Michael Mauboussin has written a heap of great work over the years. I especially like his thoughts on skill and luck and the role they play in all aspects of our life.
He presents a simple question to determine the role of skill and luck in an activity. Ask the question could I lose on purpose? If you can’t lose on purpose then chances are luck determines the outcome. If you can lose on purpose then skill plays a major role in the outcome.
When I play golf I can deliberately lose (the reality is I am garbage at golf so this is a bad example), outcomes are driven by skill. I can not deliberately lose a coin toss, I can not deliberately lose the lottery, these games are all luck and no skill. If people believe they have skill over these outcomes they are fooling themselves.
In Mauboussin’s book the Success Equation he breaks down different activities in a luck-skill continuum. He believes that share investing is more on the luck side of things than skill.
If there is skill involved in share investing, which I believe there is, then I have found it worthwhile to ask myself in what way could I deliberately lose in share investing? What criteria would you use to maximise your chances of losing over the long run? If I can avoid losing on purpose then I have increased my odds of success over the long term.
Following are some areas where the base rate has shown that owning shares with these characteristics has resulted in losing situations. There is nothing new in this list and there are many other criteria that you could use, but here is a sample of ways I have found I could lose on purpose.
- Companies with high leverage. Eventually access to capital stops and the business needs to be recapitalised. Better to be the equity post capitalisation if the business is sound.
- Companies with bad management that have a history of promotion or a dubious track record. This is a hard one to quantify but it is a bit like Justice Stewart’s comment re porn, hard to define but you know it when you see it.
- Companies that have a bad history of acquisition. This falls into the bad management category. Typically when management incentives are aligned to EBITDA growth then this is what management will do. Buying growth is a relatively easy thing to do, acquiring growth that adds shareholder value is much more difficult.
- Companies that are constantly tapping the markets for new equity and have a history of diluting shareholders.
- Companies that have traditionally been a competitive battleground with a flood of new entrants with a chequebook and goals for market share. The last thing you want from your competition is a new entrant who destroys the economics of your industry.
- Turnarounds that seldom turnaround. A revolving door of new management thinking they can defy the base rate and make a go of it. Ugh.
- Companies that pretend Revenue = Profit and that scale will get them there. The best businesses almost have positive cashflow from Day 1. Go back and look at REA in the early years.
If I can avoid these companies then hopefully I have tilted the luck a little bit in my favour over the long run but there is no guarantee.
This is not to suggest that if a company meets any or all the criteria above they will always fail.
Sometimes a highly levered or highly promoted stock within a terribly competitive industry can perform really well. Tesla springs to mind. You could have said these things about Tesla for a long time. It just goes to show how much luck can play in investing decisions. But there is a big difference between not owning Tesla and shorting it. The problem with shorting is you never know when your skill is going to kick in (if you indeed have any) and luck leave the building.
An early mentor of mine years ago told me that your last rule is to know when to break your rules, you never know when your rules are going to stop working. So I always try and be flexible.
I broke a rule with Big Un Limited (BIG) and I learnt the lesson the hard way that some rules are not to be broken, sorry mentor. I broke my rule of not buying a company that has a dubious management reputation. Luckily for me my entry was good enough for me to exit with a profit. But for now I am going to stick with trying to avoid situations where I can lose on purpose, no more breaking rules.
The other thing Jesse Livermore taught me is that the brothers and cousins of the mistake family are endless. You think you have taken care of one but you always have to be on guard as the next one is just around the corner. Investing is bloody hard.