Are You an Analyst or an Investor?
The transition from analyst to investor is found by developing your skillset beyond finding great ideas to executing on great ideas
In the early 2000’s, when I was in college and starting my journey into microcaps, I traveled to meet a gentleman that would become a mentor to me. I wrote about him here.
In the 1970’s and 1980’s he trained stockbrokers, and his personality reflected that era and profession on Wall Street. He was loud, opinionated, and arrogant. He was also the first conviction investor I ever met. I became his student and he trained me.
When I lacked conviction, he would scream at me, “Are you an analyst or an investor?!”
This was his way of forcing me upsize my conviction or get out and move on. He believed a position should be big enough to move the entire portfolio and big enough to hurt when you're wrong.
In the book, More Money Than God, Sebastian Mallaby, chronicles the rise of the hedge fund industry. He retells some entertaining stories of the pioneers: A.W. Jones, Michael Steinhardt, George Soros, Julian Robertson and others.
I love this story from the book about Michael Steinhardt because it reminds me of my training.
John LeFrere, an analyst hired by Michael Steinhardt in the 1970s, recalls his first weeks on the job; he visited IBM and returned convinced that its profits were headed upward. At the partnership's Monday-morning meeting, LeFrere recommended buying IBM stock ahead of that Friday's quarterly results, but Steinhardt pushed back. The boss had been watching IBM splutter about aimlessly on the stock ticker, and he had a black feeling in his gut that the stock was going nowhere.
“Mike, I think you're wrong,” LeFrere said. It took courage to contradict Steinhardt, but LeFrere had a strong build and figured he could bench him.
“I hate the pig,” said Steinhardt.
“Mike, I don't care how it looks on the tape. The results are going to be good and the stock's going up.”
Steinhardt's contrarian radar flickered. “How much you want to buy then?”
“How about ten thousand?” LeFrere ventured, calculating that, with IBM trading at $365, owning three and a half million dollars' worth of one stock was about the maximum conceivable.
Steinhardt hit a button and ordered his trader to buy 25,000 IBM immediately.
“Mike, I said ten thousand,” LeFrere said anxiously.
“How convinced are you of your fuckin' opinion?” Steinhardt barked.
“I'm very convinced.”
“You better be right,” Steinhardt said grimly. He hit the button again and bought another 25,000.
That exchange left Steinhardt with some $18 million worth of IBM, representing perhaps a quarter of his capital. It was a hefty concentration of risk in one stock, five times the size that LeFrere had recommended. But when IBM's results came out at the end of the week, the stock shot up 20 points, yielding an instant profit of $1 million. LeFrere had survived his rite of passage.
Julian Robertson at Tiger Global, often simplified the entire hedge fund business into one sentence:
"Our mandate is to find the 200 best companies in the world and invest in them, and find the 200 worst companies in the world and go short on them. If the 200 best don't do better than the 200 worst, you should probably be in another business."
One of Robertson’s pet peeves was when an analyst would express high conviction in something but recommend a small position (1%). He believed that a small position in a great idea was a sign of intellectual cowardice.
He would stress test the analyst by forcing them to make it a 5% or nothing bet. He wanted to see if the analyst would flinch. He used size as a stress test to see if the analyst had the balls (a term Robertson used frequently) to live with the swings of a concentrated bet.
Robertson also enforced a strict “four sentence rule” at his infamous Friday analyst lunch meetings. Analysts were often expected to sum up an investment thesis in four sentences.
Robertson believed that if you couldn't explain the "why" simply, you didn't truly understand the value. He would then use that simple thesis to challenge the analyst: "If it’s that simple and that good, why aren't we bigger?"
Finding great ideas is one thing. Making all the necessary decisions (valuation, sizing, etc) around great ideas is another thing. It’s the difference between being an analyst and being an investor. Many analysts can’t make the leap.
In Robertson’s biography he said, "There are not a whole lot of people equipped to pull the trigger. I’m usually the one who pulls the trigger."
Not all ideas are great ones, so most of these hedge fund titans had it drilled into their analysts’ heads to only bring the great ideas.
In the book, Black Edge, author Sheelah Kolhatkar chronicles the rise of billionaire fund manager Steve Cohen and his firm SAC Capital. It describes the culture and tactics he used to influence analysts to get a “black edge” which is another word for inside information.
The book is an expose of sorts chronicling the FBI and SEC investigation that eventually led to SAC Capital paying $1.8 billion in fines and forfeitures to settle criminal insider trading charges.
According to the book Cohen implemented a "conviction scale". This was a formal internal ranking system used by analysts and traders to rate their confidence in a buy or sell recommendation, ranging from 1 (lowest) to 10 (highest).
The scale functioned as a way for traders to communicate the value of their information directly to Cohen, helping him decide whether to buy for his own account.
A score of 9 or 10 indicated near absolute certainty in a stock's performance. These high ratings were assumed to have been gathered through a black edge.
Ironically, the rating system was initiated by the firm's compliance department, which aimed to create a buffer to protect Cohen from explicitly receiving material nonpublic information, and instead acting on the high-conviction ratings.
I’m not advocating the pursuit of insider knowledge, but I do like the idea of a conviction scale.
Framing new ideas in this manner is a good way to limit yourself from being lured into mediocre ideas. Only investing in 9’s and 10’s would likely save us all pain and discomfort.
Given my style of investing, I find great ideas fall into two buckets.
First, the “no brainers” that are meant for you. These show up when opportunity, luck, diligence, and serendipity create a perfect storm and serve you up something on a silver platter. The type of great opportunities that look so obvious they leave you scratching your head as to how everyone else has missed it. I get 1-3 per year. These are the 9’s and 10’s minus the insider information of course.
Second, opportunities that fit holistically but not perfectly into your investment strike zone, and the low valuation is incentive enough to add it to your farm team to see how the situation matures. I find I get ten or so of these per year. But it’s hard to conviction rank them because they are formed from intuition on how situations can develop. The hit rate is lower, but the slugging % if you get 3 out of 10 right makes them worth the effort. You express the uncertainty with a smaller position size.
In a similar way George Soros believed in taking small positions while investigating a trade and to feel out the market before committing a large amount.
The titans of trading and investing did not like losses. They had very short leashes on positions that were going against them.
Legendary trader Paul Tudor Jones enforced brutal discipline on his sub-managers/traders. Jones would walk over to a trader who was bleeding money and ask where his stop was. If he didn’t like the answer, Jones would lean in and say:
“If it hits that price, I'm not just closing the trade. I’m closing your entire book for the week. You're done. Go home.”
Tony Gannon worked for Jones and gave an interview describing how Jones would tap an analyst on the shoulder and tell them their position was being liquidated because they had lost their edge or conviction.
To Jones a trader who couldn't pull the trigger on a loss was a liability to the entire firm. The threat of closing their book wasn't just about that one trade, it was about protecting the firm's capital from a trader who had lost their objectivity.
Jones believed that once a trader's conviction turned into stubbornness, they were no longer capable of seeing the market clearly. By benching the trader and forcing them to go home, he was mandating a psychological reset.
I’ve always loved how Stanley Druckenmiller views losses, "If you're extremely confident in yourself, taking a loss doesn't bother you."
This is true not just in trading but with investing. The lies we tell ourselves to help fuel our “hopium”. Those “just another quarter stocks” that keep stringing us along or holding onto losers because we are anchored to our cost basis. We have an inborn human desire to sell winners too soon and hold losers too long.
If you are a great stock picker, half of your picks will be winners and half will be losers. This means you must make more money from your winners than you lose on your losers. Enough so that you can still beat the market.
The term for this is Payoff Ratio.
Payoff ratio is what separates the best investors from the rest. It measures how much a manager gains when they’re right compared to how much they lose when they’re wrong. A payoff ratio over 100% means your winning ideas more than make up for your losers and is typically the result of a disciplined approach to running winners and cutting losers.
For example, a payoff ratio of 170% means a manager is 1.7x as right as they are wrong.
Many investors look at payoff ratio and focus on the first part, finding big winners. But cutting losers is an equally important part of the equation.
Lee Freeman-Shor and Clare Flynn Levy analyzed the trade data of many of the best fund managers in the world. They showcase their findings in Stock Market Maestros, and David and I interviewed them here.
I asked them which decision type do successful managers have the most trouble with?
Their answer: Cutting losers
Here are some strategies highlighted in the book that great stock pickers use to help keep their losers small.
- Use the “Blank Piece of Paper” Test. I also call this the honesty test. This acts as a mental reset. We all invest differently with different time horizons. Some will do this daily. Others might do this monthly, quarterly or annually, but an investor should look at their portfolio and ask: "If I had a blank piece of paper today, would I buy this stock at its current price?". Don’t BS yourself. Be honest.
- Write pre-mortems. Write out the things that could disrupt your thesis. Keep those things top of mind. The only way to do this effectively is to study a business’s entire ecosystem. It isn’t a 5-minute thought experiment, but the result of a deep analysis.
- Create pre-determined reassessment points for losers. In microcap this is difficult because drawdowns are rather normal, so the % needs to match what would be deemed “concerning”. For some, it might mean when a position drops 30% compared to the benchmark, portfolio, and/or peer group. The point is to have a trigger that forces you to do a full reassessment like you were looking at the company for the first time.
- Speak with investors that disagree with you. This is difficult because we all desire to find confirming evidence, not disconfirming. But the best investors don’t become anchored to what they want to be true, they are always anchored to finding the truth. High conviction that is subject to change is the sweet spot in microcap.
- Be very cautious adding to losers. Outside of macro declines that pull down everything, when a stock is constantly on a downtrend it’s fascinating how often the stock is telling you something. Very few good decisions come from throwing good money after bad adding to losers in a steep decline. Many great investors simply let the position get smaller or sell them out completely.
Whether it is Steinhardt doubling down because of a visceral certainty or Paul Tudor Jones forcing a psychological reset to prevent stubbornness from draining capital, the common thread is a mastery over one's own conviction. It’s a demanding internal tug-of-war where you must have the ability to size up a no-brainer and yet possess the humility to cut a losing position before it clouds your objectivity. As the data from the world's best fund managers suggests, your success won't be defined by a perfect track record, but by a superior payoff ratio where your winners far outsize your losers.
Ultimately, the transition from analyst to investor is found by developing your skillset beyond finding great ideas to executing on great ideas. I talk about these skills in my upcoming book, Stock Picker.
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