How to generate extreme returns (Part 1) – an introduction

First published on 2/29/20. Revised on 4/11/20.

My goal as an active investor is to out-perform standard stock indices by a large margin over an extended period.

A standard stock index is a formidable opponent, as the vast majority of active investors would attest. Most generate returns insufficient to beat a passive investment in a diversified index in a single year. Those who do are unlikely to repeat the performance in other years. However, those who maintain sustainable market-bearing returns exist, albeit in small numbers.

Achieving extreme returns can be a complex study weaving disparate topics from finance to psychology. Yet, similar to complex phenomena in the physical sciences, simple rules, governed by constraints, underlie chaos. Simple does not imply that the rules are easy to learn or execute. Rather it means that the rules are clearly defined and hence possible, though difficult and unintuitive, to learn. This series of studies attempts to explain the simple rules underlying the complex, oftentimes disorderly, achievement of extreme returns.

First, avoid permanent loss.

 “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” -Albert Einstein

It is perhaps counterintuitive to introduce the topic of extreme returns in the form of loss avoidance. It is akin to telling a new driver that the point of driving is, not to travel from A to B, but to avoid accidents. Yet the practice of defensive driving to avoid accidents inevitably leads to safe travel. Similarly, the practice of avoiding losses eventually results in returns.

Loss avoidance unleashes the power of compounding to produce extreme, if not downright mind-boggling, returns over time. A $10,000 investment generating 10% per annum provides $1.7 million profits in 30 years. However, a single year of loss can cost years of profits. In the previous example, a 50% loss in the 30th year is equivalent to losing all profits in the prior 7 years. Consecutive 50% losses in the 29th and 30th year wipe out profits accumulated over the prior 15 years.

Second, to avoid permanent losses, one must invest, not speculate. Investments are decided based on cash flows, and speculations on anything else.

Investors perceive a business having two values: the observable market price, and the unobservable yet conceivable intrinsic price. Investors establish the intrinsic value of a business on an absolute basis, meaning it is based on the sum of future cash flows discounted by appropriate interest rates. Speculators have little consideration for intrinsic values. Their chief concern is future price movements based, not on fundamentals, but on predictions of the behavior of others. Some assets, such as collectibles, can only be speculated and never invested because they do not generate cash flows. Hence they can only be priced based on past transactions. Their values are based on circular reasoning, that is they are bought because they were bought in the past. This increases their prices, attracting more buyers, further increasing prices, and repeating the cycle. The speculative logic can collapse any time.

To further differentiate investors and speculators, one distinguishes absolute valuation from relative valuation. Believing that a business should trade at 20x earnings because its peers do is an example of relative valuation. However, such speculative logic quickly collapses with second-order thinking. If one purportedly buys the business in question at lower than 20x peer earnings, the purchase would increase the peer group multiple higher than 20x, which is the impetus for further purchases. Circular reasoning inherent in relative valuation means that the logic can collapse at any time.

Third, stay away from excessive leverage.

Investors have to be ready for the markets to do anything. It is challenging to tell what will cause a crisis, so investing with a plan to defend against crises is absolutely necessary. The more leverage is used, the lower the ability to ride through temporary quotational losses, the weaker the defense against crises.

Fourth, define your circle of competence and stay within it.

“Real knowledge is knowing the extent of one’s ignorance.” -Confucius

“There is nothing wrong with a know-nothing investor who realizes it. The problem is when you are a know-nothing investor but you think you know something.” -Warren Buffett

“It ain’t what you don’t know that kills you. It’s what you know for sure that just ain’t so.”-Mark Twain

To avoid losses, you have to avoid what you don’t know. The successful investor does not have to know everything, but has to be certain of the boundaries of his knowledge.

To evaluate a business, the investor has to know the factors that are important and knowable. The intelligent can identify the important elements, but only the wise can tell whether they are knowable. The wise is aware of the limits of understanding.

For example, it is easy to identify oil prices as a primary determinant of revenues for an energy exploration business, but it is utterly unwise to believe that one can forecast oil prices with certainty. Oil prices are important but unknowable. Forecasting customer retention for a software subscription business that has maintained consistent retention for 20 years is relatively more certain. Retention rates are important and likely to be knowable in this example.

For some businesses, the important factors are never knowable. Their prospects can never be predicted with certainty. Hence these businesses can never be wise investments. Buffett places them in the “too-hard” pile. Why leap over 7-foot hurdles when you can step over 1-foot hurdles?

Fifth, maintain a process that guards against destructive instincts.

“If the Earth formed at midnight and the present moment is the next midnight, 24 hours later, modern humans have been around since 11:59:59pm – 1 second. And if human history itself spans 24 hours from one midnight to the next, 14 minutes represents the time since Christ.”

The implicit mathematics shows that the existence of modern humans occupies one-tenth of 1% of 1% of time since the formation of the Earth, and the existence of civilization (crudely defined as time after the birth of Christ) is one-thousandth of that. In short, humans have not existed that long, and human civilization occupies a tiny part of that short history.

Hence, the human instinct has mostly evolved in environments before civilization. The important implication is that instincts useful during pre-civilization may not be so now.

Consider the human instinct to follow crowds. Pre-civilization, humans lived in hazardous environments with dangerous predators, and lacked sufficient food, water, and shelter. A tribe offered better protection against hazards and more resources than the individual. There was safety in numbers. The tribe was so essential to human survival that following others became a basic instinct. Fast forward to today, investors are unlikely to live in conditions similar to those their ancestors did. There is no pressing need to live closely with others in a tribe to protect against hazards or obtain necessities, but the instinct to follow others still exerts itself because our instincts are mostly shaped during pre-civilization.

Following the crowd in investing is detrimental. If one buys and sells stocks when the crowd does, one would buy high (the crowd buying increases prices) and sell low (the crowd selling lowers prices).

To weed out destructive instincts, investors require a systematic process that provides fair treatment to all analytical thoughts. Any thought has to be properly judged and given due process. The lack of due process is akin to a court with only one attorney. The sole attorney may present an excellent argument, but a judge can never find it valid without weighing other perspectives.

Along the lines of the same analogy, the investor takes the role of an attorney (when presenting his own perspective), listens to opposing attorneys (when considering the perspective of others), and finally arrives at a conclusion, whether presented or not (when weighing all, available and unavailable, perspectives as a judge).

The complexity of achieving extreme returns is proportional to its rewards. Identifying simple, clear rules is akin to locating a lighthouse, essential in pointing the right direction amid the perplexing, inundating, and stormy sea of investing.

“It [referring to investing and achieved outsized returns] is not supposed to be easy. Anyone who thinks is easy is stupid.”-Charlie Munger

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