High Conviction Investing

Originally posted on Evergreen Memos on 6/16/2021

Above average investing is near impossible if you don’t do the work.

When I was in my twenties, I’d listen to a famous investor pitch a stock, think “I’ve struck gold!” and rush out and buy the thing. This was not smart. I borrowed his idea, but I couldn’t borrow his conviction.

In other words, he did the work necessary to hold during a market “correction”, which is a nice way of saying I lost a lot of money in not a lot of time.

Having purchased the company on a whim, I had no problem selling even faster at a loss. I suddenly had zero faith in the company because I didn’t know it. Price alone makes for a lousy north star. I was young and speculating; not investing. When luck went my way and a stock soared, I was a genius. When it tanked, the stock tipper was at fault. It was easy to blame them; I was a tourist, not an owner.

Ironically, I was working my tail off as a junior analyst to earn the money, then doing zero work to invest and then lose the money.

I don’t know about you, but I much prefer the opposite of this. Thankfully, I learned these lessons when I was very young and relatively poor, so the dollars involved were small. You don’t want to learn how to invest with large dollars at risk.

How to Hold Compounders

It takes a surprising amount of time to internalize this simple framework, but to compound capital you have to:

  • know what you own
  • know why you own it
  • know the value of what you own

This isn’t to say that every stock one researches will be a winner. Far from it. Thankfully, you don’t need to come anywhere close to 100% to be an elite investor. If you find a few gems, 50% of your picks can be turkeys. Evergreen has - and expects to maintain - a much higher batting average than 50%. Yet only half of our positions need to be winners if we own enough compounders. It’s easy to forget, but this is an asymmetric game: you can only lose 1x your investment, but some picks can 10x or even 100x if held long enough.

And therein lies our point on work.

You will never hold the compounders long enough to achieve stellar returns if you don’t have an edge or understand what you own. Reason being, all compounders plummet in value at some point.

Say an investor purchased Apple on a whim in late 1998. Unless they immediately moved to the deep woods its likely they’d have sold in 1999 when the stock crashed 70% lower. Only the people who have conviction - and frankly, an iron stomach - weather these crashes. Narratives are not enough. You need deep industry expertise (past work) or recent analysis (current work) and the correct mindset to withstand the pain of extreme paper losses. This is why most retail investors struggle with stock selection and even passive investing.  

Think of all the investors that bought Snowflake at the IPO but don’t have a clue what the company does. How will they react if the stock plummets 80%? How many sold after it lost 40% from its December high? What can such investors anchor to? A nosebleed 50x sales multiple valuation? Good luck. For all I know Snowflake is the next Apple. Even at today’s crazy valuation, it could be cheap based on its prospects and ability to reinvest capital at high returns on equity. I don’t know, I haven’t done the work. Which is one of many reasons why I don’t own it.

This is what makes investing part time so difficult. Part time investors don’t have the time to do deep dives on one company, let alone 20. They’re not going to kick the tires. They can’t obsess about risk or portfolio management. Some might if they love investing as much as I do. But they probably have better things to do with their time.

Consequently, most retail investors end up relying too heavily on:

  • Gut intuition
  • Market timing
  • Narrative plays
  • Hot tips from friends or *gulp* CNBC

While this doesn’t guarantee underperformance, it’s a dingy of a boat to count on in open and volatile waters.

Major drawdowns happen, sectors fall out of favor, interest rates spike, etc. Any number of random short-term events can tank a stock. When you wake up one day and see one of your holdings is down 10% for no reason, despite zero negative news about the company, what do you do? It’s baffling. When that happens, you need something to fall back on to avoid doing something silly.

That might be your own valuation work (even using back of the envelop math) or perhaps it’s three to five crystal clear bullet points on why you own the stock. Short of that your defensive wiring is going to kick in and push you to dump the shares.

Most investors realize they shouldn’t think of stocks as flashing green and red numbers on a screen. They are ownership stakes in businesses, or in our case, real estate. Nobody in their right mind would take 6 months to find, investigate, then finally buy a local business or property only to sell a day later when someone offered you 80 cents on the dollar. Yet plenty of retail investors panic and fire sell one day holdings if they get unlucky on entry timing.

Real Estate Boosts Conviction

Our public real estate holdings could decline 30% tomorrow. If you’re like me and have invested through the dot.com crash, the great recession and now COVID, you’re painfully aware that – while a temporary problem - this can and does happen. Would that type of decline get my attention? Of course. But not because I thought thousands of cash producing assets had suddenly lost 30% of their value in a day. Absent a black-swan scenario, I’d probably be looking for ways to put a lot more money to work in our favorite REITs.

The same can be said for experienced investors in great technology businesses. However, owning real estate makes it even easier not to panic in these situations. Unlike industries that face a consistent stream of existential threats from new competitors and/or regulators, real estate is far more predictable. This is an under-appreciated benefit to holding real estate stocks (REITs) in major sell offs.

Case in point:

  1. Underlying real estate values move at a glacial pace relative to the stock market
  2. Real estate revenue is contractual, so you have great visibility into future cash flows
  3. A new competitor almost never “disrupts” a portfolio of well-located real estate. We don’t have to worry about Netflix coming to steal our Blockbuster lunch money. Even if the property use becomes obsolete (think sad / vacant malls) the land has value and can be redeveloped.
  4. Dividends – well covered and rising dividend yields are a clear reminder that - despite what that ticker price says - your asset is delivering value (income).

Personally, I’ve found it’s a lot easier to hold assets that keep sending you checks. Especially when the amounts rise each year.

All this is to say, with REITs, we’re not making blind guesses about the future of the business. It doesn’t mean we get to skip the work, but it doubles our conviction. So when a stock moves against us, we simply look at the cash flow, evaluate the health of the sector, make sure the balance sheet isn’t a disaster and check on occupancy and income trends. If it’s business as usual, our conviction holds and we do nothing. To us, that’s the work.

A little research followed by sitting on our hands is harder than it sounds, but we’re not exactly making self-landing rockets here. You have to do the work, but nobody said it had to be difficult.

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