Leveraging Luck

Mike Schellinger Blog, Educational 5 Comments

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:

  1. A company obtains a large contract that greatly increases revenue and profits.
  2. A company’s growth rate accelerates where it wasn’t expected.
  3. A company introduces a new product which will greatly increase their revenue and earnings.
  4. 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.
  5. 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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About the Author

Mike Schellinger

Mike (aka MikeDDKing) has almost two decades of investing experience primarily in micro caps. He became a full-time private investor and trader in 2006 after his investing hobby became more profitable than his corporate job managing the development of software for cellular telephones. His specialty is in finding rapidly growing, profitable micro caps that are extremely undervalued and unknown. He spends most of his day turning over every rock he can find to locate those hidden gems.

Comments 5

  1. Before I became a full time investor, I had a much greater appetite for risk in other areas of my life, particularly whitewater kayaking. Now, I don’t even want to ride a bike. Too risky. I go out for long walks every day because I don’t have to pay attention to what I’m doing. I can think about the market. I think about risk all day long. I think of my work now as 90% controlling risk.

    Other thoughts on risk in investing:

    The shorter your time horizon, the less you know about the companies you are investing in, the greater the role of taking losses quickly. I remember a speech by a particularly successful daytrader who turned $25000 into $8 million in five or six years. His average position made eight cents a share and his win rate was about 62%, if memory serves. He was lousy at picking companies but an expert at controlling risk when he was wrong.

    The longer your time horizon, and the more you know about the companies you are invested in, the more important it is to control long term risk by buying on weakness, by increasing positions that initially go against you. As Ian has pointed out a number of times, all great companies have long track records of losing 50% or more in their market price on their way to being multi-baggers. Great long term investors control risk, in part, by buying during those price collapses. They are experts in profiting from unwarranted fear among their fellow investors. The crucial issue though is identifying superior companies. Accumulating mediocre companies on weakness isn’t controlling risk.

    The most important risk factor in investing is ourselves. As I’ve quoted before on the MicroCapClub, Pogo offered a great investing insight, “We’ve met the enemy and he is us.” For instance, as an investor, I have no ability to make investment decisions based on an assessment of management. Some people do. I think Ian does, but the vast majority of investors think they have a much greater ability to assess human character than they actually do. I’ve seen that in my own investing, in renting apartments to people, hiring people, hiring building contractors. I done that hundreds of times in various businesses over the last forty-five years. The last time I worked for someone else on a salary was when I was seventeen (fighting forest fires in northern Canada). Do that enough times and you get to know whether or not you can actually assess character. Human beings are highly complex. Some are more honest than others. Many of the most successful people in life are are much better liars than the rest of us. I’m a sucker for highly-confident, charismatic executives who can tell great stories. As a result, I’ve become an expert at assessing business quality by financial statement trend analysis, a skill I know often treated with derision here at the MicroCapClub. Like a blind person, I’ve developed a keen sense of hearing in my efforts to assess risk. It has been crucial to my investment success that I have learned that about myself.

    The German army used to grade all officers two ways to create four categories in judging officers suitable to senior leadership positions. Maybe they still do. At the bottom, the stupid energetic officers. They’re real problems. They screw up everything they touch and they touch a lot. Next, lazy, stupid officers. They don’t do anything so they don’t screw anything up. Next, the energetic intelligent officers. They are suitable for executing orders in battles but not for devising the plan. Finally, suitable for the very highest positions, are the lazy intelligent officers. After the battle has been raging for three days, they are the only ones rested enough to make clear-headed decisions. Montgomery went to bed at 8pm before the Battle of Alamein, as he always did, and when he woke up, the battle was won, although many thousands of men had lost their lives as he slept.

    There are a lot of differences between being a successful investor and being a successful CEO, but there are many similarities too. Ability to admit you are wrong, ability to see things with a detached perspective, ability to allocate capital after considering contrary facts. Few people can hold contrary facts in their head, weigh them, and make useful decisions. These are all a part of controlling risk.

    Another of my favorite investment quotes, this one by Bernard Baruch, and I don’t remember it exactly, but this is close enough,

    “It isn’t the failures that destroy investment performance. They declare themselves and can be dealt with. It is the mediocrities that sap your resources, that inch along, that you keep hoping month after month, year after year, that you keep pouring more resources into, that you hope will improve but that never do, that sink your boat.”

    The vast majority of companies are mediocrities. Only about 1 or 2% have a sustainable competitive advantage. The vast majority of what is written on investment forums is about mediocre companies that the author is hoping against hope will get better. Quality companies, by definition, generate exceptional returns on capital with little or no debt. And, over time, their revenues and earnings grow at a superior rate. To me, risk control starts and mostly ends with the financials. I say that knowing that most on here disagree with me. Most have a confidence in their ability to determine which lousy companies will become at least mediocre, or mediocre will become exceptional.

    It isn’t easy. Even Buffett frequently makes an incorrect assessment. But what sinks investors’ boats, I think, is the unwillingness to recognize when they are wrong, the ego need to be right, to be perceived as an expert, as possessing clarity of vision. That’s the big risk factor. Knowing the difference between what you know, and what you think you know.

    As the pace of change in business and technology continues to accelerate, the ability to understand change becomes increasingly important in assessing risk. Hence Buffett’s recent perceptive thoughts on Heinz and Kraft versus Costco’s Kirkland, and his evolving affinity for dominant city newspapers. Change, change, relentless change.

    Personality experts have said that people can be divided into those who embrace change and those who eschew change, resist change. Our genetic makeup, our view of the world, how we interact with our pets, what kinds of cars we drive, clothes we wear, and yes, our affinity for fences, all reflect our attitude toward change. Our position on global warming, on immigration is a reflection of deep-seated, emotional characteristics that we aren’t aware of — our willingness to embrace change. Successful cultures need both to function properly, hence the liberal and conservative parties, fundamental and reformed religion, whether Islamic or Christian. Historically, great long term investors have been conservative by nature. They profit from avoiding companies and industries that change dramatically. The question is, going forward, given the accelerating pace of change everywhere in our lives, will that persist? Does an aversion to change add to or detract from portfolio risk?

    I used to write long responses to articles like this. It has been a year or two. To allay Mike and Ian’s fears, I don’t plan to do it more often than once a year or two going forward. I always get a sinking feeling in my gut after I press the submit button.

    1. Rod, I’d encourage you to write more of these responses. They are very thought provoking and a real value add to others. Thank you for sharing your thoughts. Now I’m trying to find that Baruch quote and can’t find it anywhere lol

  2. Thanks Ian. I probably won’t respond often but appreciate your feedback. Most subjects I don’t care enough about anymore to offer my views, but risk control is definitely at the center of my investment life these days. And actually at the center of my dream life at night.

    A couple more thoughts occurred to me since I offered those last comments.

    Low risk strategies are boring. That’s why, until recently, I’ve avoided them. I like action. I like making decisions. For the last year or two however, I’ve been invested in a hedging strategy that means I almost never have to make a decision. The decisions are all made based on triggers that are pre-ordained before I take the positions. I sit here all day, thinking I should be doing something interesting, watching these four securities I now focus on go up and down, down and up. They hit my triggers once every month or two. Other than that, I’m wasting my time. I should be doing my income taxes or cleaning up my house or reading a good novel.

    I think that’s why lots of investors don’t buy high quality companies when they are at the kinds of value the market offers only every year or two. Rolfe at Wedgewood does that, and a few others, but it is boring as hell. Statistically, in relation to free cash flow, these companies are generally less expensive than the market, so the problem isn’t value. It’s action. People want action. They don’t want to make 12%-15% a year, consistently, they want to make 30-40%. Or 300%. That entails risk, including trying to predict the unpredictable. That’s why Las Vegas is so successful.

    Speaking of Las Vegas, they make their money based on two simple principles. The house prevails 53% of the time, and they control the amount wagered per bet. They don’t, for instance, allow you to go in and wager $100 million on a game of blackjack. They’ve figured that they can maximize the number of bets if they allow bettors to win 47% of the time. That’s real risk control.

    The application of that principle to investing (and thus risk control) is that returns depend on three factors: win rate (number of winners versus losers), amount, on average, gained (or lost) per investment, and amount risked. You can have an exceptional result with the first two and still go broke. If your win rate is 90%, and your percentage win per investment is 100%, but you invest 100% of your money in one stock each time out, sooner or later you’ll go broke. It’s the Russian Roulette principal of risk control.

    In addition to an inability to identify superior management coupled with a superior business model, other than by results, I have an inability to predict the market. I’m always bearish. That’s not good. So I’ve developed a strategy that is not dependent on my ability to assess management and that is market neutral. An investor, to control risk, needs to know what they know, what they are good at.

    Here’s another, hopefully final, thought. The reason only 1 or 2% (I should have actually said 1%) of public companies are exceptional is because businesses are human endeavors. Only 1% of violists or mathematicians or football players or golfers are exceptional. Only 1% of investors are exceptional. Maybe, however, 90% (or some significantly larger percentage of investors than 1%) think they are exceptional. Certainly 90% of speculators think they are exceptional. That’s risk.

    To be exceptional you need to work hard, but you especially need self-control, need to get your ego under control. Maybe only 1% of people are good at that. My favorite investment book of the last couple of years — Exceptionalism by Greg McKeown. Doesn’t mention investing, but does explore self-control.

    In my business life, when I actually ran businesses, my rule was that only about 30% of employees, contractors, suppliers were reasonably honest, cared a little, showed up on time, could be counted on. I came to think of my business life as a search for customers, suppliers, employees who cared. About something. Anything. Something other than going home at 5pm, watching TV and drinking beer. Their own little lives, their own little circles of circumscribed awareness.

    1. Back in the late fifties, Bill O’Connor, an analyst/trader at McDonnell & Co, simplified the luck factor by saying, “Go where good luck can happen.” It worked for him, and cut out a lot of possible investments that didn’t have a prayer of big gains.
      John Gay

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