This is Part Two of the review of The Joys of Compounding by Gautam Baid. If you haven’t already, you can read Part One here first.
Now moving on to the last two sections of the book, (4) Portfolio Management and (5) Decision-making.
IV. Portfolio Management
For value investors, the earnings used for valuation should be owner earnings. Owner earnings tell us how much cash enters the business owner’s pocket. This refers to actual, spendable cash, not inventory and receivables.
Owner earnings are widely regarded as the holy grail for understanding the true earning power of a company.
Buffett defined owner earnings in his 1986 letter as follows:
(a) Reported earnings plus (b) Depreciation, depletion, amortisation, (c) the average annual amount of capitalised expenditures for PPE that the business requires to fully maintain its long-term competitive position and its unit volume.
One Dollar Test
For every dollar retained by the business, at least one dollar of value must be returned to shareholders.
This can be measured based on the return on invested capital (ROIC), which tells you how efficient capital is allocated by the management.
Read more about this in my post about The Warren Buffett’s Way.
Read more History and Fewer Forecasts
“Market forecasters will fill you ear, but will never fill your wallet”
As humans, we hate uncertainty and randomness.
So we try to make predictions. We come up with forecasts and projections about the future of the economy and businesses.
But there is no point in predicting because the world is far too complex, things don’t move in silos. And the markets, as with many things in life comes in cycles.
With each decision you make, there are a few factors that directly affects the outcome. One factor itself is connected to other factors, which accumulates to a network of factors.
There are probably millions of moving parts, which could impact your decision. Each a different magnitudes, but we have a biased judgement and cannot see beyond the first five.
The current COVID-19 pandemic seems like a never-ending battle we are fighting.
If we look back in history, humanity survived great atrocities. The swine flu, the Black death and more. In future, mankind will learn the lessons from COVID-19 and manage viruses and pandemics better. Faster and accurate contact tracing, greater speed of vaccine development, and we will never have a shortage of ventilators and masks.
Human Nature Has Not Changed in Centuries
Linking back to the markets, it is driven by the pereninal emotions of greed, fear and speculation.
Buffett and Munger, the two most recognised people in the world of investing, did not make their money from predicting economic booms and bust.
As Buffett mentioned, if the Fed whispered the level of interests rates to him, it would not affect his decisions a single bit.
There is no point predicting the markets, because the underlying value investing philosophies still remain the same.
The Myth of Diversification
You might have heard this countless times, “Diversification reduces risk”.
But does it really?
The reality is, when you diversify, risk is not reduced. Instead, risk is transferred from one form to another.
When you are diversifying, you are essentially exchanging company-specific type of risk (unsystematic risks) which may be very low, for market risk (systematic risk) which tends to be higher.
Also, risk comes from not knowing what you are doing.
Avoid owning too many stocks. More than 20 stocks is a sign of financial incompetence.
A good number if around 10-15 stocks, provides a comfortable degree of diversification as suggested by Bill Ackman.
What “Do Not Put All Your Eggs In One Basket” should mean:
Don’t diversify for the sake of it.
Diversification is only effective if holdings respond differently to a given development in the environment. – Howard Marks
What diversification really means is, do not place all your investments on similar bets.
For instance, a single market, asset type (e.g. all stocks, all bonds), inflation hedges, and pay attention to interest rate sensitivity.
By diversifying this way, we can ensure that when the macro environment changes drastically, we will not be exposed to dramatic and sudden reversals in our whole portfolio. And, in this way we can sleep better at night.
How to Maximise your Capital: The Kelly Criterion
If you are able to precisely determine the odds and payouts of a given bet, the Kelly Criterion bet size will maximise your capital in the long run.
This is the Kelly’s formula:
It’s a useful way of thinking about whether you should establish a position and the size of capital invested.
That said, there are limitations to the Kelly Criterion.
- It’s hard and impossible at times to get precise odds and payouts.
- Long-run is based on a number of events not a time frame. Unless you are a frequent investor, you are unable to get the full benefits of applying Kelly.
- Black Swan events are underestimated (F is overestimated), leading to investors placing bets above the optimal amount.
Updating Our Beliefs in Light of New Evidence
In investing, we have to balance between conviction and flexibility.
“Strong opinions, loosely held.”
When the facts change, change your opinions.
However strongly held your opinions, be adaptive to changing your views when new facts and situations are presented.
To prevent confirmation bias, expose yourself to differing opinions and views. Discuss about a stock with others and find out about their perspectives. Ask a friend to be a devil’s advocate and challenge your assumptions.
If you clone and “copy” someone else’s investment ideas, especially if they have a track record, some times you might have a good shot of making money.
It’s only natural for us to do this way, especially under the influence of an authority. For instance, copying trades of fund managers because you admire them and they have a track record of past success.
But the problem comes when we blindly copy what others are doing.
We let what other’s have said, substitute for our lack of thinking.
In investing, you can borrow someone’s ideas but never their conviction.
It’s fine to admire and respect other investors, but you should only purchase a stock only if the business falls within your circle of competence and has a good margin of safety.
Be personally responsible for your own decisions. If you lose money from buying a stock that was recommended, you can’t put the blame on others.
Develop the ability to think independently, do your own research and due diligence, instead of buying a stock just based on recommendation.
Even when you invest based on your original ideas, mistakes are part of the process. But at least you own them and there’s a high chance that you are able to take away worthwhile lessons.
Whereas, if you make mistakes just because you cloned someone else’s thesis, who can you blame? And what lessons do you learn?
Choose the right people, then clone their behaviour, thinking, process and orientation – and never blindly their ideas – and you will become like them over time.
True Essense of Compounding
In the final chapter, Gautam Baid puts together the essence of compounding into 6 key aspects of our lives:
- Compounding Positive Thoughts
- Compounding Good Health
- Compounding Good Habits
- Compounding Wealth
- Compounding Knowledge
- Compounding Goodwill
A quote by Gandhi describes compounding aptly,
“Your beliefs become your thoughts, Your thoughts become your words,
Your words become your actions, Your actions become your habits,
Your habits become your values, Your values become your destiny.”
Compounding is the eighth wonder of the world, never underestimate the exponential gains of compounding.
The trick to leading a happy, healthy, and successful life follows the same route. Take one small step at a time, and keep learning.
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