How many times have you looked back at past investment decisions and thought, “What the heck was I thinking?!”. Don’t worry, that happens to everyone, even the professionals. Early on I started keeping an investment diary to track my thought processes and experiences on every investment I’ve owned.
You can’t become a great investor overnight because its most important lessons can’t be taught, they have to be experienced
When I read through the diary I see commonalities amongst the winners and losers. The types of companies, management teams, share structures, etc. However one of the most glaring things that correlated to performance was how I bought my positions. All my winners had one thing in common, I was always averaging up. Most of my losers had one thing in common, I was always averaging down.
My buying strategy has evolved over the years. Early on I would pile into positions too quickly after naively believing what management would tell me. Overtime I realized giving up a small amount of upside to de-risk the investment was well worth it. I normally buy my positions in thirds as my conviction grows. If something doesn’t check out along the way I’m not stuck in a huge position.
I buy my first third after extensive due diligence and after talking to management. I dig through all the filings, industry journals, place some calls into customers, suppliers etc. Think of this as passing the smell test. I’m also making sure I have ample margin of safety.
Margin of safety = if your investment thesis is completely wrong you will still make money
I buy my second third after traveling and meeting management at their head quarters. I want to see what their offices look like, the interaction between management. Is it a dictatorship or a democracy at the management level? Can I find an employee who hasn’t been told “to be nice to me” and ask them questions? Does the company do the little things well? Do they pay attention to detail? What do they drive? What are their motivations? etc.
I buy my last third after the management team does 25% of what they say. The majority of microcaps over promise and under deliver. You make money on the ones that under promise and over deliver. It takes time to make sure you are betting on the right jockey. They need to prove this to you by executing, so buying this last third might not happen for months. With most of my winners, I bought this final third 100%+ higher than my first third.
My personal investment philosophy is to buy microcaps that I think can be 5-10x in a few years. It might sound insane, but I don’t buy stocks where the peak potential return is less than 100%. I’m trying to find and buy undervalued companies that have the potential to get very overvalued. That is my margin of safety. If I’m initially buying a $0.50 per share stock, I’m likely buying it because I think it can be a $5.00 stock in a few years. So who cares if I’m buying my last third at $1.10 after the investment has been greatly de-risked by management execution. Even after these small microcaps double, lets say from $10 million market cap to $20 million, they are still very under followed and not even on institutional radars. In all my big winners, I was constantly averaging up.
We’ve all heard investors say in a boastful tone, “XYZ stock is down again today, thank you very much Mr. Market for a great buying opportunity!”
We’ve all been there, so we all know they are full of SH!T. Averaging down never feels good. There are some instances when averaging down makes sense, but constantly averaging down never makes sense.
This one lesson of constantly averaging down was taught to me very early, in a rather extreme way. When I turned 18 years of age I took control of my college savings and decided to invest it. This was 1999-2000, the peak of the Dot Com bubble. A broker convinced me the next big thing was a recent smallcap tech IPO called Ibasis. I don’t remember the exact prices, but I believe I bought my first shares at $35, bought more at $25, more at $17, more at $10, more at $4, and sold everything close to $1. In a matter of 12 months I lost close to 90% of my college savings that my parents saved for me over 20 years. Luckily I was working full time and I was going to a cheap college, so I could continue to pay my tuition. Over the years that followed I would be taught this lesson over and over again. Investing is a life long education and its teacher is loss.
When you find yourself constantly averaging down it’s normally a sign that your ego has taken over. You’ve convinced yourself you have to be right, but you forget that being broke and right is the same thing as being wrong. Your ego clouds your judgment and slows your thinking. Many investors have gone broke trying to prove the market wrong, and you certainly aren’t going to prove yourself right by throwing good money after bad.
Successful investing isn’t about being right all the time; it’s more about the ability to identify when you are wrong quicker.
Andrew Stanton of Pixar sums this up even better – “Be wrong as fast as you can”.
Investing is tough because you have to constantly anticipate how other peoples thinking is going to change before they know it themselves. This means you have to buy investments early, before the investment is obvious, but there is a thin line between being early and being wrong. If you are constantly buying the stock lower it is likely the latter. If you find and buy great investments, you’ll likely be making subsequent purchases at higher levels. This is something to be proud of.
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