I was fortunate to have an opportunity to work with and be mentored by the great investor and trader, Rakesh Jhunjhunwala, for 8 years. While my core focus was Private Equity, due to the small size of his team, I had the chance to evaluate investments across multiple asset classes.
Given there are reams written about his approach on stock selection, I will focus on the behavioural learnings I gained which are not often talked about. I will focus on three.
- It’s not just about buying right. Investors need courage to take meaningful positions and patience to hold over long periods of time
- How an investment firm handles mistakes is critical to its success
- You can’t create wealth with borrowed knowledge
It’s not just about buying right. Investors need courage to take meaningful positions and patience to hold over long periods of time.
While TV anchors and journalists report every move the boss makes, the most important facts are the most poorly reported.
- 8 stocks make up 75-80 percent of the portfolio with the largest being well over 25 percent of his portfolio: i.e. he runs a very concentrated portfolio
These stocks have been held over very long periods of time: patience has been key to success
Wealth has been created by not only buying at the right price but by taking a meaningful bet and also by holding onto winners through multiple market corrections and even through periods when these stocks have traded well above their fair range valuations.
Quality stocks have the ability to compound earnings over long periods of time as their management teams navigate the environment better. Selling a quality stock “just” because it is or appears expensive exposes one to numerous unconsidered risks.
- A stock could trade even higher from its existing level before it corrects.
- Idle cash will need to be redeployed exposing one to “reinvestment risk”. There is a high risk that sales from a high quality stock will be redeployed in a lower quality one just because the latter is available cheap
- Or you sell and wait with the belief and hope that one can buy back the quality stock at a lower price in future. And this price never materializes.
Lock in of profit, will deliver short term emotional relief, but will have adverse longer term results for portfolio performance/wealth creation.
However the argument for patience is primarily an emotional one. Not selling winners for long periods of time requires extraordinary effort and behavioural control because it is an act against our natural Instincts. Our brains are wired to protect us against threats. In stressful market situations, the protective emotional instincts of the brain flood the more rational ones, triggering a self-defence mechanism which urges one to sell to lock in profits or to protect against further losses.
Our normal tendency is to sell the winners and hold onto the losers. One needs to act contrary to human nature to develop patience not to sell the winners and have discipline to cut losses when the investment thesis is wrong or facts have changed. I believe this is the primary factor that separates the good from the great investor. An American publication recently reported that most of Warren Buffet returns have been generated by 10 stocks which he has held onto for large periods of time while he has invested in about 400-500 stocks through his investment life.
Ironically, this factor also explains why people have made money in real estate and prefer that Asset class to Equities. Real estate is a leveraged investment bet where one cannot see the mark to market on a daily basis and where liquidity is not easily available. The investor is forced to exercise patience and hold.
I don’t want to suggest that one should never sell winners. There are valuation metrics that investors can use to evaluate if the market is in dangerous territory as it was in January 2008. The trick is to differentiate when markets are in a normal valuation range but volatility and media commentary makes you nervous and you get the urge to sell vs situations when valuations are in bubble territory but you don’t want to sell because no one around you is nervous. More on this in another blog.
Developing a firm culture that does not punish mistakes
When one makes a right call, one does not know what part of the success is linked to luck vs right process. One therefore does not really learn much when one is right. However, when one is wrong, clearly it is disproportionately due to bad process as margin of safety should have covered for any bad luck. This is why failure teaches many lessons. Few firms however will introspect on what they learned from their mistakes because there is often a witch hunt on who to fix the blame onto. I was part of many investment decisions at RARE that went sour (and a few that went right). There were at least 2 investments which could be solely ascribed to me. However, never once was I blamed or reminded for the ones they went wrong any time I proposed a new idea or challenged someone else’s thesis. The boss always maintained that the ones that went wrong may have been my ideas but the final decision was his. Not only was this reflective of his character as a person, but it also shows how this has sown seeds of success where his team are unafraid to speak their mind or offer new ideas because they are weighed down by history
Accepting mistakes is liberating. Rather than looking for excuses in the environment or with the promoter, one can introspect on where the investment logic was weak and what one learnt from the error. Investment mistakes do not kill you (as long as one has been prudent on what to risk). Fear of making mistakes does. Fear kills courage of conviction and results in seeking comfort in consensus which will eventually deliver consensus (market) returns.
How an investment firm handles mistakes therefore becomes integral to its future success.
You can’t create wealth with borrowed knowledge.
I mentioned earlier that buying right is only part of the equation. Having the courage to take a meaningful position, and conviction to hold the stock through adverse market corrections or through exuberance is the other half of the success equation.
However, if ones relies on borrowed knowledge, for example a tip, how does one build the necessary courage and conviction? Consider the following:
- Is the tip a “trade” or an “investment” for the person who suggested it to you?
- How deep is their conviction? Is it a meaningful position in their portfolio? Did they research it themselves or got it from another source?
- If facts change, as often they do, and the investment hypotheses is no longer relevant, has the person who recommended you the stock also remind you to sell?
Will you have conviction to hold onto something for long periods of time that one does not understand?
Investing principles are simple, but following them is not easy. We have to get used to being uncomfortable –and master the self-preservation instincts of the rational mind. “We cannot rely on receiving wisdom, rather, we need to discover it for ourselves” through a journey no one else can take on our behalf. Rakesh Jhunjhunwala is a great real-life example of how to do this.