What I learned sailing over an underwater volcano
Earlier this summer, with gusting wind in my hair, fine sand between my toes, and harsh salt on my hands, I was sitting at the helm of a 40-foot (12 meters) sailing catamaran. As a sailor I know that alertness and preparation are crucial to not only enjoyment but even, frankly, survival, in some conditions and locations. A particularly treacherous stretch of this trip was the crossing from the island of Carriacou to Grenada (in the Lesser Antilles, Caribbean Sea). A strong current coming from the Atlantic Ocean forcefully pushes boats right over a 4,300 foot (1,300 meters) active underwater volcano, surrounded by many hydrothermal vents that can produce hot water and gas. If you manage to stay out of the maritime exclusion zone surrounding the volcano, you may quickly find yourself too close to a series of sharp rocks. Most of them protrude of the water by tens of feet, but one is deceptively submerged in a mere five feet of water, ready to pierce any boat’s hull in seconds. The only safe way to navigate this passage is to be careful and patient.
One of my fellow crew members on this cruise was a dear friend, Jake Taylor. In addition to being a great interviewer and a gifted investor, Jake is also an author of a phenomenal investing book that came out earlier this year – The Rebel Allocator. His book caught the attention of none other than the legendary Charlie Munger, Warren Buffett’s long-term business partner. Jake has a talent for asking great questions, and it is no surprise that during this passage our conversation quickly took us in a very interesting direction – our strengths and weaknesses. It was fascinating to note the way sailing and investing put both to a real test! And Jake’s question got me thinking about my strengths and weakness as a stock picker.
A moment of introspection
I spend a fair amount of time looking back at all my investment ideas, including any stock I have seriously contemplated buying over the years. I try to learn as much as possible not only from my successes, but even more from my mistakes. Apart from spending time with clients, and speaking about what we do as investment advisors to help families and entrepreneurs keep and grow their fortunes, what I enjoy the most is the search for new investment ideas. I actually think of it as a treasure hunt!
The only effective way to learn from introspection is to be absolutely honest with yourself. I concluded that I have at least three strengths and at least one weakness when it comes to investing. I am great at spotting true investment “lemons” that can turn sour in a heartbeat, and do true damage to any portfolio, much as a sharp rock can shipwreck a boat at sea. I don’t experience the fear of missing out by chasing very risky high-flying stocks or seemingly alluring bays surrounded by deceptively shallow reefs. I am also endlessly patient in buying and selling my holdings, like a ship’s captain seeking the best route, and the safest anchorage for the night. My biggest weakness, though, is my inability to predict the future, notably the full potential of my stock picks. I tend to grossly underestimate their ultimate value … the same way that I usually underestimate the speed the sailing vessel can fetch on any passage!
I vividly remember my first meeting and long conversation with my future mentor, boss, and partner – Mr. François Sicart. I was much more interested in ways not to lose money than curious about the ways to make it. We spoke about the internet bubble that, when it burst, took people’s savings and fortunes with it. We also discussed Enron, which turned out to be a fraud and led to huge losses for many gullible investors. Mr. Sicart explained that the internet bubble was a trying period for disciplined investors, who didn’t give in to the madness, while Enron was a company he looked into, but passed on it because the accounting and the business itself didn’t make sense, and raised too many questions.
In the years since then I have identified three red flags that discourage me from investing in companies:
- TOO MUCH DEBT: Any company that borrows heavily runs the risk of being unable to pay it off or even pay interest on it. Thus, a promising but debt-laden business can actually go bankrupt, wiping clean all shareholders. After a decade of cheap credit, many companies have taken on excessive debt, becoming vulnerable in a downturn. This source of trouble is relatively easy to spot as long as a company’s filings are honest and accurate, and no debt is hidden off the balance sheet.
- QUESTIONABLE MANAGEMENT: I never forget that individuals run businesses. Even when the numbers look fantastic (as they did for Enron), if there are any reasons to believe that the management is pursuing illegal or unethical practices, it’s wise to stay away. Unfortunately, questionable managements have a gift for selling investors on a very convincing story. The best test? If something sounds too good to be true, pay attention. Very often for me, the warning is just a hunch I can’t ignore – a feeling that I wouldn’t leave my wallet with the people I’m meeting. When that happens, I am happy to walk away.
- SECULAR DECLINE: Every industry and every business goes through life stages. They emerge and grow only to stagnate, shrink and fade away. Historically, companies would take decades to earn dominance of their markets, and decline was similarly slow. Today, we see $100B+ companies with massive underlying businesses that didn’t exist 10-20 years ago. We also see $100B+ companies fall from their peak in a few short years. To me, secular decline means the period in a company’s life when the business diminishes consistently and irreversibly. Recently, we’ve seen an accelerated decline in the retail industry, for example. Shopping has moved online, and store visits have been falling for years, leading to countless bankruptcies. Too often though, a secular decline can be mistaken for a cyclical downturn or just a passing hiccup in long-term growth. For me, correctly identifying the less obvious secular declines is the hardest part of identifying potential investment lemons.
Free of FOMO
Fortunately, I have not developed a frequent ailment among investors, i.e. fear of missing out, or FOMO. A rising stock with a convincing leadership can be seductive, and it’s easy to ignore many red flags. Not long ago, I wrote about a South African furniture retailer (When Bottom-Up Research Helps Top-Down Understanding) which not only became a major global player with acquisitions across Europe and the United States, but whose leadership was dubbed as visionary by the most respectable financial periodicals. I kept watching its meteoric rise with great curiosity. We at Sicart never bought it, fortunately. In late 2017, the CEO resigned and the stock fell 96% after fraud was discovered, with over $10 billion in overstated profits and assets. This case study is a classic example of all three qualities of an investment lemon occurring at the same time: questionable management used excess debt to cover up a secular decline in its industry – retail.
As a kid, I remember planting lots of trees with my parents: pines, birches, oaks, alders, walnuts, fruit trees, even junipers and magnolias. It was a great lesson in patience. I remember how at first, I used to check in on them daily with a growing disappointment in their lack of progress.
Investing is very similar. First, we need to take the time to get to know a new potential investment opportunity. Second, we might have to wait for the price to come down. Third, once we buy the stock, we may have to wait for the returns to come. Nothing matters more in investing than patience, and most of us need to develop it over time.
After my last year’s trip to California Redwoods, I decided to plant a sequoia tree (You may have read about this in earlier articles). I got a few seeds, planted them according to the instructions that came with them, and now I’m watching five little trees (sprouts, really) get slightly bigger every month. Those sequoias my take my experiment in patience to a whole new level, like no birch or pine ever could!
To make my professional life easier, I like to keep a wish list of companies I would like to own at some point. Many I may never buy, because I won’t buy any stock at an all-time high price. But once a stock ends up on the list, I just wait. Sometimes months, sometimes years. It is surprising how often my patience pays off and wish-list ideas end up becoming attractively priced. Even when the price is right, though, I don’t rush. I don’t know where the bottom is for any stock, so at Sicart we buy them gradually, sometimes over months or even years. Each of those investment opportunities is a small piece of a bigger puzzle, building an ever bigger, enduring family fortune. Time works in our favor. Time, in fact, is the biggest asset the family wealth can actually have!
Predicting the future
The investment profession is obsessed with attempts to predict what’s next. We want to know if the economy will grow 3.2% or 3.4%. We try to guess if the Federal Reserve will move the interest rate by 25bps to 50bps. Stock analysts attempt to forecast quarterly per share earnings down to the last penny. Which, when you think about it for a minute, is not just impossible but also useless. A global company with operations in 100 countries, sourcing inputs from 50 countries, buying, selling, and reporting in dozens of currencies, is subject to numerous external forces. They include not just economic and political developments, changing consumer preferences, but even weather patterns that can seriously disrupt trade. (Think of hurricanes or, yes, volcanic eruptions, that can ground planes for days.) How can a 22-year-old analyst in a dark gray cubicle in downtown Manhattan predict earnings with pinpoint accuracy of a single penny?
I strongly believe that it’s not that single penny’s worth of earnings that makes or breaks a company. Instead, it’s the long-term ability to generate lasting and growing cash flows. I count these cash flows in hundreds of millions or tens of billions, and let the Wall Street analysts lose sleep over the pennies.
However, knowing how to avoid lemons and having the patience to correctly time your stock purchases are not all that’s needed to succeed. It’s also essential to see the full potential of your investments. I always assume that if I buy the right stock at the right price, the upside will take care of itself. I can’t forecast the full potential of most of my holdings, or the timeframe that will produce it. If anything, a lot of my picks tend to go nowhere for more time than most can bear, only to rise in a very satisfying way. What I lack in forecasting skills, I make up with my biggest strength — patience.
An even more patient seller – Letting them run
I don’t think that every weakness has to be turned into a strength. To be honest, I can’t think of many ways that I could improve my forecasting abilities, but I’m fully aware of my weakness, and I make my decisions accordingly. Since I eliminate so many investment opportunities by weeding out the lemons from my idea list, and I give myself all the time needed to make the right purchase at the right price, I just have to make sure I hold on to my stocks long enough to realize their full potential, letting them run or even, sometimes, fly.
Many investors like to have a price target in mind. They think, “If I bought XYZ at $10, I need to sell it at $20.” I have never been fond of price targets. Looking back over my record, the best picks doubled or tripled in price. Some even rose by a factor of ten, or became “tenbaggers,” as legendary fund manager Peter Lynch liked to say.
Mind your own race
On another trip last year, we watched a sailboat pass us by rushing to get to the anchorage ahead of everyone, and definitely ahead of us. Apparently, New Yorkers’ commuter habits die hard even if you are standing behind a helm of a sailing vessel. Once we cleared the peninsula, we got to see our front runner sitting still on one end of the bay awkwardly leaning to one side. The boat was stuck on a reef aptly called “the bareboat bounce”, where anxious boat renters take an easy shortcut into the bay unknowingly risking running aground. We passed them with ease, and comfortably found a good spot for the night. Hours later a few local fishermen made a little money helping the speedy cruiser get off the reef. The next day, we got to see the captain snorkel around his boat assessing the damage. The are many shortcuts in life, sailing and investing, but not all of them are worth taking!
This experience reminded me of Ben Graham’s, the father of value investing words (who lived through both the Roaring 1920s, and the Great Depression) :
“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go. In the end, what matters isn’t crossing the finish line before anybody else but just making sure that you do cross it.”
With the U.S. equity market hovering at all time highs for many reasons that may not be sustainable, it’s good to reflect for a moment and ask ourselves — what race we are in, where shallow reefs might be hiding, what really matters, what our finish line is, and most of all, whether we have the right plan and the discipline to get there.
In investing, as in sailing, you can’t avoid confronting your weaknesses. But it’s much more constructive to play up your strengths and use your weaknesses to guide you on your path. On our ten-day catamaran voyage, whenever someone asked me how soon we would get to the next destination, I would always say, “Probably under two hours,” — only to hop to another island in under one hour. I can’t accurately estimate any stock’s full potential because there are too many moving parts; I can’t accurately estimate the time any sail will take. I do like to study the charts, and give myself plenty of time, the same as I do my thorough research before I buy stocks cheaply, and I give them plenty of time to run — and possibly even fly!
This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.