Investment Practices and Strongly Held Beliefs
Practices
We want to own businesses that can compound shareholder equity either through increases in the value of their assets, or through cash flow that is reinvested in assets that will grow in value.
We want to make investments that have a good chance of being priced a lot higher in the future.
We start with the premise that markets are unpredictable, so we spend no mental energy in trying to predict them. HOWEVER, it is important to understand the overall risk environment and the fact that asset returns will eventually return to historical norms.
We always try to invest with a margin of safety.
We don’t invest in a trading portfolio to try to make fast money.
We will not make market timing or liquidity bets with clients’ capital. We will use valuation and behavioral biases to our advantage.
What we do not own is as important, if not more important, than what we do own.
We target a fixed benchmark of 12% annual return on our equities. It’s a better focus for investment decisions. If we orient to matching or beating a benchmark, such as the S&P 500, it would not help clients. Benchmarks are an arbitrary return, can be hugely risky (when everyone else is indexing like today), and trying to beat it leads to poor quality decisions. Benchmark focus is risk-seeking, and a fixed return focus is risk-avoiding.
We invest where the elements are in place for the stock price to go much higher. Whether it’s improved operating performance, far too cheap on a valuation basis, under pressure due to temporary factors, change of strategy/management team, etc.
There are four types of stocks: 1. Risky stocks that everyone knows are risky (Tesla, unprofitable tech, meme stocks); 2. Risky stocks that people don’t think of as risky (Kraft-Heinz, General Electric, Meta Platforms); 3. Respected companies with beaten down stocks that can appear cheap on the surface, but are actually risky (called value traps), i.e., Intel, Bed Bath and Beyond, IBM; and 4. Beaten down stocks that are actually great companies but trade cheap for temporary/behavioral reasons. The last group (#4) is what we strive to own.
We try to make money and avoid losses by doing the hard work of understanding what we own and putting a conservative value on it. We don’t have any special powers, just experience, an understanding of accounting, finance, economics, markets, and awareness of the behavioral mistakes others make. And having the right tools to do our job.
Beliefs
For the retirement phase of life, you need a portfolio that can withstand a prolonged and possibly severe bear market period as well as an erosion in the value of dollars brought by inflation.
Positioning is the most important thing.
Price declines are not the same thing as ‘losing money’.
Past performance does not predict future performance.
Markets can, at times, be completely irrational. At one point during the pandemic Zoom, a money-losing business, was worth more than Exxon. It is important to be aware of those times prices become unanchored from reality.
Much or the investment industry is set up to create the illusion that something exists that other people can’t have.
The truth about the investment industry is that the people who make investment decisions, and drive stock prices, are mostly doing it with other peoples’ money. Not their own. Advisors can get caught-up in the ‘performance derby’ and focused on short-term outcomes, not long-term risk-adjusted returns. In that process, huge mistakes can occur. So, we as individual investors, have an obligation to be aware of those mistakes, have the patience to let them play out as mistakes (avoid them), and put money to work productively.
For stocks, a lot of money is made in situations where operating results are less bad than pessimists broadly expect, as opposed to in situations where the operating results of popular investments come in even better than the optimists believe. You also, in our opinion, get more margin of safety when you invest that way.
Warren Buffett got rich by not being stupid as opposed to outsmarting everyone else.
Advisors can take these approaches in their investment strategy: 1. Overdiversify you using a ‘best of breed’ approach; 2. Give you a portfolio that does not deviate too far from the S&P 500, or 3. Give you a momentum-based portfolio of today’s popular investment. Townsend does not believe these scenarios serve you, the client.
Markets are partly financial (data driven and quantitative), but also partly behavioral.
Markets historically revert to the mean. And you want to be on the right side of mean reversion when it happens.
Markets are composed of capital seekers and capital suppliers. Capital seekers may have a financial incentive to mislead you. Capital suppliers have a responsibility not to be misled.
Investing is not about prognosticating the future. It’s about figuring out what are good risks to take and what are bad ones. We know that we don’t know the future and we don’t pretend to.
There’s no rocket science to investing. There’s just time and hard work that it takes to do it well. There is no superior formula, algorithm, or mouse trap.
When you work with a firm that has a large investment committee, the investments that they make can reflect a combination of biases, corporate agendas, inter-office politics, and business considerations. These scenarios can lead to general mediocrity. Townsend believes you are best served by a firm that works hard to mitigate all of that.
Prices reflect a set of expectations. Since markets are completely unpredictable, we try to stack the odds of favorable outcomes in our favor by just owning good long-term investments. And owning good investments means assets that are going to cash flow, and we want to pay less for that cash flow than what it is worth in the present. That sometimes is going to mean owning things that are out of favor or controversial.
It is our opinion that in the process of trying to prop up economies by suppressing the price of credit, the Federal Reserve has obscured the price discovery mechanism and the result is a possible distortion of asset prices and incentives, and, it has contributed to a speculative/risky environment. It is important to understand the incentives of the Fed and impact on the financial system and pricing.
“Acknowledging what you don’t know is the dawning of wisdom.” – Charlie Munger
“Remember that just because other people agree or disagree with you doesn’t make you right or wrong — the only thing that matters is the correctness of your analysis and judgment.” – Charlie Munger
We want the market to agree with us….but later.
Strongly Held Beliefs
Townsend believes the 5 big destroyers of capital are 1) Inflation; 2) Taxes; 3) Misbehavior (overtrading, excessive fees, performance-chasing, leverage, etc.); 4) Misallocations (bad investments, too much risk, etc.); and 5) Catastrophic loss.
We see the math of investing is asymmetric. If you are down 33%, you need to be up 50% to break even. If you are down 50%, you need to be up 100%. Therefore, avoiding large losses can be the best way to maximize your compounded returns.
We see only three conclusions with respect to every investment: ‘Yes’, ‘no’ and ‘too hard’.
We see only three possible actions with respect to every prospective investment position: ‘Go long’, ‘Go short’ and ‘Ignore’.
If markets were predictable, trillionaires would exist.
Most of a stock’s movements, including declines, are normal variability and not worth spending any mental energy on. Much more important is to identify investments that don’t carry heavy risk of a permanent loss of capital. That means avoiding future bankruptcies and avoiding overvalued investments.
Wall Street is a caveat emptor system. It may not make sense for investors/retirees to be served by a firm that promotes investments, uses sell-side research, rather than a firm that develops its own independent research and approaches every investment with a high degree of skepticism.
Pricing power matters in business.
One of the best outcomes of rising rates is that government interest payments will take up such a larger percentage of their budgets, which, in turn, will force a shrinking of wasteful expenditure, subsidies and heavy interventions. This will likely transition the economy to become more market-based, which is healthy because people will then produce, innovate and become more independent.
Wall Street’s job can be to sell stock and investment products to clients. In the process, Wall Street can overstate the investment merits of what they are promoting. Lyft, Peloton, Beyond Meat are prime examples. Many companies widely-touted by sell-side brokers and Wall Street media partners can be geared to appeal to individual investors. you often hear about these on outlets such as CNBC, who should know full well that these promoted ideas are hyper-risky. Once their share prices decline by 90% you rarely hear about them again.
We believe due to loss aversion and periods of excess leverage, markets, on average, go down twice as fast as they go up.
