Sometimes it just feels like the stock market has gone mad
At such times, it's truly important to remember the lessons of Anthony Bolton, one of Britain's greatest investors of all time
Bolton states that bull markets cover cracks while bear markets expose them
Remember this, because the cracks are always there in one form or another
It's like a smiley face - if you look at it in one direction it smiles back at you,
but if you flip it around it looks all grumpy
Today, we will learn how to survive and even thrive
during times of stock market madness and this is:
A top five takeaway summary of Investing Against the Tide, by Anthony Bolton
This is the Swedish Investor - bringing you the best tips and tools to reach financial freedom through stock market investing
Takeaway number 1: Conviction from many discrete elements and facts
Anthony Bolton was one of the fund managers at Fidelity where other investing superstars like Peter Lynch worked at the time
He worked there for 28 years and gathered tons of experience on how to excel by investing in small and mid-sized companies during this time
Bolton says that the investing landscape has changed a lot during his time as an investment manager. In his earlier years the
focus was on digging up information that others didn't have access to or that they had missed
Today, on the other hand, information exists in abundance
and the secret to beating the rest of the investing community is now to analyze that information better than everyone else
By having a structured way of analyzing many discrete elements and facts before making your investment decisions,
you will have more conviction when you invest against the tide and you will be less susceptible or making large mistakes
Anthony's approach to investing is quite bottom-up and he has six different areas that he judges before buying a company stock
Only by being convinced after
aggregating all of these six factors will he make a purchase
One of the most powerful questions that you can ask to ensure a strong business franchise is this:
"How likely is it that the business will be around in ten years time and to be more valuable than today?"
More importantly than what the management is doing is how they are rewarded
The right incentives will often lead to strong performance
We'll cover this in takeaway number two
... and this in take away number three
You'll often benefit a lot as a shareholder when your company is purchased by a competitor
Small and medium-sized companies are more likely to be takeover targets
Bolton says that combining fundamentals with price information gives him an edge
What he wants to see is a company with an attractive story where the attractiveness hasn't yet been factored into the price
Therefore, he typically avoid stocks that have increased a lot in short periods of time,
say 200% in three years or something like that
Some information comes from newspapers, some from annual reports,
perhaps some from other analysts, interviews with managers, etc
Since the information is unstructured in its nature, it's your task as an investor to organize it
so it's possible to make investment decisions based on it
For example, to make it more visual you could rate each of these six factors on a
0-5 scale with five being the highest possible score
Doing this and doing it well take some time, so next up
we will look at how you can filter out companies that are worth diving deeper into
Takeaway number 2: A relatively low price
Mean reversion is a truly strong phenomena when it comes to investing
You can learn about this in greater detail in my summary of The Acquirer's Multiple,
but for now, just consider that most things go back to normal
A strong business turns into a normal business
A great manager turns it to a mediocre manager
But most importantly - a low valuation turns into a normal valuation
Therefore, Anthony Bolton wants to own stocks that are cheap -
cheap both when compared to historical prices and to peers
His primary 4 measurements for this are: PE (or price to earnings), price to book, price to sales and EV/EBITDA
Bolton likes to evaluate these over 20-year periods,
but for our example here, 10 years will have to do. We're going to look at:
Apple
Toyota; and
Gap
We can see that Apple trades at a higher price than it has ever done before, no matter which key ratio
we'll look at, while, for Toyota and Gap just the opposite is happening. They haven't been as cheap in 10 years as they are now
We can also see that Apple is more expensive than the average of the S&P 500 on
every key ratio while Toyota & Gap are cheaper
This is a good place to start looking for smart investments. But remember from takeaway number one -
valuation is just one of the discrete elements that you have to consider before buying a stock
It's always easier to spot price anomalies than to know when they will correct themselves
Therefore, we want to have time on our side when we are investing in these types of companies and
this is what the next takeaway will be about
Takeaway number 3: Skeletons in the balance sheet
Peter Lynch said that:
"Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets"
Let's say that you've found a company that is really cheap according to the valuation metrics that we used in takeaway
number two, then chances are that the business is not doing too well at the moment. It might even be losing money
We would prefer if mean reversion kicks in before the company goes bankrupt and because of this, we need to make sure that the
financials of the company are intact
Look at the balance sheet, and specifically you want to avoid companies that have:
- Huge debts
Compare the debt to the equity of the business or to the profits, if applicable
Don't forget to include items such as future payment obligations, pension fund liabilities and redeemable preferred shares
- Soon repayable debt
Understand the debt profile and if the company has enough cash on hand to survive in the short term
- High yielding debt
if the company has bonds outstanding,
it's a good idea to look at where they trade. If the yield is really high on them,
it's a sign that bondholders are skeptical about the future of the financials of the company and that means that you should probably be worried too.
Avoiding companies with weak balance sheets will make you miss some winners, but at the same time, it will make you avoid many more losers
Takeaway number 4: A to-do list when you are not doing that well
Even the greatest investors have periods when they don't do too well
Here's a short checklist that you should consider if your portfolio catches the flu:
The optimal conviction level is somewhere around 50%. You must maintain conviction,
but you also want to keep your flexibility
Don't ever box yourself into a corner
The great activist investor Bill Ackman famously lost a lot of money shorting the stock of a company called Herbalife
Probably his biggest mistake was to box himself into a corner by expressing on live TV that he thought the company was a fraud
Because of this his ego was on the line and he admitted defeat much too late
Don't try something completely new just because of a few bad years
Warren Buffett said that:
"I will not abandon a previous approach,
which logic I understand even though it may mean forgoing large and apparently easy profits, to embrace an approach
which I don't fully understand, have not practiced successfully, and which possibly could lead to substantial
permanent loss of capital."
Go through your worst investments historically and look for common denominators. Are you making a mistake that you've made before?
Make sure that your portfolio matches your conviction level
In other words - is the stock that you believe the most still your largest holding in the portfolio?
If not, it's time to rearrange by doing some buying and selling
Takeaway number 5: Look for asymmetric payoffs
An asymmetric payoff is a situation where there's a big upside yet a small downside
Peter Lynch famously coined the term "tenbagger", which means a stock that increases 10 times in value
Consider that if you just catch one such stock you can fail completely and pick 9 companies that goes bankrupt and
still be profitable
This asymmetry is very powerful, and a question that I think is interesting to consider when picking a stock is therefore:
"In 10 years, would it be possible for this company to be worth 10 times as much?"
For most companies that already are very large today the odds of this happening are very low in my opinion.
I just don't see how, for instance, Apple would grow from $1.13 trillion to $11.3 trillion
Or Microsoft from $1.1 trillion to $11 trillion
Or Amazon for that matter, from $850 billion to $8.5 trillion
While not impossible, we should consider that the most valuable company ten years ago was Exxon Mobil with a market cap
of $316 billion and in 2000, it was Microsoft at $560 billion
Anyways, enough ranting, my point is that small companies are more likely to have asymmetric payoffs than large ones
An example of a stock with an asymmetric payoff would be the smaller oil company
An oil company with a favorable valuation and a strong cash flow that at the same time
reinvests its cash aggressively in new exploration activities
The downside is very low in such a company, and the upside is enormous,
especially currently when the oil prices are at their lowest since 2004
A combination of "normalized" oil prices, the finding of a large oil well and a following increase in the p/e multiple would
easily turned such a company into a tenbagger
Another example would be the smaller pharma company with similar characteristics
It should have a fair valuation and a strong cash flow that,
to a large extent, is being reaped back into research to find the next big thing
Moreover, such R&D should happen in a decentralized organization with energy devoted to numerous different prospects
If the drug with a large market is found this type of company will also easily turn into a tenbagger
Another way to invest against the tide is to invest in the unsexiest stocks out there that you can find
This strategy has been made famous by Peter Lynch in his book "One up on Wall Street"
Check out my video on his book to learn how to identify the unsexiest stocks in the unsexiest industries, but with the sexiest returns
Cheers!