrinsic value to match the stock’s current price – to find out what’s the free cash flow (FCF) growth estimates the stock market is pricing in the stock. So, rather than attempting to estimate how future FCFs might look over the next ten years, the idea is to estimate the level of growth currently implied into the stock price, and then correctly anticipate any changes that aren’t yet fully reflected in that price.
5. Think probabilistically – Now, this one isn’t an easy habit to form and I have struggled with it for years. But this is an important quality investors attribute to their success – the ability to constantly consider probabilities of various outcomes. Nothing in investing is sure.
Mathematical psychologist and a collaborator of Daniel Kahneman, Amos Tversky once said that in dealing with probabilities, most people only have three settings – “gonna happen,” “not gonna happen,” and “maybe.” Now, you won’t be able to achieve much success as an investor if you consider probabilities of future outcomes using just these three settings.
As per Mauboussin, one must constantly seek an edge, which can come from a sound process of making decisions rather than the outcome alone. The reason is that a particular outcome may not be indicative of the quality of the decision. Good decisions sometimes result in bad outcomes and bad decisions lead to good outcomes. Over the long haul, however, good decisions portend favorable outcomes even if you will be wrong from time to time.
One important attribute Mauboussin talks about great investors and their probabilistic thinking is this –
Great investors recognize another uncomfortable reality about probability: the frequency of correctness does not really matter (batting average), what matters is how much money you make when you are right versus how much money you lose when you are wrong (slugging percentage). This concept is very difficult to put into operation because of loss aversion, the idea that we suffer losses roughly twice as much as we enjoy comparably sized gains. In other words, we like to be right a lot more than to be wrong. But if the goal is to grow the value of a portfolio, slugging percentage is what matters.
When you have a sound investment process and are able to understand the underlying business well, that is when you can make better probabilistic decisions. And that counts a lot.
6. When facts change, change your mind – English economist John Maynard Keynes asked –
When the facts change, I change my mind. What do you do, sir?
It’s easy to fall in love with your ideas so much and that’s what keeps you stuck in a losing cause. The stock doesn’t know that you own it. Sometimes investors take the idea of long term investing to an extreme. They forget that they need to constantly re-evaluate their positions and change them as situations require and new data becomes available.
Charlie Munger’s insights on this are invaluable –
The ability to destroy your ideas rapidly instead of slowly when the occasion is right is one of the most valuable things. You have to work hard on it. Ask yourself what are the arguments on the other side. It’s bad to have an opinion you’re proud of if you can’t state the arguments for the other side better than your opponents. This is a great mental discipline.
Mauboussin writes in his note –
Great investors also update their views as new information arrives. The idea is that you can represent your degree of belief about something by a probability. When new information arrives, you update that probability. The formal way to do this is to use Bayes’s Theorem, which tells you the probability that a theory or belief is true conditional on some event happening.
…The best investors among us recognize that the world changes constantly and that all of the views that we hold are tenuous. They actively seek varied points of view and update their beliefs as new information dictates…Good thinking requires maintaining as accurate a view of the world as possible.
7. Minimize mistakes due to behavioral biases – Successful investing is 1% about what you know and what you buy, and 99% about how you behave. But then, we humans are not wired to behave well, especially in areas of uncertainty (like investing). We suffer from innumerable cognitive biases. Interestingly, how much ever we read about these biases and how they fool our brains often, we still fall for them (blame your brain). So the idea of dealing with these biases is not to try and eliminate them (nobody can’t), but to try and minimize the mistakes caused by them.
Checking stock prices daily, focusing on the short term, reading a lot of news, and indulging in “social media” investing triggers a lot of these biases. So avoiding or minimizing these activities i.e., noise, will automatically minimize your behavioural mistakes. I can vouch for that from my personal experience over the years.
Mauboussin writes –
Great investors are those who are generally less affected by cognitive bias than the general population, learn about biases and how to cope with them, and put themselves in a work environment that allows them to think well.
8. Know the difference between information and influence – Mauboussin writes here –
Investing is an inherently social exercise. As a result, prices can go from being a source of information to a source of influence. This has happened many times in the history of markets. Take the dot-com boom as an example. As internet stocks rose, investors who owned the shares got rich on paper. This exerted influence on those who did not own the shares and many of them ended up suspending belief and buying as well. This fed the process. The rapid rise of the dot-com sector was less about grounded expectations about how the Internet would change business and more about getting on board.
He then suggests what great investors do on this account –
Great investors don’t get sucked into the vortex of influence. This requires the trait of not caring what others think of you, which is not natural for humans. Indeed, many successful investors have a skill that is very valuable in investing but not so valuable in life: a blatant disregard for the views of others. Success entails considering various points of view but ultimately shaping a thesis that is thoughtful and away from the consensus. The crowd is often right, but when it is wrong you need the psychological fortitude to go against the grain.
9. Size your positions appropriately – Success in investing has two parts: finding your edge and fully taking advantage of it through proper position sizing (allocation). So, if you have two ideas with the same expected return, but one is in a highly-leveraged financial company and one is a very stable consumer products company, you should allocate substantially more money to the latter because there must be a premium for certainty.
Almost all investors focus on finding that edge, while position sizing generally gets much less attention. But apart from finding a good idea with a high degree of conviction, one needs to maximize the payoff from the same to move the needle in a portfolio. And that can be done only by appropriate position sizing.
10. Read and keep an open mind – I cannot over-emphasize the importance of reading here, as I’ve already written a lot about it. Mauboussin writes in his note –
Berkshire Hathaway’s Charlie Munger said that he really liked Albert Einstein’s point that “success comes from curiosity, concentration, perseverance and self-criticism. And by self-criticism, he meant the ability to change his mind so that he destroyed his own best-loved ideas.”
Reading is an activity that tends to foster all of those qualities.
Munger has also said –
In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time–none, zero.
Mauboussin writes –
Great investors generally practice a few habits with regard to their reading. First, they allocate time to it. Warren Buffett has suggested that he dedicates 80 percent of his working day to reading. Note that if you are spending time reading, you are not doing something else. There are trade-offs. But many successful people are willing to make reading a high priority.
Second, good readers tend to take on material across a wide spectrum of disciplines. Don’t just read in business or finance. Expand the scope into new domains or fields. Follow your curiosity. It is hard to know when an idea from an apparently disparate field may come in handy.
Finally, make a point of reading the material you do not necessarily agree with. Find a thoughtful person who holds a view different than yours, and then read his or her case carefully. This contributes to being actively open-minded.
I suggest you read Mauboussin’s complete notes – Reflections on the Ten Attributes of Great Investors.
In investing, often you can’t lose on purpose, and thus it is on the ‘luck’ side of the luck-skill continuum. This doesn’t mean that you simply give up on investing, because it has a large element of luck in it, up to chance. You just have to think long-term and use probabilities to your advantage. And here – in investing – the way to change your luck and move on the surest path to success in the long run is – a good process.
Now, even with a good process, you have to be patient and use discipline. But if you focus only on the outcome, you are less likely to achieve it. Instead, if you focus on the process, the outcome will take care of itself. Thus, one important takeaway from Mauboussin’s note is that you must not judge decisions – especially yours – not only on results, but also on how they were made.
Good luck, most often, favors a good process.
Venkatesh Jayaraman says
Good Article Vishal, Thanks.
For whatever, I am today has come from Reading and Reading a lot. I personally benefited a lot out of it…For me Reading part should be the first quality, that a investor must have.
Vishal Khandelwal says
Glad to know that, Venkatesh. Thanks!
Pankaj Gupta says
Vishal, Excellent Article.
Every investor need to revisit these 10 qualities regularly
Vishal Khandelwal says
Indeed Pankaj. Thanks!
Ankur Agrawal says
Having a basic knowledge of Accounting is extremely helpful while reading financial statements. Even Peter Lynch said this in his book ‘Learn to Earn’ :-
“If Stock Picking ever becomes your hobby, do yourself a favor and take an accounting course”
I am learning basics of accounting from youtube through “Sudhir Sachdeva’s” channel. He explains everything brilliantly.
Couldn’t agree more on reading. I have been reading different kinds of books for over 3 years now and enjoying it a lot. It is definitely a must not only for succeeding in investing but in any field of life
Thanks for posting this Vishal. The more I read about great investors, the more I see concurrence on discipline and rationality being critical in comparison to ‘genius’. Focus on avoiding simple cognitive biases and the itch to ‘do something’ just because others are doing it, can help one avoid the usual pitfalls.