Editor's note: Whether you're a novice investor or an experienced pro, it pays to have a strategy. It can help limit your losses... and improve your investing game. Whitney Tilson, the editor of Stansberry's Investment Advisory, couldn't agree more. In today's Weekend Edition – which was last published in a December 2019 issue of the Stansberry Digest – Whitney shares three ways you can find success as an investor... and it all comes down to having a system in place.
It's extremely difficult to achieve superior investing performance over time. Nearly every study out there shows that few investors can do this.
If you want to be one of the few who can beat the odds, my first bit of advice is to keep things super, super simple.
Investing isn't about running big spreadsheets and complex valuation models. The trick is to think sensibly about businesses... project what's likely to happen to them in the next few years... and compare this with other investors' expectations.
There are three possible ways to succeed in investing: be a good stock picker, be a good market timer, and/or use leverage.
I've tried all three... They're all difficult, but from my experience, the second two ways are the hardest. Few people are consistently good at timing the market, and leverage will eventually blow you up.
But many people are capable of finding the occasional undervalued stock – the proverbial 50-cent dollar. Let me explain...
1. The first step to becoming a good stock picker is to develop a sound strategy.
To start, you need to answer a handful of questions...
What are your interests and strengths? Where do you have an edge? What countries, industries, and market caps will you focus on? Are you going to be short selling? Will you be fully invested at all times, or will you sometimes hold substantial amounts of cash? How much trading do you plan to do? How long will you hold your positions?
The key is to develop a well-articulated, well-defined strategy that differentiates you from the millions of other investors in the market.
There are many ways to do this...
One of them is size. If you're investing with a small pool of capital, you can invest in the nooks and crannies of the market – areas with more inefficiencies.
Time arbitrage is another. The vast majority of money in the world is managed by people who are evaluated on a short-term basis... so investors who can look a year down the line have a big advantage.
Then you can consider concentration. Most professional investors (think index funds and institutional money) are required to be super diversified.
If you invest in 10 stocks and put on the occasional 15% – or even 20% – trade with high conviction, this can be an advantage. But be careful... Excessive concentration can be deadly when you make a mistake.
You can also find an informational edge. This is especially valuable in less-developed markets. These are much less "efficient" than the U.S. – the most picked-over stock market in the world.
Never underestimate the power of "boots on the ground" research, either. You can gather information from interesting sources by talking to friends in a given sector or even walking into a store and speaking with a company's employees.
Even if you can't get more information than others, you can still develop your analytical skills by taking the same information as everybody else and analyzing it better.
You'll also gain more experience over your career. As an investor, it takes years – even decades – to develop your instincts... But once you have them, they can be your most valuable edge.
Experience will allow you to develop an emotional edge as well. Human beings are hardwired to be irrational when it comes to financial and investment decisions. If you can control your emotions, you will have a distinct advantage over your competition.
Finally, you can build relationships. Smart investors build and maintain a network of contacts to exchange ideas and information with others in order to gain valuable insights before everyone else.
Once you've developed a strategy and know your skills, you need to...
2. Apply a consistent, simple framework to evaluating stocks.
The first step is determining whether the investment is within your circle of competence.
You need to ask – and correctly answer – whether you truly understand a company and its industry. Do you have an edge, or are you just the proverbial sucker at the poker table?
You don't need a huge circle of competence, but you must understand its boundaries. Straying outside of your circle of competence is one of the deadliest mistakes you can make.
The second point on my cheat sheet is company and industry evaluation.
Before you buy a stock, you need to evaluate the underlying business and determine its quality. Does it have sustainable competitive advantages, a high return on capital, steady growth, a strong balance sheet, and good free cash flow?
Careful investors should also take a step back and look at the industry in which a company operates. Are there favorable trends behind it or not?
And lastly, you need an approach to evaluating management.
Before you invest in a company, ask yourself the following three key questions: Are they good operators? Are they good capital allocators? And are they trustworthy and shareholder-friendly?
Let's say I find a company that scores highly on all three metrics: It's within my circle of competence, it's a high-quality business in an attractive industry, and management is top-notch.
Time to buy the stock, right? Not so fast...
The problem is that most companies that meet these criteria for me also meet the same criteria for every other investor – which is then reflected in the stock price!
That's why it's critical not to forget the final step...
3. Be patient and clever enough to wait for a stock to become significantly undervalued, with a big margin of safety.
The fundamental way to value most assets – whether it's a company, bond, piece of real estate, etc. – is discounted cash flow. It simply means estimating the future free cash flows that the asset will generate, and then discounting them back to the present.
The concept and the math are simple. The hard part is correctly predicting the future free cash flows. But this is what you must do to value something. If you can't, that's OK – just move on and focus your energies elsewhere. But there's an even simpler way to think about valuation when it comes to stocks...
Just think about expectations.
Almost every stock price reflects the consensus expectations that investors have about a company's future. It's not hard to figure out – just read a few analyst reports if you'd like to know the consensus viewpoint.
Once you know what the expectations are, what determines whether a stock price goes up or down is whether a company's performance exceeds or falls short of those expectations.
Sometimes, you can make money buying the stock of a company that investors love. Expectations are high, but the company exceeds them – think Netflix, Amazon, or Adobe.
This is typically known as growth investing. That means investors pay up for a stock that's eventually offset by a company's high growth rate over time.
But numerous studies show that investing in richly priced, popular stocks generally doesn't work out so well. It's difficult for any company to grow at a high rate for an extended period, and most don't.
For most of my career, I did the opposite: I looked for out-of-favor companies in which investor expectations were low. So when any hint of good news – or even stabilization – came, it would send the stock soaring.
This is classic value investing. The goal is to identify companies that are encountering difficulties that the market thinks are permanent, but instead prove to be fixable.
Another way to think about expectations is the term "variant perception." Hedge-fund manager Michael Steinhardt coined the phrase. It simply means "what do you believe that's different from the consensus view?"
It's easy to develop a variant perception. What's hard is being right. That's especially true now that many smart people are using supercomputers to look for even the tiniest mispricing.
When asked about the most difficult part of being an investor, Steinhardt said...
The hardest thing over the years has been having the courage to go against the dominant wisdom of the time, to have a view that is at variance with the present consensus and bet that view.
It's especially hard because it can take years before your variant perception is proven right. In the meantime, you are bombarded by the conventional wisdom as expressed by the market. (As French investor Jean-Marie Eveillard said, "It's much warmer inside the herd.")
But if your goal is to develop superior investing performance over time, you must put in the work to find undervalued stocks. And by following these three simple steps, you'll be off to a great start.
Editor's note: This year marks Stansberry Research's 25th anniversary. And to celebrate, Whitney and our founder Porter Stansberry are unveiling an investing breakthrough that has taken nearly two decades to create. This powerful new system measures the likelihood of every potential outcome, before you get in... to show you which of 4,817 different stocks could double your money. On Thursday, January 25, Whitney and Porter will reveal all the details... Click here to learn more.