This is a list of the most important things that I’ve discovered. Sometimes I have learned these things the hard way.
It’s hard to make money if management steals from you or is overpaid. You might also be buying into a company with inflated books.
It sounds so obvious that unethical management should be avoided. But this wasn’t obvious to me at first as most investment books don’t mention it at all. And boy did I learn things the hard way.
Don’t trust, just verify
There isn’t much of a connection between what management says and their integrity. Some CEOs are very eloquent and say all of the right things. Ignore it. You really need to look at their actions and their past history. The insiders who enrich themselves at shareholders’ expense are likely to do it again.
- You gain an edge from reading university textbooks on mineral exploration and mine engineering.
- Almost all technical reports are inflated. Gullible and naive me took a long time to figure this out. I thought that these technical reports were supposed to create transparency for investors. However, it is clear to me now that they don’t and that Canadian regulators rarely protect investors. For example, companies are allowed to release press releases about technical reports before the report is filed on SEDAR. Barkerville Gold has demonstrated the flaws with the current system. Historically, Canadian regulators have often been a story of “too little too late”. They continue to be ineffective in protecting investors.
- You gain an edge from reading quarterly MD&As.
- Almost all mining stocks should be avoided. Perhaps this is an extreme opinion. But I am fairly confident that many mining companies will do a poor job of generating shareholder returns (see my post on mining mania).
- Very few institutional investors know what they’re doing when it comes to mining.
Don’t copy successful investors
In the past, I used to think that famous/successful investors really knew what they were doing. I read the book Stock Market Superstars (by Bob Thompson), which interviews many notable Canadian money managers. But as I started learning more about mining, I began to look into their stock picks and realized that they owned a lot of junior mining garbage such as Yukon-Nevada/Veris Gold, Barkerville, etc. Nowadays, I think that most star managers are more lucky than skilled. Sometimes stock markets exhibit bubble-like behaviour and cause those chasing the bubble to temporarily have very good track records. It’s hard to figure out who is lucky and who is skilled.
Don’t copy other investors (do your own homework!)
Sometimes other investors don’t know what they’re doing. See my previous post on shorting Value Investor’s Club. On VIC, it seems that:
- Every company has a moat.
- The new CEO is going to do a better job than the old CEO.
- The stock is about to go up because management is about to get promotional. They will talk to investors more, a road show is coming, the stock will be listed on a more prestigious exchange, etc. etc.
- If #3 doesn’t apply, management is praised for being non-promotional.
- There is going to be a turnaround that improves profits.
- Everything about the company is considered to be a good thing. If there was recently a secondary offering, the stock will go up once the overhang clears out. If the stock is about to have a secondary offering, the stock will go up because the extra capital is a good thing.
- Most importantly, the authors rarely understand the industry. That is why they use dopey metrics such as peer EBITDA multiples, market cap per unit of resource in the ground, etc. If they truly understood a particular industry, they would know the relevant valuation metrics.
Some assets are way too hard to value
Warren Buffett learned things the hard way when he bought GenRe and lost a lot of money on its derivatives book (Doug Dachille has an excellent lecture that explains everything). A derivatives book cannot be valued accurately unless you get to look at the individual contracts. Sometimes, both sides of a derivatives trade will report a profit (!).
I haven’t fully learned my lesson but mining assets are generally extremely difficult to value accurately, especially without access to engineering data and a team of specialized engineers. These stocks should be avoided.
Some industries are too difficult to predict
Bill Gates has many failed predictions in his book The Road Ahead. If somebody much smarter than me can’t figure it out (anybody who reads Donald Knuth books is hardcore), then what chance do I have? I think that many tech stocks should fall into the “too hard” pile, even if you understand the technology.
Secondary offerings and IPOs
These rarely make sense for investors as the transaction costs are much higher than bank loans, leasing, and other forms of financing. Underwriting fees, lawyers, and accountants eat up a lot of money. It’s hard for investors to make money when the company spends so much money on raising capital.
The brilliance of Warren Buffett and “wonderful businesses at fair prices”
It took me a long time to realize that Buffett is a lot better than other value investors out there. I wish I had paid more attention to him when I first started learning about investing instead of focusing on Joel Greenblatt, special situations, and commodity stocks.
Benjamin Graham came up with the idea of buying cheap and applying a margin of safety. Buffett’s biggest innovation on top of Graham was to buy wonderful businesses at fair prices. I think that most value investors still haven’t caught on. On VIC, sometimes you will see writeups for quality businesses like Mastercard, Carmart (CRMT), MTY Food Group, and Altisource. In many of those cases, the author of the writeup was only looking for a short-term profit. In hindsight, those companies were worth holding onto. (An exception would be Contango Oil & Gas.)
Theories that can’t be proven
People often have top-down theories about how businesses and stocks ought to work (myself included). Most of these theories are wrong. I need to be more careful about getting suckered into theories that seem to make sense but are very difficult to prove. For a long time, I believed in the theory that we are in the middle of a commodities supercycle. Maybe the theory is true… I really don’t know. But the problem is that the theory is hard to prove or disprove.
- There hasn’t been many supercycles. The supercycle theory might simply be a product of data mining. If you perform too much analysis on random data, you will find patterns and correlations that aren’t there.
- The theory is vague. How long is a supercycle supposed to last?
- The underlying theories don’t have too much empirical support. In general, macroeconomic theories don’t have a lot of support for them.
Of course, most investing frameworks are difficult to prove. Nonetheless, I think that the “wonderful businesses at a fair price” model has more empirical support than the commodities supercycle theory.
- There has been a lot of wonderful businesses throughout history, so there is a large number of data points that support the model. It is unlikely that the correlation between wonderful companies and good stock performance is an artifact of data mining.
- You can quantify the theory. Wonderful businesses are those that have high unleveraged pre-tax returns on capital. (Though I’d admit that moats are hard to quantify.)
- The underlying theories do have some empirical support. The mathematics of compounding favours companies with high returns on capital and earnings growth. I think that there is empirical support for variances in skill, behavioral psychology, momentum effects in return on capital, buying stocks at low valuations, etc.
The second problem with the supercycle theory is that it seems to have weak predictive power when it comes to stocks. The theory could’ve gotten me into a lot of trouble as it would predict that the TSX Venture will make money for shareholders. I think that the TSX Venture will lose money on average, even if the commodities supercycle plays out.
Business is hard
Making money in the real world is very difficult. To generate above-average returns consistently and reliably is very, very difficult. Unfortunately, human beings like myself tend to be overoptimistic and don’t have enough skepticism when it comes to above-average returns.
Many of the companies posting above-average returns won’t repeat them. Those in commodity industries are usually lucky. New supply will usually flood the market and cause the business cycle to swing the other way. Other overachievers are simply committing fraud or using aggressive accounting. In other cases, businesses seem to be making money because they have taken on many tail risks that haven’t blown up yet (e.g. leveraged REITs betting on financial instruments; they blow up every several years). It takes work to spot the truly wonderful businesses.