Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
When you are trying to find great businesses early, intelligent fanatics early, before it’s obvious in the financials, you aren’t going to be right all the time. You need to accept this.
When you are trying to find great businesses early, intelligent fanatics early, before it’s obvious in the financials, there are a lot of moving parts and imperfect information. These companies are small. The businesses are emerging and their leaders are still learning.
You aren’t going to be right all the time, and you need to accept this.
We often read quotes like this one from Peter Lynch:
We all nod our heads in affirmation, but deep down we think we can be right all the time. We think that holding out for perfection makes us better.
You don’t have to look much further than those that create investment checklists that are longer than the Bible. The truth is that perfection doesn’t exist in small public companies. They all have a few warts and they will all have growing pains.
Far too often we investors form these long checklists and try to find businesses that conform to the past. But most times the great companies don’t fit a mold. They are outliers that are misunderstood. And they are led by intelligent fanatics who do things different and better.
The best checklists are short and allow you to explore those things that are different.
Accepting that you aren’t going to be right all the time isn’t an excuse to be lazy. You are still doing an excessive amount of work. You still have a high hurdle and you are not pulling the trigger at everything you see. You are a sharpshooter. You are a sniper.
I pull the trigger about once or twice per year on a new idea, and I do an extensive amount of due diligence. But I still know I’m not going to be right all the time so my position sizing in the beginning reflects this uncertainty.
Your position sizing needs to correlate with management execution.
Let’s say you find a unique small business run by whom you believe to be a person of character, ability, and vision. After you’ve done the work, you buy a little. As management executes you buy more. The best ones are the companies you are continuously averaging up in. But these are also very rare.
Let me ask you a question..
How many companies have you owned where you genuinely liked them more 1-2-3 years later?
Exactly, not very many. So you weight your position sizing in the beginning accordingly. I like to buy about 1/3 of my position in the beginning.
It’s impossible to have the same conviction at the beginning of a new investment that you had at the end of a successful investment.
Conviction is a lot like love and trust, it can only be built over time, and so should your positions. If you are doing it right you will get bigger in the things that are working and smaller in the things that aren’t.
I think one of the most mis-used quotes of Warrant Buffett is “Our favorite holding period is forever”.
He didn’t mean that every stock should be held forever. He certainly wasn’t talking about microcaps. You can’t buy into small microcap companies saying you are going to hold them forever. It’s just silliness. They are too young, too small, too impressionable to make such a statement.
Holding forever only works when management executes forever.
Mistakes are made in microcap when you take your eye off the ball. It’s a constant game of buy and verify your thesis, and the smaller the company the more often you verify. It can sometimes be a full time job to know what you own at all times.
If the business is telling you to hold, you hold. If the business is telling you to sell, you sell.
Be as active as you have to be. No more. No less.
As you gain experience and go through the process your vision for new ideas gets sharper and your reaction time gets better. You will still kiss your fair share of frogs, but you’ll be able to identify when you are wrong quicker. Sometimes being less wrong is as good as being right.
Investing isn’t a game of perfection. It’s a game of continuous improvement. A professional baseball player earns $15-20 million more for getting a hit 5% more often than an average baseball player. The difference between getting a hit 30% of the time versus 25% is a big deal. A small increase in average and productivity can greatly increase your earnings power.
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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.