A true investor should aim to generate a satisfactory return on capital over time while minimising the risk of capital loss, according to Magellan Financial Group chief investment officer Hamish Douglass.
Performance numbers certainly back Douglass and his investment team as "true investors". Over the past 12 months, the Magellan Global Fund delivered a 29.5% return. Since inception the fund has secured a 12% return, outperforming the market by 7.5%.
Christine St Anne, Morningstar Australia’s editor, presents an edited extract of some his observations which appeared in his recent annual global investor report.
1) Incorporate a margin of safety and invest within your circle of competence.
Douglass quotes Benjamin Graham, who co-authored Security Analysis and authored The Intelligent Investor, and coined the phrase "margin of safety".
"Graham's margin of safety is the difference between a stock's price and its intrinsic value. In theory, the further a stock's price is below its intrinsic value, the greater the margin of safety against future uncertainty. I believe the concept of margin of safety to be one of the most important principles for investors," Douglass says.
Douglass also believes an investor is best-placed to invest according to their "circle of competence" and to focus on his expertise.
"The most outstanding investment records have been built by people who specialise, develop a deep understanding and stay within their circle of competence," he says.
2) Be prepared to walk away.
Douglass acknowledges it can be difficult for investors to walk away and sell an investment after something goes wrong, but if the due diligence does not ultimately support an investment case then the investor must be prepared to walk away and wait patiently.
3) Focus on the batting average.
"To develop an outstanding batting average, it is far more important to minimise the inevitable investment mistakes than be obsessed with trying to find the 10 time investment winners," Douglass says.
He says Magellan is obsessed with the rigour of its investment research, describing it as an "inch wide and mile deep".
"Extensive investment due diligence and staying within your circle of competence is critical to improving the investment batting average. We note that very few tennis players have won the US Open or Wimbledon with a high unforced error rate," he says.
4) Do the analysis and think independently.
It is also important to understand that being contrarian does not make you a good investor.
"Many investors have caught 'falling swords' by seeking to be contrarian when other investors are panicking," Douglass says.
Magellan undertakes extensive analysis before making a contrarian investment call in order to avoid catching the falling sword.
"Our investment returns over time will depend on whether our analysis of the economics and competitive positioning of a business is correct," he says.
5) Understand opportunity cost
An investment opportunity looked at in isolation can often look attractive, according to Douglass.
He says a proper assessment of opportunity cost takes into account both the expected return and risk in comparison to the next best alternative.
"In assessing an investment opportunity we look at what the investment will do to the portfolio's expected return, quality attributes, volatility risk, and currency exposure, and if it shares underlying business risks with other portfolio holdings," he says.
"Often, the best course of action is to invest in what you already own."
Douglass draws on the analogy of a football team to describe how Magellan assesses the opportunity cost of each stock in its portfolio.
"Our portfolio consists of around 25 players and each player has a role to play in winning the game. Some stocks play a defensive role and some play an offensive role. We seek to place the best players in each position and when considering a new investment we ask ourselves which player (or stock) we are prepared to replace it with. By doing so, we are actively assessing the opportunity cost of new investments," he says.
Finally, Douglass ends with a quote from Charlie Munger which he believes summarises the qualities of a good investor: "Preparation. Discipline. Patience. Decisiveness."
