This article has been written by Amay Hattangadi and Swanand Kelkar, both executive directors at Morgan Stanley Investment Management.
There is a Chinese saying that the faintest ink is more powerful than the strongest memory. This is a simple truth about writing things down so that one does not have to rely on memory alone for recollection.
Yet, this is lost on many, especially in the investing world. We were fortunate that early on in our careers we worked under bosses who made us write down stock investment theses, ideally not extending beyond a few bullet points. To borrow a line from Warren Buffett, “this is simple but not easy”.
We have spent many a morning at our desks trying to write an honest rationale for a stock that we have fallen in love with, only to toss out sheet after sheet into the waste paper basket.
Ideally, a stock rationale should have three parts.
First, there should be a description of the key business advantages. Some people call this the moat around a business and the description should also include a view on sustainability of these advantages. Deep distribution reach, low cost of production, sustained pricing power or Intellectual Property Rights on a product or service are some examples. One should also look for metrics that reinforce this description of moat like market share and change in market share, superior profitability or return ratios.
Second, there has to be a description of the business drivers for next 12–18 months. If the moat is about the structural advantages, this part is more about cyclical changes that one is expecting. Again this has to be quantified with measurable metrics like expected sales growth, operating margin, earnings, return on equity etc.
Third, it should be clearly defined where one differs from consensus market expectations. If the rationale reads like a consensus report then it is quite likely that all the good things are in the price. An ideal investment opportunity comes along when a solid moat is clouded by short term challenges and the market decides to focus more on the challenges than the structural advantages.
Rationales should end with a ‘review’ price, as opposed to ‘target’ price, which is one’s estimate of what the fair value of the stock should be, based on current information. The emphasis here is on review price rather than a target price because the latter merely denotes an exit price for the stock, whereas often the process of evaluating an existing investment involves periodic review, as and how goal posts are achieved.
The biggest advantage of writing things down is that it forces one to rummage through data to back one’s argument. For good measure, send your rationale to a large number of people. Putting it out there for all to see makes one more accountable and hence careful. Writing things down also helps weed out half-baked ideas at the initial stage itself before they can damage the portfolio.
Often, one comes out of corporate meetings where a Chief Executive Officer with great presentation skills has held sway and enthralled you. The halo effect creates an urge to press the buy button then and there but writing down the investment thesis acts as a circuit breaker. What felt like a no-brainer a few moments ago, does not feel that way once the rubber hits the road or in this case, the pen hits the paper.
Having clear operational metrics with every rationale helps measure actuals against expectations. Thus, every quarter when the relevant data points come out, it is essential that the original rationale is revisited to see if the thesis is on track or needs re-assessment. To be sure, one does not have to be robotic about this; that is, just because a metric is not reached, a stock has to be automatically sold but the process of re-assessment is critical. In investing, stock theses will inevitably go wrong and such timely assessments helps in limiting the likely damage from slow poison and steering clear of value traps.
In the happy instances where the review price has been reached, it is important to see whether this has been reached primarily through re-rating or because operational metrics surprised on the upside. If it has been mainly through operational outperformance, setting a fresh review price is easier.
Filtering out the signal from the noise is possibly the most difficult skill that an investor has to master. In times of volatility when emotions and headlines tend to hold sway over one’s thinking, re-visiting the rationale to see how much of it affects the original thesis has a calming effect. It is surprising on how little an impact, daily breaking news has on such rationales. Also, during times of volatility, some great bargains become available. If one has a review price handy for such stocks (this time lower than then market price), buying things when there is blood on the street becomes easier.
Unlike sportspeople, investors do not have sophisticated frame by frame action replays to correct flaws and improve technique. Having a collection of rationales written over time is the best that we have and a record of one’s own thought process helps unearth biases and mistake patterns. Being cognizant and rectifying them will go a long way in accelerating one’s evolution as an investor. Also when the chips are down, it is a morale booster to read an old rationale that played out well and gave large returns.
The most frequent complaint that we get from investors is that “We are numbers people, not writers!” but all it takes is lucid articulation of thoughts in simple language. And as regular readers of this newsletter will agree, one does not have to be a Hemingway to write about investing.
