Mistakes that can ruin your quality stock portfolio & how to avoid them

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Mistakes that can ruin your quality stock portfolio & how to avoid them


Renowned financial author Lawrence A Cunningham says it is essential for investors to have a quality-focused long-term investment strategy if they want to achieve success in the investment world.

In the same breath, he says it is very challenging to follow such a strategy, as it involves resisting the temptations to respond to short-term attractive opportunities and standing by decisions that may not be looking very right at a particular point of time.

Cunningham believes such challenges can lead investors to fall in the trap of making unacceptable mistakes, leading to permanent loss of capital.

Lawrence Cunningham is a famous financial author with more than a dozen books on Berkshire, Warren Buffett, value investing and finance under his belt, and many of them have been labeled as top investment books of all time.

One of his books,
Quality Investing: Owning the Best Companies for the Long Term outlines the investment philosophy of London-based hedge fund, AKO Capital, and the lessons its portfolio managers, Torkell T Eide and Patrick Hargreaves have learnt over the years.

The firm generated returns more than double the market (9.4% per annum versus Europe’s 3.9%) since inception more than a decade ago.

The book contains tips and strategies for investors to build an investment checklist that can dramatically increase the chances of outperforming the market on a long-term basis.

What is quality investing
Cunningham says one should look for some key qualities in a business that can stand the test of time and help it fend off competition.

According to him, Warren Buffett was the master of using this approach and became one of the richest men in the world by following this strategy on a long term basis.

He says three things indicate the quality of a business: strong and predictable cash generation, sustainably high returns on capital and attractive growth opportunities.

“Each of these financial traits is attractive in its own right, but combined they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can then be reinvested,” Cunningham wrote in the book
Quality Investing: Owning the Best Companies for the Long Term.

He says investors make two common mistake in investing:

  1. Those made when buying and
  2. Those made when deciding to continue to hold, instead of selling, a stock

Mistakes made while buying stocks
Cunningham believes the goal of every investor should be to be both smart and wise to avoid big mistakes. “The best thing to do after making or observing a mistake is to acknowledge it and absorb the relevant lessons to avoid repeating it. In the case of quality investing, to paraphrase Mark Twain, while scenarios do not repeat exactly, they do rhyme,” he says.

Several mistakes can affect the initial purchase decision of an investor. Cunningham lists out the common ones into a few categories that, if kept in mind, can significantly reduce the probability of repeating them in the future.

Consider quality investing as a ‘top-down’ approach
Cunningham says investors should consider quality investing as a ‘bottom-up’ exercise and should focus primarily on a company and its industry, taking all the microeconomic factors into account.

He feels although many investors do follow this approach, there are some who engage in ‘top-down’ analytics by looking at the broader environment, which includes considering the state of international trade, the rate of inflation or the relative strengths of currencies. Cunningham says investors can make mistakes if they give more importance to and follow a top-down approach over bottom-up analysis.

This is often the case when large macroeconomic factors start affecting stock prices, leading to investors questioning their exposure to factors such as trade, inflation or currency values.

“Although these macroeconomic trends warrant close attention, as they bear on given companies and industries. However, when top-down factors trump bottom-up analysis, it often leads to choosing companies and industries for the wrong reasons,” he says.

Another risk of using a top-down investment approach is weak conviction, as investors who want to hold an investments for the long term require conviction upon buying stocks to withstand volatility.

Cunningham believes when an investment idea is dependent on macroeconomic factors, it is far more difficult to have a conviction about a company or even an industry.

“When adversity or surprise strikes — for example when commodity prices fall or currencies reverse — it can be harder to stand by the thesis. The result is often not only a mistake on buying, but a mistake on selling prematurely — even the dreaded syndrome of buying high and selling low,” he says.

Being over-optimistic
Cunningham says over-optimism is a common source of making errors in investing, and it can affect portfolios of quality investors.

He says investors often fall in the trap of believing companies, which assure investors that good times are around the corner. One needs to be cautious of such companies as they frequently lead to making mistakes.

“Most next-Monday industries and companies continue to disappoint, because their infirmities are due to external factors that no management can permanently overcome. Even for investors able to pinpoint the time when a structurally challenged industry is due for its moment in the sun, they still must time the sunset. That means, timing both the decision to buy and the decision to sell, which makes it twice as likely to make a mistake,” he says.

Staying overconfident
Cunningham says overconfidence is the root cause of many mistakes, as investors often overestimate their knowledge and abilities.

“Straying beyond the boundaries of one’s knowledge and experience increases the risk of making an error. For instance, any investment in a stock that depends on the outcome of external factors beyond a company’s control is on shaky ground,” he says.

Cunningham feels investors should stay alert to the risks of venturing into unfamiliar zones, which can help recognize and respond to surprise events or disruptions rationally.

Overlooking the downside risks of debt
Cunningham feels many investing mistakes crop up when investors overlook the downside risks of debt or its sources. “Debt can be seductive, because even those wary of excessive leverage can be deceived into stressing its upside more than its downside. After all, leverage can readily be rationalised, with managers and advisers alike explaining how unconventionally high debt levels are either under unusually tight control or insulated from the usual risks of calamity amid business adversity,” says he.

Cunningham believes debt-oriented mistakes are most likely during periods of economic expansion as amid prosperity, even mediocre companies appear to perform exceptionally well. “Such an environment leads to making mistakes, more dangerous than overlooking the downside and sources of debt,” says he.

Mistakes while retaining stocks
Quality investing means owning the best companies for the long term, and investors often make mistakes as they get complacent and fail to recognise when a ‘once-great company’ is falling out of favour.

Cunningham says as no firm is invincible, investors should devote considerable effort to monitor and notice signs of deterioration to prevent further damage to a portfolio.

Ignoring the gradual decline of a company
Deterioration of a company takes place gradually over a few years or more and does not happen all of a sudden. There are only a few rare cases when the decline of a company is so rapid that it is easy to sell as quickly as a ‘frog might jump from boiling water’.

Cunningham advises investors to detect the gradual decay of a company and resist complacency and denial even if it had given great returns in the past.

He says the overall deterioration of a business generally begins with small things not going according to the plan, like growth not materialising, unexplained pressure on margins, more discussion of competitive pressures or gradual increases in capital expenditure.

“A material profit warning, even from a company in a relatively stable industry, can indicate that serious internal problems are brewing and suggest the need to fully re-evaluate the investment thesis,” he says.

Cunningham feels investors should monitor even small setbacks and evaluate a business rigorously as a string of setbacks later can signal a larger set of problems, which can emerge as it is too late for a business to make corrections or for the investor to mitigate losses.

Remaining unperturbed to changes to market conditions

Cunningham says since quality investing chooses great companies for long term, investors may get complacent and fail to sell ahead of a decline.

“It is tempting to interpret adversity as transient—to see sagging growth as a blip rather than a structural issue, or a new competitor as unthreatening to a company’s core business. This attitude promotes a long-term view, but can also create blind spots. While each change warrants individual scrutiny, a few categories of change seem to account for a large portion of mistakes,” he says.

Failing to spot accounting irregularities

Over one-fifth of public companies misrepresent earnings by an average of 10% by using premature revenue recognition, inflating gross margins, improperly capitalizing expenses, depleting reserves and manipulating cash flows.

Many times investors choose to ignore accounting red flags, which are a powerful indicator if the underlying business is healthy or deteriorating.

Cunningham says investors should study the financial reports of a company carefully to spot whether all the financial parameters will remain healthy in the future.

“As accounting is the language of business, every investor must be conversant in it. Beyond assessing the fundamentals of asset turnover and margins to evaluate business quality, financial reports often contain innumerable subtle clues about the sustainability and predictability of earnings growth, cash flows and return on capital. They also occasionally reveal chicanery, eliminating a company from contention as a quality investment,” he says.

Falling for the ‘Endowment Effect’
Cunningham says as quality investing involves conducting rigorous fundamental analysis and holding stocks for the long term, it creates an endowment effect, which is an over-appreciation of things already owned compared with other opportunities.

According to him, quality investing is particularly susceptible to the endowment effect because the considerable upfront and extensive research increases the effect as the investor’s sense of ownership confines not just the stock, but also their analysis and judgment.

He feels the longer a stock is owned, the more the emotional connect with it. “The endowment effect may manifest itself when an investor continues to own a stock despite a drumbeat of negative events revealing a deterioration of the company’s fundamental economic characteristics. One strategy to combat this is to ask whether, with a fresh start, you would still buy the same company today,” he says.

Cunningham feels the endowment effect can also play a positive role in quality investing as it strengthens resolve amid constant but erroneous pressures to sell.

How to reduce the chances of making a mistake
Cunningham says the best way to avoid investing slip-ups is to design an investment process to overcome obstacles and reduce mistakes. He lists out few steps that one can follow to avoid such mistakes:-

  • Have complete knowledge about a company

Cunningham says to take error-free investment decisions, it is important for investors to know a business very well. Hence, he suggests investors to conduct a detailed fundamental analysis to know a business better.

This, he feels, can be done by a meticulous review of all public information, such as financial reports, as well as mining other independent sources.

  • Collect information from various sources

Cunningham says investors should gather information about a company from various sources in order to be able to form a full picture of a target investment. To execute this approach properly, one needs to have an inquisitive mind, a desire to read widely and a willingness to gather information broadly, he says.
Cunningham says checklists can help focus on rationality and confront the important questions about an investment. “A good checklist should enumerate all the desired attributes for an investment and, ideally, the steps required for full due diligence. It should also incorporate lessons learned from previous mistakes and be regularly updated accordingly,” he says.
He says investors should compare the hypothetical performance of an unchanged portfolio with actual performance to check how much value trading decisions add.

“The exercise is an acute reminder that doing nothing can be a positive action and weighs every decision against this,” he says.
Investors should dissect past mistakes to detect causes, context and patterns. “Such autopsies are most effective if they address a wide range of mistakes, realized and unrealized — for example, by assessing both purchase and sale decisions that should, or should not, have been made,” he says.

  • Recognise and counter biases

Cunningham believes investors should be careful of not letting biases dictate their investment decisions. “A primary technique for mitigating the influence of biases is to focus as far as possible on the process rather than the outcome: adhering to fundamental investment principles in the face of inevitable market gyrations,” he says.

So Cunningham feels a long-term quality investment strategy must be finely balanced against the recognition that things can, and will, change. He believes all companies evolve to some extent, and closely monitoring such evolution is an essential part of the investment process.

(Disclaimer: This article is based on Lawrence A. Cunningham’s various interviews and his book Quality Investing: Owning the Best Companies for the Long Term
.)





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