Forgive me for sounding somewhat Zen, but the more I learn about investing the more I realise just how much there is that I do not know, and more importantly, the more I realise how much there is that I cannot know. Investing, like many worthwhile pursuits, always gives you ten new problems for every one that you solve.
Some things are just very complicated
There’s an upcoming book called “The Ant and the Ferrari”, the title of which neatly captures what I’m getting at. Imagine you’re an ant, standing on the bonnet of a shiny red Ferrari. As far as your beady little eyes can see the whole world is flat, smooth and red. What lies outside your immediate ability to see, as well as your cognitive ability to understand, is the rest of the Ferrari.
Underneath that shiny red bonnet lie tens, if not hundreds of thousands of parts, each of which has behind it centuries of technical evolution. The materials, the manufacturing techniques, the highly advanced electronics and adaptive technologies in the dampers and the differential; they are all many many orders of magnitude beyond the ant’s ability to comprehend.
That’s an analogy of the relationship between humans and the universe, but it also applies to investing.
Some things are fundamentally unknowable
After a brief period where we thought the universe might be relatively simple and mechanistic, it now seems far more complex and strange. For all we know, quantum theory and string theory might just be scraping at the first layers of an onion which has thousands of layers. But beyond complexity, some things just cannot be know (as far as we can tell). The Uncertainty Principle implies that:
“it is impossible to simultaneously measure the present position while also determining the future motion of a particle”
Replace the word particle with ‘company’ and you have investing in a nutshell. There is no possible way to know how any of the factors which affect a share price will pan out in the future. Not the economy, not the company itself or its market, and definitely not its share price.
So what to do about it?
The mainstream academic answer to all this complexity and fundamental uncertainty is to avoid looking at the things that you can know nothing useful about. This means that they generally ignore the economy and the businesses within it. They ignore the business cycle and social and technological developments.
Instead, they focus on what can be measured. This means they focus on the long-term averages of risk (volatility) and returns from various asset classes where they have enough data to be statistically ‘confident’. You then invest in something like 5 or 10 different asset classes which are uncorrelated (i.e. when one goes up the other goes down), with a slight leaning towards those assets with the best long-term returns, which is equities.
Overall this has been a pretty successful strategy with the current peak exponent being Yale University and the Yale Model.
So the take-away point of looking at the academics and what their universities are doing is:
It’s probably better to ignore what you cannot know and then diversify because you cannot know what will happen to any one company, country or asset class
Uncertainty for stock pickers
As stock pickers we can’t just run to the nearest index, invest and go to sleep because it’s the index that we’re trying to beat. So how does a firm realisation of the sheer, incomprehensible bulk of uncertainty affect a stock picker’s strategy?
For me, it means that I build my investment process around several key pillars from which all the details follow.
The key defence against the unknown is diversification. This comes in several flavours which are:
- General – Don’t put all of your eggs in one basket is the ancient advice. For me this means upwards of 30 separate holdings in any portfolio. This is because the fortunes of any one company are uncertain.
- Industry – Across those 30 or more companies I try to have as many different industries as possible. This is because the fortunes of any industry are uncertain.
- Geography – I try to focus on international companies because the fortunes of any one country or geographic region are uncertain.
- Operational – I want companies that are operationally diverse. This can mean they operate in a range of industries, or perhaps a range of areas within an industry, or they have a range of diverse products, customers, suppliers and aren’t depended on the powers of any one (or few) ‘super employees’ (i.e. Berkshire Hathaway and Warren Buffett).
Given that the future is uncertain and that many unpleasant things are bound to lurk out there, I prefer large companies because they may be more capable of surviving down-turns and depressions.
Look for a proven history of profitability and growth
I want companies where they have earned profits through thick and thin for many years with no losses to tarnish the record. An unbroken history of dividend payments for a decade or more is also high on my wish list. It’s even better if the profits and dividends have grown consistently across business cycles too.
Avoid excessive levels of debt
This is the lesson that we are all learning now. Debt is pro-cyclical, toxic and very bad in many ways. It’s precisely because I don’t know what’s going to happen that I only want to invest in low debt companies. That way when there is a recession or depression or credit crunch, the companies I own won’t hit the wall immediately, or have to raise additional equity. Instead they can sit back and take market share from those who do.
Pay a low price relative to past earnings and current dividends
I have no idea where share prices are going this year, next year or ever. What I do know though is that they more or less track the earnings of companies over the long-term. Sometimes they’re 20 or 30 times the earnings and sometimes they’re 5 or 10 times the earnings, but in the long run it is earnings that drive share prices.
Since I know that share prices swing from high to low and back again, but the precise timing and extent of these swings is unknown and unknowable, it makes sense to ignore any predictions of future prices and just buy when prices are low and, of course, sell when they’re high.
If only it were that simple. But with a robust and long-term measure of what’s high and what’s low it’s possible to do precisely that.
Uncertainty, uncertainty, uncertainty
For property investors the mantra is location, location, location. For equity investors it should be uncertainty, uncertainty, uncertainty. Always be thinking about how much you don’t know and how it can hurt you and how to protect against it.
Remember, for every factor that you understand about an investment there are probably ten more that you know about but don’t understand, and another ten thousand that you haven’t even thought of.