Resetting the compass (even when times are good)

Resetting the compass (even when times are good)

For many investors, the sharemarket seems daunting and impossible to understand. One day it’s down on fears that interest rates might rise or that the US will default. The next it’s up on confirmation that they have or on speculation that the debt ceiling will be raised.

In our experience, confusion amongst investors exists, at least partly because of the human tendency to complicate matters. That, and the fact that many experts being replied upon simply end up being wrong. The tendency to make simple things difficult coupled with a plethora of daily news to be distracted by ensures obfuscation rather than clarity is the environment in which investors find themselves operating in. Of course, it doesn’t need to be this way.

As Warren Buffett once observed:

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

For Warren Buffett, we reckon the framework has been incredibly simple:

1. Buy sound companies when available at rational prices.
2. Take advantage of cheap leverage.
3. Allow enough time for compounding to guarantee epochal wealth.

At Montgomery Investment Management, the framework is the result of the application of Occam’s Principle of Parsimony – the KISS principle as its more commonly known. Creating a framework that every team member in the office can appreciate helps us to deliver the satisfactory returns we have achieved to date. How? That’s part of our intellectual property, but in terms of its application to our investment strategy – the part we can share – there really are only two key ingredients:

1. We must buy businesses within our circle of competence and then from those, only the businesses with bright prospects.
2. We like to think about share price volatility a little differently to most.

It is fair to say that while successful sharemarket investing is not easy, intelligent investing is not complex either. There is room for many to do well in the market and you don’t have to be an expert on every company, or even many, to succeed over the very long run.

All that’s required is the ability to evaluate companies within your circle of competence. And the size of that circle is less important than knowing your circle’s boundaries. Once you understand and appreciate your limitations, simply avoid the temptation to stray outside the circle, and fill your portfolio only with those you do understand. The benefit of such discipline is that you will know if the companies in your portfolio have bright prospects for the future.

As Warren Buffett elegantly put it:

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now…Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

Which brings me to the second investing requirement. Our approach towards price volatility is perhaps the more difficult of the two to adhere to once an investment is made.

Accepting that returns will rise and fall with the market is the very first step to approaching the sharemarket. The alternative is to simply turn it off to avoid being distracted by its daily noise. If you choose to watch share prices swinging around daily, and in turn, their impact on your portfolio, your emotions will constantly chip away and dismantle your sound investing framework.

Accept that returns in the short run will always rise and fall with the market.

Many believe they are investing when they buy a share on no basis other than they believe it will go up. As you have heard here countless times, betting on ‘up’ is no different to betting on ‘red’ or ‘black’ and yet many who wouldn’t dream of gambling unwittingly do so on the stock market every day.

Treating shares merely as a blue line wiggling up and down on a screen and hoping the next wiggle goes up is no more an investment strategy than flipping a coin. Even a series of heads cannot ensure your long term outperformance. Many investors obsess over share prices, but prices simply reflect what someone else, perhaps foolishly, is willing to pay that day.

Instead, treat the stock market as a place to purchase shares of some of Australia’s best businesses and buy them for less than they are worth. And if you have done your homework and indeed truly understand that what you are buying complements a portfolio of businesses whose earnings are sure to march up over the years, then rather than getting emotional, make share market falls a time of great joy – much like discovering, for one day only, that the car you’ve always dreamed of is 75 per cent off.

Many years ago, we discovered that these two basic tenets are the foundations to successful long term share market investing. How unfortunate not to have noticed much earlier, as they’re genuinely easy to follow, and combined, enormously profitable over the very long run.

Every professional discipline has a set way to approach a problem. Investing is like any other profession. To excel at it, you have to understand the underlying structure and frame your own approach to follow it unswervingly day in and day out.