If you ever meet the “investment guru” on the road, kill him

[2015]

I’ve spent the past 12 years of my life employed in various ways as a professional investor. While this a significant amount of experience in most professions, in the investing world, this is barely a full economic cycle.

The statistical odds for a very long and successful career as a professional investor are dim. Tenure and success tend to work in opposite directions when it comes to investing. There are many who succeed for short periods of time but very few who consistently perform over multiple economic cycles. Long term success is a mythical unicorn in this business: always advertised but rarely seen. Oracles of the future usually turn out to be either frauds or lunatics.

It may be a fool’s errand to try and escape the gravitational pull of being just another statistic doomed for the odds, though having brought a career in private investing upon myself, I figured I had to give the odds a run for their money. Sadly, if I’ve learned one thing over the course of my career, it’s that it’s not a fair fight. The odds are against you over the long run.

The only strategy I’ve found is to accept your fate and plan ahead on not being right all the time.

As professional investors, we obsess over finding our confidence. We try to distill our thoughts on why we like a deal and how the risks are mitigated. We focus on our due diligence and try to know every angle on the business, markets, exit option, etc. We search for certainty and knowledge in an uncertain world.

Despite our mountains of diligence and precise forecasts about the future, we always come back to the same place before we make a decision to invest. Writing a check out of our bank account and hoping we get it back with a return some day. Despite being professionally “trained” investors with institutional grade due diligence, at the final hour of every deal, we are left asking: What if I’m wrong? What if I missed something? What if I’m the sucker in the room?

There is a strong dissonance with this feeling and the need to be “right” / “confident” which is a job prerequisite for most professional investors. As an industry, we build ourselves (and our egos) up on our skills as forecasters of the future. Even with years of experience and varying levels of skill, all investment managers are at the end of the day imposters as oracles of what the future will hold. No one really knows what will happen in the future. Everyone is wrong some of the time.

As an investor trying to manage a family office capital base, I’ve found this dissonance haunting. I’ve felt as investment managers, we’re all selling security and confidence in a world full of unknowns. Instead of trying to cram down and ignore the inevitable fear we feel at every closing, what if we embrace it and make it central to our process? What if we make what we don’t know as relevant to the investment decision as what we do know?

This is all good and well, but what does that actually mean when it comes to selecting investments? One approach to reconciling this intellectual disconnect is stochastic investing.

To think about an investment stochastically, I try to articulate a set of scenarios based on what can go right and wrong, and attach a set of probabilities and investment outcomes to each scenario. If you understand the levers of a business and how different scenarios will impact income, you can start to see how these scenarios will impact exit prospects & price. Investments are lot like quantum entities, you need to see them as a probabilistic mixture of different scenarios instead of a snapshot in time. Once you start look at investments this way, the shape and certainty of the outcome distribution curve becomes as important as your expected return. By thinking about investments as set of outcomes, you start to get a real sense of the true volatility and expected return on capital over the long run.

Okay, so you start thinking that way? What is a good distribution curve of expected returns?

I like to “plan ahead on being wrong” by trying to find investments with what I call non-binary return curves. In binary return deals, your returns (either up or down) can be tied to very specific variables or drivers that you can’t understand or predict. If there is a big driver of returns/downside that I don’t understand or is unknowable (e.g. commodity price, new product acceptance risk) and/or risk-return amplifiers like high leverage, I try to avoid these situations as much as possible.

Ideal investments for me are situations where the probability of losing capital over a reasonable investment horizon is very low but there is good probability of making decent money if you are a right. I am comfortable making small mistakes but spend a lot of my energy and time trying to avoid big ones. If you are right about your thesis 60% of the time and don’t lose materially 99% of the time, you are doing amazingly well.

This strategy works great if you’ve understood the situation correctly, but what if you’re wrong? We all miss smaller risks on a regular basis but what if capital pancaking risk is in front of your face and you don’t see it?

This is always a possibility and something an investor can never lose vigilance around but how does one approach it from a practical perspective? For me this means I only invest in businesses or companies where I know enough to understand how the business works. Do I understand the business model and how they make money? Is the management team the right people for the situation? Do I understand the cash to cash cycle, the drivers of their cost structure, the stickiness/durability and volatility of their revenues, the short term & long term growth prospects and threats? The questions can be endless — when do we know enough?

This is the hardest question of all and it comes back to intellectual honesty being a first principle. If you are prone to excessive self-confidence or paralyzing self-doubt, investing isn’t the business for you. The investment world attracts a good amount of confidence-men and delusional egoists and and complacency is the beginning of your own metamorphosis into their ranks. As professional investors, we need to allow for the non-dualistic reality of both being the expert and the fool at the same time.

At the end of every diligence process, we must look into ourselves and ask ourselves that question and be open to the answer we don’t want to hear. This process isn’t a pure intellectual process but at least for myself, it comes from listening to my gut and feelings. If I’m taking a short-cut or glossing over a material risk, there is usually something in my gut that tells me something is wrong. The feeling is subtle and easy to ignore, but if I’m honest enough to look, it’s always there. While monitoring this unconscious “sixth sense” is something that only develops with experience and practice, there are practical ways to start being mindful about the certainty of knowledge.

One method for me is to monitor my “rate of learning” in any given situation. When you start learning about a business or investment, the rate of learning is very high. As you spend more and more time focused on learning about a business or industry, the rate of new insights / key learning decreases and stabilizes at a much lower rate. It’s a separate discussion on how to choose your sources of information to make sure you are looking at the right info, but if I find myself changing my view often or not understanding the information coming at me, I definitely don’t know enough to make the investment.

This is long way of saying investing is as much knowing yourself as knowing the business. Sustainable returns in the long come from embracing uncertainty & your fallibilities rather than trying to ignore them.