The Psychology Of Investing

By | April 3, 2016

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The longer that I’ve been at this investing thing, the more convinced I am that the difference between an average investor and a good investor is all in the mind. I’ve been investing for over 15 years now and I’ve learned a lot along the way. I think it took me the better part of a decade to work out what makes a good business and a quality investment. The much harder aspect of investing is to summon the courage to commit your capital in the face of hundreds of other people telling you otherwise. These people can be respected investment analysts, talking heads on TV, and even your own friends and family. I now have a pretty good idea of what makes my cut as a high-quality business. That tends to be a business that produces high returns on equity in excess of 20%, strong free cash flow generation and conversion of revenue to free cash flow, all combined with a strong market opportunity and rapidly growing topline growth. Now these businesses aren’t necessarily easy to find; however, when you do identify them they are easy to spot. The harder aspect of investing is to commit your capital to these high-quality opportunities that you’ve identified in the face of 101 reasons not to do so. I’ll give you an example. Celgene (NASDAQ: CELG ) is an exceptionally high-quality business with strong rates of revenue growth and good cash flow generation. However, when you look at the stock, it’s had a rough go of things over the last three months. My own purchase is down a good 10% from where I made it. There are all manner of concerns with the stock, most of which I believe will prove to be relatively immaterial over the next five years. The biggest threat is the regulation of drug pricing under the Democrats. There is also the threat that Celgene may be unsuccessful in diversifying its revenue base away from Revlimid, its chief moneymaker. All those things are likely to be unfounded. It’s not in the Democrats’ best interest to make drug discovery unattractive to commercial interests. That will just dry up funding and investment into areas of medicine that have a real human need. Celgene also managed to negotiate a deal with the generic drug manufacturer that will effectively push out its window of exclusivity to almost 2025. That’s almost 9 years for the company to explore new partnerships, invest in new R&D and acquire potential companies that can diversify its revenue base. Yet, despite of this, the company’s stock price remains stubbornly near one-year lows while other companies are now routinely making 52-week highs. I’ve committed capital to Celgene; however, I feel I twang of remorse whenever I check my trading account and see this position solidly in the red while most of my other recent growth investments are now well in the green. I was thinking further about exactly why that is in my case. I don’t think it’s an aversion to losses. Rather I believe that in general we all have a desire for positive affirmation. That’s true for us with our friends with family and even in the workplace. We all want validation that we’ve made the right choices in all aspects of my life. Unfortunately in investing, things don’t this work that way unless you happen to ride a solid growth stock that just consistently appreciates month after month and year after year. You’re not going to get positive reinforcement of your investment decision continually. If you’re looking at taking deep value positions where you have the potential for the greatest upside, you need to lose the desire for positive affirmation and that’s not easy. In fact, it’s really hard because when you see that position continuously in the red, it makes you think that others in the market know something that you don’t or that you have missed something in your analysis. Deep value investing is a pretty lonely game. Invariably it means going against the crowd in almost every bet that you make. And this is where Buffett really stands out for me . More than any other investor, he has shown a unique ability to shut out external influences on his thinking and just go with his gut conviction in purchases of American Express (NYSE: AXP ), Solomon Brothers and to a lesser extent Coca-Cola (NYSE: KO ). These investments were all done at times when those companies were on the nose. American Express suffered from the effects of a salad oil scandal which effectively cut the company’s share price in half. Solomon Brothers suffered from a devastating bond trading scandal which at one point threatened it with bankruptcy. Even Coca-Cola ( KO ) looked like a business that was heading for a sustained slowdown at the point when Buffett invested, with annual revenue growth declining from 17.1% the decade earlier to just 5.2%. I look at my own current list of holdings, and there are more than a few that have suffered or are suffering through crises where investors doubt their ability to make a comeback. CochLear ( OTC:CHEOF ) was the most recent example of a situation where a devastating company event was successfully overcome by the company. Before 2011, CochLear was a high-quality, high-growth business delivering cochlear implants across the world. In fact, the business was the market leader for implants. Unfortunately in 2011, the company suffered from a product recall that sent the company’s share price down by almost 40%. When you are a healthcare company with a reputation for high quality, a product recall event could potentially be a devastating reputational blow. I recognized the opportunity and went in guns blazing . CochLear subsequently recovered lost market share and continues to grow strongly. The net result is that the share price has more than doubled from the lows that it reached during this period of crisis. However, it wasn’t smooth sailing. In fact, the company’s share price was depressed for a period of six months after I made my investment and there was more than an occasion there where I had to reflect and think about whether I’d made the right move. In more recent times, investors have been making assumptions that Chinese economic growth is going to slide to a standstill, and with that, the prospects of Baidu (NASDAQ: BIDU ) and Alibaba (NYSE: BABA ), two of China’s great growth stories will be heading down the toilet. However, both these companies have such strong competitive advantages that I took the view that they will likely prosper for a long time and proceeded to buy. In less than a month, the market subsequently reassessed its view of the Chinese recession and, more importantly, the long-term prospects of Baidu and Alibaba, and I find both positions up more than 17% from where I made my initial investment. The one remaining position that I have which is a real test of my conviction in the company and its ability to overcome adversity is my investment in Chipotle (NYSE: CMG ) that I’ve written about here extensively. The company has significant problems in regaining customer confidence in relation to its E. coli and norovirus scandals. This is a play where you have to believe that customers will ultimately forget these incidents over time, and the company can bring back customer trust and reestablish its position as a provider of high-quality food. However, it’s hard to see this as a long-term outcome when you’re bombarded with images of empty stores and constant analyst downgrades and reminders of incidents on social media of customers getting ill. I look at this investment as a test of my long-term ability to pick a company that has the potential to rebound after significant negative company events, and also as a test of my ability to stick with a position whose outcome is uncertain but which has the potential for significant upside. Investing is as much a test of your character as anything else. It tests the level of conviction that you have in your research and your ideas, and it’s the ultimate test because you literally have to put your money where your mouth is and be prepared to wait a long time to see if your conviction was correctly placed. Those that have the ability to master their emotions and drown out the noise truly have the qualities to be successful long-term investors. Given his track record of making many such successful contrarian plays in the presence of significant negative events and placing large amounts of capital in these plays, I place Warren Buffett at the very top of investors with the greatest mastery of their psychology. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Scalper1 News

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