Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Microcap companies are illiquid and volatile. Stock price moves of +/- 10% on a weekly or even daily basis are the norm. Most investors are OK with volatility as long as it’s only to the upside, but become unnerved when it occurs to the downside.
So you want to be a full-time microcap investor? Perhaps you are focused on making your first million? In either case you are focused on growing your capital at high rates of return. But are you emotionally ready for the pain? Do you have the stomach for it?
Microcap companies are illiquid and volatile. Stock price moves of +/- 10% on a weekly or even daily basis are the norm. Most investors are OK with volatility as long as it’s only to the upside, but become unnerved when it occurs to the downside. Morgan Housel recently wrote a great article, The Agony of High Returns, in which he highlights the price volatility in the best performing stocks over the last twenty years. For example, Monster Beverage has gone up 105,000% over the last twenty years and yet it has suffered four separate drops of 50% or more. Housel’s sub-title to his article is also a fitting conclusion, “Even with a time machine, a lot of people wouldn’t want to own the best performing stocks.”
Successful investing consists of long periods of boredom and short periods of horror. In Roller Coaster Investing Sanjay Bakshi highlights Wabco India Ltd a company that faced similar volatility during its six-year rise. I’m working with Sean Iddings on a series of case studies we call, The Intelligent Fanatics Project, that we’ll be publishing later this year. One of the intelligent fanatics is Herb Kelleher of Southwest Airlines (LUV). In 1971, Southwest Airlines went public at a $8.5 million valuation (2016 inflation adjusted: $50 million), a microcap even by todays standards. Soon after IPO, Southwest fell to a $2 million market cap, but for those that held their shares over the long-term….$10,000 invested in the IPO would have compounded at 19.3% for 43 years and resulting in $17,722,914 today (170,000% return). How is this possible in a shitty industry like airlines?! It was Herb Kelleher’s vision and leadership. Sean Iddings and I will tell you more about him later this year. Southwest’s monstrous 43 year run consisted of 22 drawdowns of 20% or more. Sanjay Bakshi writes, “If you end up owning a fantastic business, then plan to hold it for a long time. And prepare yourself for a roller coaster ride. If you have chosen the right business to own, the ride will be worth it.”
Volatility in multi-baggers is normal as influxes of capital move and shake the stock price. Similarly, most multi-baggers will have long periods of stagnation as fundamentals backfill, old shareholders get bored, and new shareholders enter. The key in developing the conviction to hold is to have a long-term focus. This long-term focus allows successful investors to disconnect emotion from investment decisions so they can differentiate business performance form stock performance. The thought process of, “The stock is down 20-30-40-50% from its highs, but the business hasn’t changed, so I will hold”, is the psychological-emotional state an investor must get to when holding great businesses. Stock performance is rarely linear. It can take two years for a position to go up 400% in six months. Unfortunately, this type of conviction to hold can only be fully developed through experience. Over the last year I’m down 40% in one of my largest positions, but the story hasn’t changed, so I will continue to hold. Ten years ago I wasn’t able to disconnect stock performance from business performance. The rough volatile seas of the market would have easily thrown me overboard. An investor must experience the highs of success and lows of failure several times before they can exploit these emotions in others, but let me offer some advice that will hopefully shorten the learning curve.
We all want to get rich quicker, and this desire is our biggest impediment. Often times we have already envisioned spending our returns before we achieve them. “These stocks should double in a year, and when that happens I will buy xyz”. Our returns are linked to consumption. The first step to turning small money into big money is realizing money is about freedom not consumption. Don’t obsess about the goal. Focus on the things you can control like your actions and behaviors.
Successful investing is extremely difficult because it’s one of the only life endeavors where you often times don’t receive short-term positive feedback. For example, lets say you want to lose ten pounds over the next few months. You are in control of what you eat and how you exercise. So you change your eating habits, add exercise to increase your metabolism, and on a weekly basis you can track your progress. The pound or two you lose each week gives you reinforcement and encouragement to keep going.
Unfortunately investing isn’t so kind. Investors rarely get short-term encouragement and positive feedback. The short term is often filled with pain, uncertainty, isolation, and volatility. It is common place for investors to go through 6-12-24 month stretches of underperformance. This is why it’s important to not judge your long-term performance with a short-term yardstick. Warren Buffett in his 1963 Partnership Letter “The Ground Rules” focused on providing his investors with the right yardstick to judge performance:
Rule #5: While I much prefer a five-year test, I feel three years is an absolute minimum for judging performance. It is a certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
Once you understand your yardstick then you get rid of all distractions that promote short-term thinking. Turn off the noise. Why? Because to beat the market you can’t think like everyone else and be manipulated like everyone else. Only listen, read, follow, take advice from those sources that make you better. Stay within your circle of competence and know your positions better than most. Spend twice as much time knowing what you own versus new ideas. What you don’t own can’t hurt you.
If you don’t have much experience investing through turbulent markets, then prepare yourself mentally. I’ve invested through two bear markets, one when I was just Getting Started and the second when I was a full time microcap investor. Even though I’m not inexperienced, I still like to test my psyche with mental exercises. When my portfolio is “beat up” and I’m feeling drained I like ask myself: “What if I wake up tomorrow and my positions are all down another 25%?” I think to myself… I will quickly check and see if anything material had changed in the businesses I own. If nothing has changed I will hold or buy more. If something did change, shaking short-term investors, but was immaterial against my 3-5 year long-term expectations then I will hold or buy. If something did change and it’s material against my 3-5 year long-term expectations then I will evaluate and may sell based on its severity and the company’s current valuation. This exercise is most crucial during bad markets and/or when your positions aren’t doing well. Don’t hope for the best, prepare for the worst, and have a mental framework or plan. Famous hedge fund manager and trader Paul Tudor Jones would call this “writing a script for the market” which would help give him the correct mental state.
P. Tudor Jones on preparing for the trading day.Good advice for investors too,just "write the script" over long-term pic.twitter.com/n0yySEbprX
— Ian Cassel (@iancassel) February 24, 2016
Don’t concentrate on your investing goal, focus on your actions and behaviors. The most valuable action for any investor is reading. Have you ever noticed that great investor’s offices are filled with books, not computer screens? Becoming a learning machine helps you connect the dots and develop mental models for better faster decision making. You can read about great investors, intelligent fanatics, or other broad subject matter. Reading also keeps your eyes off the flickering lights of the stock market.
Great way to block out the noise is to do it with books 🙂 pic.twitter.com/FqLtQLUApa
— Ian Cassel (@iancassel) February 21, 2016
“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.” – Charlie Munger
Keep your body active. A recent study by Berkshire Hathaway’s subsidiary Brooks showed 83% of respondents agreed that they come up with their best ideas while running. You also need to keep your spirit happy. Whether it’s meditation, prayer, or whatever .. sitting in a quiet place without any distractions is a powerful way to clear your mind. Although my wife says I have no problems clearing my mind 🙂 When your body and spirit are happy, your mind is happy.
In conclusion, if you want to make big money focus on the long-term and develop the conviction to stomach volatility. The best performing companies ever had extreme stock price volatility. Experienced individual investors should always have an edge over those managing other people’s money because they only have to manage their own emotions and expectations. Over time you’ll be able to disconnect stock performance from business performance. If you are invested in great businesses and the story hasn’t changed, don’t let volatility and lulls in stock price scare you out of your positions. Measure your performance with a yardstick not a ruler. Get rid of everything and everyone that promotes short-term thinking, and create a balanced lifestyle anchored in reading, exercise, and meditation.
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Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Nicolai Tangen is the CEO of Norges Bank Investment Management, Norway's $1.4 trillion sovereign wealth fund.
Dilution is the subtle erosion of ownership. This hidden, persistent addition of new supply of shares leaves shareholders with less and less of the company’s value. Dilution, like inflation, is a silent killer of returns.