Morgan Housel wrote an excellent article entitled Ironies of Luck which contains a great quote that states: “Luck is the flip side of risk.” This is something I’ve come to appreciate over the years and I’d like to tell you why and how you can leverage it. You can also meet Morgan at our upcoming MicroCap Leadership Summit.
I have been fortunate to have many stocks that make big moves including many that are multi-baggers. My general rule of thumb is that I only purchase stocks that I think have decent odds of appreciating 100% within 24 months with reasonable downside protection. In microcaps, that is a margin of safety that has served me well.
My portfolio generally holds 20-30 positions in microcaps and I usually have a handful or so at any given time that I think have high odds of doubling over the next year. One thing that has struck me over the years, however, is how wrong I often am about which companies actually produce the outsized returns.
The natural reaction to incorrectly handicapping the companies that produce outsized returns is that there must be a flaw in my due diligence process that I haven’t figured out. Sure, that can be part of the problem. But I also appreciate the limitations of research. In fact, I have written on this subject [HERE]. The article that I just linked, however, focuses on the risks and not on the flip side of risk which is luck which Morgan so elequently states.
What I have come to appreciate over the years is that luck is often a factor in which stocks that I own produce the outsized returns. Let me give you some examples of places where you can have luck:
- A company obtains a large contract that greatly increases revenue and profits.
- A company’s growth rate accelerates where it wasn’t expected.
- A company introduces a new product which will greatly increase their revenue and earnings.
- A company with a great growth profile is suddenly found by institutions that accumulate significant positions in the stock driving the price and earnings multiple higher.
- The company is bought out for a significant premium.
I’m sure I could come up with many additional examples of places where luck plays a role but I think the picture is clear.
Now one thing I’ll add is that when you own great companies (see the My Secret Recipeseries of blog posts) with great management teams I think it is fair to say that you increase your odds of luck. I can’t back that up scientifically, but I think I can empirically. Let me use a sports analogy to illustrate. A great basketball player generally is more likely to pull off a near miraculous play to win a game than a mediocre player. It is a great athlete’s skills that enables him or her to do the unexpected.
In Morgan’s article he states:
“In investing, a huge amount of effort goes into identifying and managing risk. But so little effort goes into doing the same for luck. Investors hire risk managers; no one wants a luck consultant. Companies are required to disclose risks in their annual reports; they’re not required to disclose lucky breaks that may have led to previous success.”
Taking the above statement a step further, companies usually don’t provide much information on where luck could play a role. Stating these types of things is just plain dangerous for management to do as it creates false expectations that could come back to haunt them. Therefore, these surprises to the upside tend to appear more random because we have less of an idea of where they could happen.
The way I have found it is best to leverage luck is in asset allocation and specifically in diversification. Most people look at diversification only as a way of managing risk. That it certainly is. However, diversification also provides you more opportunities for luck to play a role. I’ll say that another way that is perhaps an oversimplification because no two companies are exactly the same. If I have two companies that I think have the same odds and percentage of appreciation, I’d rather own both companies than have twice the holdings in a single company.
Now I could continue by talking about the mathematics of why this is better. However, I don’t want to put you to sleep. The reason to diversify for luck is the same as the reason to diversify for risk which I think most people inherently understand. That is, it provides you with more consistent results while minimizing the possibility of really bad results and insanely good results. If you put many good companies into that diversified portfolio, you should end out with really good portfolio performance. For those that want to look into the math of diversification there are many resources that discuss it such as this one [HERE].
In summary, in order to obtain consistently good results I find that the best thing for me to do is to own a diversified set of great companies. I want to have many opportunities for good luck.
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