Why This Warren Buffett Advice is Fatal For Classic Graham Investors
It snared my father when he first started investing, and nearly lead me to quit picking classic Benjamin Graham stocks altogether.
It's a trap that a lot of people fall into and most never even realize the critical mistake they're making.
It has a huge impact on your portfolio. It can lead to many wasted years when you should be busily compounding your money instead. That's why, despite conventional wisdom, I ignore Buffett's no-called-strike metaphor.
Net Net Hunter has been up and running for nearly a year and I've been lucky enough to talk to an ocean of interesting people about investing. Every so often, however, I'll get a disturbing question from an investor who signed up to receive free net net stock picks and is considering full membership.
Benjamin Graham gave investors a tremendous gift when he developed this strategy decades ago. Net net stocks provide outstanding returns as a group. While the rest of the investing community is struggling to keep up with the market indexes, investors who follow Benjamin Graham's net net stock strategy typically beat the index, earning 25% or more per year on average over the long run.
Not all net nets are profitable, however, which is why I've developed a technique to screen out the less promising candidates. When it boils down to it, like everybody else, I want the best stocks in my portfolio.
But every time someone sends me an email telling me that there aren't any net net stocks anymore, or that their portfolio is fully stocked with American net nets, I get a little bit frustrated.
Classic Benjamin Graham Investors Should Cultivate the Right Mindset
"Hi Evan, I was quite disappointed when I got your free net net stock pick this afternoon and saw that it was for an Australian company. Could you please send some great American net nets because those are the only ones I'd like to buy."
I recently got an email like this from one of our readers who had requested free net net stock picks. Unfortunately, this attitude is exactly the wrong attitude to take when it comes to investing. It doesn't matter if you're investing in growth stocks, low PE stocks, dividend stocks, or net net stocks -- expecting great investment opportunities to come your way when you want it, where you want it, is a great way to achieve marginal returns, or big losses.
Let me put this another way. Friedrich Nietzsche, a brilliant German philosopher from the 19th century, said that ideas come when they want to, not when you want them to. The exact same thing is true about good investment opportunities. It doesn't matter how eager you are to invest in a great investment opportunity in your home country -- that opportunity will come when it wants to, completely independent of you.
A lot of investors get this backwards. When an investor really wants an investment opportunity to be available, he can start to play certain psychological tricks on himself. If the craving for a great investment is strong enough then he can start to mould reality to make that great investment happen. An investor who's fallen into this trap, in other words, will start to gradually twist the facts, skew his own perception of the situation, and even erode his own standards for investment, just to make that investment opportunity available.
This mindset -- that a great opportunity should be there when you want it to be there -- gives you a tremendously strong incentive to fall into this psychological trap.
Classic Benjamin Graham Investors Should Also Ignore Buffett's No-Called Strike Metaphor
The problem with blindly following Warren Buffett's advice, without thinking critically about it first, is what I call falling into The Warren Buffett Trap. Buffett provides so much great advice that some of it completely contradicts other things he's said.
His advice about selectivity in investing fits that mould perfectly - and this has a great impact on portfolio construction.
Warren Buffett compared investing to a game of baseball with no called strikes. In that type of game, you could just stand at bat and wait for the perfect pitch to come your way before you swing. You wouldn't have to swing at the curve balls or fastballs. You could just stand there and wait for the most opportune pitches to come your way. In a game like this, you'd have a great batting average.
The investing metaphor should be obvious. As an investor, your funds sit in your brokerage account waiting to be invested. Every single day you have stock quotes presented to you which you can either ignore, or take advantage of. If you know the value of the stock in question -- as Benjamin Graham insisted you do -- then you can just wait for situations where a stock you're interested in is priced well below its real world value before you invest. This is the essence of Benjamin Graham's Mr. Market analogy.
Waiting for a great pitch seems like the obvious thing to do when you can't find a good stock to buy. It's, at least, a lot better than just buying the terrible investments in your home country because, after all, it's your home country. The result of this investment policy should be obvious - losses, and probably large ones.
But there's an underlying problem with Buffett's no-called-strikes solution. If you wait to invest in the best opportunities then you'll pick a much higher percent of winners... but you will do much worse as a net net stock or classic value investor.
If you've seen my investment record then you'll notice two things: the number of companies that I've invested in over the past few years are comparatively small, but my portfolio has done spectacularly well. Over the last 3+ years I've only held just over 25 net net stocks. My win percentage, the percentage of positions that have yielded positive returns, is a hair under 78% and the winners have lead to extraordinarily high returns. In fact, the average annualized return of each of my positions is just over 38% per year. That's fantastic, and the only way I could have achieved that is if I swung at great pitches each and every time I swung.
In the world of net net investing, sitting in cash significantly hurts returns. You need to invest to earn great returns, and time is a significant factor in the returns that you're able to achieve. Time out of the market is time not compounding your money and your portfolio returns will shrink as a result. To top it off, the market can hover at an expensive valuation for years, so your portfolio could hold a significant amount of cash most of the time. This inactivity can trim your compound annual returns by 40 or 50%. Ouch!
So what should a deep value investor do?
International Investing is Critically Important for Net Net Stock Investors
The return of American net nets over the past 5 years has been terrible. I think this is because the American market has seen a glut of low quality net net stocks: resource exploration firms, Chinese reverse mergers, etc.
Net net stock investors did not have to purchase these sort of investments, however. There are numerous modern first world economies with well developed capital markets outside of America, or your own home country. These capital markets have their own ups and downs, providing value investors with significantly more opportunities than are available in the USA. Countries such as Australia, Singapore, Canada, and the UK have great financial regulation and their stock markets open up a world of possibility to deep value investors. The legendary investor john Templeton said himself that if you look beyond your own boarders you'll find a lot more bargains - and better bargains - than you will if you stick to your home market.
Over the past 3 years I've had most of my investments outside of the USA, and I've seen most of my profits come from Japanese net nets. In fact, at the time of writing, 60% of my portfolio is currently invested in friendly first world markets, and I expect that percentage to grow.
This focus on finding international net nets has helped me avoid buying a lot of the troubled firms that are truly terrible investments. Rather than being forced to buy firms with quickly evaporating net current asset value, loaded with debt, in questionable industries, I've been able to purchase growing industrials which are buying back stock and have a tiny PE Ratio. Creighton's PLC is a good example.
...as is Art Vivant, in Japan.
Even Warren Buffett Said He Would be Fully Invested...
Warren Buffett's no-called-strike analogy is often cited by investors, but his comments about wanting to be fully investor aren't nearly as well known.
If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling.
- Warren Buffett, June 23rd, 1999, Businessweek
That's right. In 1999, near the peak of the dotcom bubble, the world's greatest value investor gave a hint at how he would invest if he were a tiny investor once again. Rather than sit in cash, he'd be stocked full of cheap securities.
Take Care of Your Downside and Your Upside Will Take Care of Itself
I can sum up nearly my entire classic Benjamin Graham investment philosophy with one short sentence: Take care of the downside and the upside will take care of itself. Good investments will help you do that.
Great investment opportunities don't exist just because you want them to so you should really swing at the great pitches. Don't wait for them to come your way, though. Go out and find them.
There's a world full of stocks for your to sift through and a lot of bargains to be found in friendly first world countries. Looking for net nets in multiple countries means playing a dozen different games of baseball at the same time. While there's more pitches to examine before you swing, you should always be able to swing at something.
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