Betraying Your Investment Framework

Framework

Many of you will know I talk regularly about my investing practice and the framework I am developing.  Having been at this for only two years I am well aware this framework will remain a work in process for a good while yet, but so far it is based on two essential tenets.  One, investment in free cash generative, growing businesses.  Two, investment in these businesses at reasonable valuations.  But I have a confession to make.  I have in the past few weeks had my head turned.

In the Beginning

I think it essential for new investors to immediately begin to establish a framework that they are comfortable with.  Doing so will give them a good grounding, and help to eliminate some of the erratic decisions beginners often make.  I’m still working on this, fully in the knowledge that it will be a lifetimes’ work.  I bet if you asked Warren Buffett or Charlie Munger, they’d say the same thing.  At the ripe old ages of 87 and 93 respectively, they’d say they are still learning.  And that’s how it should be.  Look at the process of investing as an intellectual exercise and you’ll be that much more passionate about it.  The more passion you develop, the more you’ll want to improve and try to eliminate weaknesses in your processes.  Hopefully you make a little money along the way!

I read a lot, I listen to a lot of podcasts, and I enjoy the variety of debate to be had on Twitter.  All have been essential in helping to structure how I think about investing.  I’ve made mistakes.  Sold otherwise quality investments early because of a lack of patience.  Bought into speculative oil exploration companies.  But mistakes are part of the process, and mistakes are inevitable.  Most importantly, however, is that you learn from them and move on.

The GARP Framework

People love putting labels on things.  You may get asked what type of investor you are.  It’s an interesting question.  Would you have an answer?  If I had to put a label on how I look at things currently, it would be GARP.  Growth at a Reasonable Price. Look at the majority of the holdings within my portfolio and you’ll see mostly smaller-cap, growing companies on reasonable valuations.  A few years ago I’d have identified as a value investor, however the more I think about it, the less sense this makes to me.  The essence of value investing is in buying something for less than we perceive it to be worth.  By that rationale, we’re all value investors, aren’t we?

But this is where my thoughts are starting to diverge.  Let’s look again at what I am drawn to:

  • Quality, growing companies, which are
  • Free cash flow generative, and
  • Trade at reasonable valuations

The Pure Growth Framework

It all began a few weeks ago, whilst listening to an interview conducted by Patrick O’ Shaughnessy on his podcast, Invest Like the Best.  Patrick spoke with David Gardner of The Motley Fool, about companies who ‘break the rules’.  These are, by and large, young and growing companies who are disrupting important high-growth industries.  Gardner enumerated five criteria when searching for a business of this type:

  1. Top Dogs and First Movers – Businesses at the forefront of new industries, setting the pace.
  2. Visionary Leadership – Management adept in capital allocation, able to anticipate future movements.  Visionaries able to find solutions to people’s needs.
  3. Competitive Advantage and Moats – Businesses with defensive characteristics and pricing power.  Brand association.  Unique leadership.
  4. Price Momentum – Companies with positive price momentum and strong past price appreciation.  “Stocks that have already done very well”.  Buying low is seldom a good idea.  Don’t wait for the ‘dip’.
  5. “Overvalued” Companies – If a business disappeared tomorrow, would it cause disruption?  If something is termed “overvalued”, it’s a buy signal to Gardner.

In many ways, this train of thought is not particularly new or innovative.  I believe the difference to be that Gardner lives and breathes this philosophy.  He also never sells.  As he mentions in the podcast, he bought Nvidia in 2004 at 6, watched it appreciate to 40, watch it subsequently drop back to 5, watch it then stagnate for years before enjoying the massive rally seen in the previous two years.

Now, it goes without saying that a number of his picks have failed spectacularly.  Trying to identify those companies that will go on to be leaders in their field is extremely hard.

Thinking Time

To date, the quantitative-focused strategy I am using appears to be working.  My third-quarter results published recently appear favourable, however as mentioned the evidence only goes back two years.  Far too short a period of time to suggest the strategy will prove successful in the long-term.

The strategy works for me for a number of reasons.  Firstly, I work full time in a demanding job, and can’t devote much time to stock-picking.  A quantitative strategy rules out poor quality businesses and those who don’t make money.  It works in my favour, because I don’t have the time to over-trade and over-think.

But make no mistake, it is easier to extrapolate past data and try to project revenue growth forward than it is to try to identify those companies that will go on to change the world.  A qualitative strategy like Gardners takes an awful lot of effort.  But look at the potential rewards.  Gardner first bought Amazon at just over three dollars a share and continues to hold today.  Amazon, Netflix, Google, Facebook, Nvidia.  All companies who have changed the world.  This process is made all the more difficult due to the fact that most of these types of companies aren’t profitable from the beginning.  In some cases it wasn’t even clear how they would even make money, let alone go on to generate the kind of returns that propel their stock price into the stratosphere.

And Gardner never sells.

In the case of little old me, this kind of thinking would represent a substantial change in my philosophy.  I’m sure I’ll be writing about this again in future posts, because there’s an awful lot to digest here.  I said at the beginning of this post that I think it essential for investors to work to develop their own strategy.  I think it equally important to stick to it once you’ve done so, less you end up being led all over the place by any speculative suggestion you read.  At the same time, the ability to adapt and improve must be core to your thesis.  So the question for me is, at what point do you end up betraying your investment framework?

Happy investing!

 

Leave a comment below, or find me on Twitter @BritishInvestor.

8 thoughts on “Betraying Your Investment Framework”

  1. Hi Chriss, I would say that betraying your investment framework occurs when you invest in a way that is not in line with your framework.

    However, if you change your framework because you have learned something new which you think may improve it, then that is not a betrayal.

    Also, there are two types of change: Evolutionary and revolutionary. I think what you’re talking about is evolutionary, i.e. adding some additional qualitative analysis after you’ve done your quantitative analysis. I do the same sort of thing to my strategy quite often, although less so as the years go by and the strategy matures.

    I’ve also made several revolutionary changes too, including a switch from passive to active investing back in 2003, and then from funds to shares in 2007, and then from deep value investing to what I call defensive value investing (quite similar to GARP to be honest) in 2011.

    So change is fine in my opinion, and the thing to watch out for is when you find yourself making investment decisions in an ad-hoc manner, or outside of your strategy. If that happens then either stop it (!) or change your strategy to encompass that style (although ad-hoc investing is rarely a good idea!).

    1. Hi John

      Thanks for the comment. I completely agree with what you’ve written, and probably should have explained myself a little better.

      I completely agree that change can be absolutely fine, certainly I have changed how I invest over the past few years as well. So long as you’re working towards a framework I think that is acceptable. However as you say, making ad-hoc decisions is where trouble can be found.

      Thanks

      Chriss

  2. Hi Chriss,

    Nice article.

    I don’t think we are all value investors. I regularly buy things that I think are worth less than I paid for them, in the expectation that the price will continue to increase regardless.

    I agree with you and John that your framework should evolve. We’re all learning, all of the time.

    And I tend to operate multiple frameworks (for different portfolios) simultaneously.

    Best,

    Mike

    1. Thanks, Mike.

      Very interesting that you purchase investments that you believe are worth less than what you paid. I’d love to pick your brain sometime as to why you do this.

      Chriss

  3. Your post reminds me of the saying “beware of capitalising hope” one of my favourites to recall when I find myself starting to justify slightly more unreasonable valuations of a prospective equity.

    My framework is also still under development and like John points to, being aware of an evolution vs ad-hoc (or post-hoc) change is crucial, although I’ll admit it’s hard to know when it’s the latter. I sold out of a company recently when it became clear my valuation didn’t have a good enough foundation – I’m relived now I sold it even though I made a small profit. The stock may go higher (!) but had I continued to own it I’d be speculating, not investing.

    Thanks for a very thought provoking post.

    1. An excellent comment, thank you. Having the courage to sell in that circumstance doesn’t come easily, so well done. All the more galling to watch it continue to go up (if it does), but at least you know you stuck to your framework. There are always other opportunities.

  4. Good piece Chriss. This is the first time I’ve visited your website after following you on Twitter. I’ve been investing since 2012 and am still trying to define my style, although I would say it comes closest to GARP, with a dose of rules based on my knowledge as a marketing professional (brand power, moat, barriers to entry – very much like investing!).

    Like you, I’ve diverged from my principles a few times to run with ideas. I like investing in those speculative companies that fit into what I consider growing themes. ITM.L is an example of that but I freely admit it’s very speculative, albeit one that’s working so far.

    The business landscape has been transformed by the recent spate of disruptors, so whilst I don’t think it’s a good idea to bandwagon on stocks without research i do think it’s taking some level of risk with good ideas backed by good management – as they offer stellar returns if they perform. And it’s always easier when you know the market. My past interest in gaming certainly influenced my move on KWS and just in time for FDEV’s recent jump.

    1. Hi mate,

      Glad you enjoyed the piece. Sounds very much like we share a similar investing style.

      Look forward to discussing holdings and ideas with you further.

      Chriss

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