6 Signs of a Good Investment Process

In my baseball-playing days, I was on the mound in a big playoff game, and at a key moment in the game I threw what seemed to be a good pitch, only to watch as the ball sailed over the fence for a home run. It might still be traveling somewhere over North Jersey, it was hit so hard.

Walking back to the dugout after the inning was over, I was furious with myself for throwing the pitch. What was I thinking? What did I forget to do? What could I have done better? All natural questions to ask when you've experienced a bad outcome. 

In the dugout, I asked our catcher what he thought went wrong. He said, "Nothing at all. It was exactly what I called for and it was in the right spot. You've gotta tip your hat to the hitter -- he just took a great swing."

Nine out of ten times that pitch would have either led to a strike or an out. Instead, that time around the ball was hit out of the park. The process was right, the outcome was bad. If I could do it again, I would have thrown the same pitch...just perhaps a few more inches outside. 

This story from my glory days was on my mind this week as I was re-reading Michael Mauboussin's More Than You Know (which I highly recommend if you haven't already read it). 

The first chapter of the book is called "Be the House: Process and Outcome in Investing" and addresses the importance of process when making investing decisions. Here's an important quote from the chapter:

Results - the bottom line - are what what ultimately matter. And results are typically easier to assess and more objective than evaluating process.  

But investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field...all emphasize process over outcome. 

When the market is strong, it's easy to fall into a false sense of confidence about your investment process because you're receiving almost daily positive reinforcement from rising stock prices. The opposite is true when the market is down -- you could have a good process experiencing bad short-term outcomes.

It's important to remember that there's a lot of randomness and luck involved in short-term market outcomes and they aren't indicative of investing skill.

What really matters is whether or not your investment process can survive short-term periods of positive and negative reinforcement and deliver longer-term results. In a probabilistic field like investing, a good process will produce good results over time and over a large sample.

How do you know if your process is any good? Each investor will have his or her own process, but in my experience I've found six common traits of a good investment process:

1. Stoic: It can endure both good and bad short-term outcomes without getting emotionally swayed in either direction.
2. Consistent: It doesn't adjust to current market sentiment and sticks to core competencies. 
3. Self-critical: The process is periodically reviewed, includes both pre-mortem and post-mortem analysis on decisions, and is refined as needed. 
4. Business-focused: Rather than rely on heuristics like "only buy stocks with P/Es below 15," a good investment process focuses on understanding things like the underlying business's competitive advantages (if any) and determining whether or not management has integrity and if they are good capital allocators.
5. Repeatable: A process gets more valuable with each application -- insights are gained, deficiencies are noticed, etc. 
6. Simple: The less complex, the better. If you can hand off your process to another investor without creating significant confusion, you're on the right track.

What do you think? Let me know in the comments section below or on Twitter @toddwenning. 

What I've been reading this week...

• 5 investing lessons from Markel's Tom Gayner -- David Hanson
• Cloning Neil Woodford's new dividend fund -- Monevator
• Common sense investing guidelines -- Ben Carlson
• A small cap CEO who reads Buffett and Graham -- MinnPost
• Beware when a CEO leaves for no apparent reason -- MoneyWeek

Best,

Todd

@toddwenning 

Investing Wisdom from The Wire

My wife and I started re-watching one of our favorite television series, The Wire. We're through the third season now and I've been jotting down some quotes that I thought could also apply toward investing. Here's what I have so far.

"Game done changed. / Game's the same, just got more fierce."

If you dropped Ben Graham or Philip Fisher in today's market, they might say the same thing. The core tenets of investing haven't changed, but the impacts of technology, the daily news flow, and competition from global markets have made the game much more intense. It's important not to let the intensity of the modern investing world distract you from what investing is all about.

"A man got to have a code."

In investing, it's equally important to know what types of stocks you'd consider buying and which ones you wouldn't touch with a barge pole.

"You either play or get played."

It may be more comforting to hold only cash and bonds, but in the long run, if you don't invest in equities, inflation will win the game.

"You come at the king, you best not miss."

If you're going to make a huge bet -- particularly a leveraged bet -- on a single stock, the downside risk is massive.

"See, that's why we can't win...they (mess) up, they get beat. We (mess) up, they give us pensions."

Incentives matter. You don't want to invest in a company led by a management team that has zero downside risk for their capital allocation decisions.

"It's all about self-preservation, Jimmy. Something you never learned."

Err on the side of capital preservation and seek to minimize permanent losses of capital. Live to invest another day.

"If the gods are (screwing) you, you find a way to (screw) them back. It's Baltimore, gentlemen; the gods will not save you."

In the short-run, investing results are driven by luck; in the long run, skill. If you want to play the short-term investing game, you're throwing in your lot with the whims of the gods and your odds aren't great. If you want better odds, focus on the long-run.

What I've been reading/watching this week

• Keeping things simple - Morgan Housel
• Why you shouldn't track your investing performance - Monevator
• Legacy of Benjamin Graham - Video (h/t Ben Carlson)
• Anatomy of a failed investment - Richard Beddard
• Big markets and network effects - Aswath Damodaran
• Charlie Munger on investment concentration v. diversification - 25iq
• Are you bullish or bearish? - A Wealth of Common Sense

Stay patient, stay focused.

Todd

On Twitter @toddwenning

Why You Should Probably Own Fewer Stocks

I think the average person could know three or four or five companies very well. They could lecture on those three or four or five companies, and if one or two of 'em becomes attractive, they buy 'em...You have to know the story. - Peter Lynch 

Pardon the Saved by the Bell reference. Couldn't resist.

For many individual investors, finding the time to do proper research is a real challenge. After higher-priority commitments to family, friends, work, etc., if you have time to read one annual report a week, you're doing pretty well. 

In my experience, an investor doing all the work himself or herself needs between five to ten hours a year to keep good tabs on each stock they already own -- i.e. reading quarterly reports, the annual report, conference call transcripts, etc. Thoroughly researching a brand new stock typically takes over ten hours.

So, how much time do you have to dedicate to stock research? With 50 hours a year to spare -- about an hour a week -- you might be able to cover ten companies, but it's likely fewer. If you can outsource some research to a reliable newsletter or research service, then perhaps a few more. 

The important thing is to maximize the returns on your research time. In other words, make sure you're giving each holding the appropriate amount of research time and make sure you're investing enough in each idea that it's worth the time you're spending on it.

To illustrate, I recently reviewed my own portfolio and concluded that I owned more companies than I could adequately cover in my spare time. In addition, I had a number of 2% or 3% positions that weren't likely to have a major impact on my returns, even if they did very well.

With the market still riding high, it seemed like an ideal opportunity to go through my portfolio and eliminate smaller holdings. I started by asking myself the following questions for each stock I own:

Did you read the company's latest annual report/10-K?

Did you vote your shares and read the annual proxy statement?

Is the company's competitive position getting better or worse?

Where is the company in its business cycle?

What was the company's last major capital allocation decision (M&A, special dividend, etc.)?

If I answered "no" or "I don't know" to at least one of the above questions, it was clear that I wasn't thinking about my investment like a part-owner of the business. Either I needed to re-commit to researching the company or it was time to sell the position.

There are a number of clear benefits to owning a smaller, more manageable number of stocks. For one, you'll have fewer holdings set on autopilot, more time to focus on your best ideas, and more money to put behind your best ideas.

You might even realize better performance. A 2008 study by Ivkovic, Sialm, and Weisbenner found the following:

Among households with portfolios large enough to diversify among many stocks, if desired, the holdings and trades made by those focusing their attention on a few securities tend to perform significantly better than the investments made by those diversifying across many stocks.

Diversification is important, of course, but much of your core diversification needs can be met through low-cost index funds and ETFs. For the portion of your portfolio directly invested in stocks, however, it's important to have sufficient time and resources to monitor each company and make the most of the research time you have.

What do you think? Let me know in the comments below or on Twitter @toddwenning.

What I've been reading this week:

• Yet another reason why investing is better than trading - Irrelevant Investor via Reformed Broker
• PBS interview with Peter Lynch (c. 1995) -- PBS
• Why dividend payers aren't boring - Simon Lack
• Universal lessons from every investment discipline - A Wealth of Common Sense
• The Davis Dynasty book review - Total Return Investor
• Investing for beginners: time value of money - Monevator

Stay patient, stay focused.

Best,

Todd

@toddwenning