Big three for old economy investors and not only

Being dumb is easy. Nowadays, it is even easier, thanks to an informational tsunami. Accordingly, we have so many ways to mess up. In the meantime, there are only a handful of foundational principles of investing.

I rely on those principles, too, in my investing process. In today's write-up, I would like to share three of them. Those principles are powerful because they are simple, which makes them seem naive and even foolish. It is easy to underestimate them. We do it at our own peril.

Stock picking, risk management, self-control

The outcome of our market adventures is a function of 10% stock picking, 30% risk management, and 60% self-control.

It sounds counterintuitive because we assume quality research, i.e., what to buy, is enough to guarantee profitable trade. This delusion gives bread to countless questionable analysts and writers. Investors love sugar-coated promises of holy grail stocks and easy money. Demand determines supply.

What to buy is the easy part. The missing part is the execution. No matter how wonderful the stock we choose is, it does not matter if we do not manage the risk.

The odds of being wrong are way higher than we like to admit. Despite that, we focus on the upside potential and discard the downside risk. Thus, in the long term, we undermine our chances of success.

And there is more; the quality of our risk management depends on our ability to control ourselves.

Erratic emotions -> chaotic behavior ->  inadequate risk management -> guaranteed failure

We always follow the five-step process in our everyday lives: thoughts, decisions, actions, consequences, reactions.

What we think defines our decisions, and the decisions determine our actions. Our actions have consequences that impact our emotions. And to close the loop, our emotions affect our thoughts. Drink, rinse, repeat.

Market participants, especially novices, set high expectations that are in huge dissonance with reality. That gap leads to rampant emotional response, which leads to anxious actions, i.e., unplanned and, most of the time, losing trades.

It is easy to self-sabotage by simply ignoring our behavior. Knowing ourselves requires mastering emotions, sanitizing thoughts, sifting decisions, and refining actions—easier said than done.

If the previous paragraphs were abstract, this is the opposite—concrete and measurable. It’s time to look at risk management, the second layer of the investing pyramid.

Risk management has parameters. And parameters are subject to measurement and analysis. I classify those metrics into two categories:

• Micro parameters – those are the variables concerning every trade I execute (timing, size, stop loss, take profit)
• Macro parameters – here comes a portfolio composition (number of themes and positions, preferred instruments, etc.)

Investing is a business. As such, it is based on processes with clearly defined steps and metrics. Moreover, business and investing are based on research and execution. The former is stock picking, while the latter is risk management. The ugly truth is that most market participants fail epically in the execution.

Now, let’s say a few words about the research. Stock picking is only 10 percent of the success equation. A brilliant analysis cannot compensate for poor risk management and raging emotions. I know I'm repeating it, but it's one of the few undeniable truths in investing, alongside uncertainty and change.

This is not to say we must ignore the research process. Stock picking is a rewarding process in multiple ways. A quality company with catalysts and prudent risk management is a long-term recipe for success.

Stock picking has its traps, too. One of the most dangerous is information hoarding. Gathering tons of information does not mean more clarity and understanding. The number of facts is a quantitative measure, and understanding is a qualitative measure.

What works is qualitative analysis—the kind that gives us a better understanding, not more facts. The quality of the analysis is directly proportional to our ability to work with the information. Here lies the proverbial analytical edge.

Being aware of the three layers of the investing pyramid is a prerequisite for a long and (probably) profitable career on the market.

Macro, sector, company

How to pick a company?  

Here is my answer. I follow a top-down approach based on the 50/30/20 rule.

Its postulate is simple:

·       50% of the movement in the price of an asset depends on the Big Picture shifts. Under Big Picture, I consider macroeconomics and geopolitics. Combined, it is like the tide - it just happens without caring about our opinion or whether we are conscious of its existence.

·       30% of the movement is dictated by the state of the sector in which the company operates. Following the sea analogy, the industry appears as a local sea current that determines how navigable the area is.

·       20% of the movement is due to individual stock dynamics. The stocks represent boats in the sea - they can move independently but always in the context of the local currents and the tide.

·       50/30/20 applies to medium and long-term trends. For periods below one year, the price is mainly driven by the narrative, not the fundamentals. The longer the period, the more influential the fundaments are.

The postulate leads to a few conclusions:

• We can extract Alpha from three areas - macro, sector, and company.
• All three are essential, but their impact is different both quantitatively and qualitatively.
• We can skip stock selection by investing in funds in a particular industry, but we can never ignore the macro economy, geopolitics, and the sector.

50/30/20 in practice

Here, I give you an example of 50/30/20 in practice. The thesis is on asset management and advisory banks in Europe.

In summary, 50/30/20 looks as follows:

·       Macro: rising interest rates lead to higher profit margins; geopolitical instability is driving further demand for safe havens for capital; deglobalization is leading to the restructuring of global companies, increasing demand for advisory services.

·       Sector: Banks in the EU and Switzerland in the Private wealth and Global advisory industries are excellent on all parameters—solvency, liquidity, and efficiency. Separately, the OECD's AML regulations have made banking increasingly complex and inefficient in many popular offshore areas, such as the BVI, Cayman, or Bermuda.

·       Company: Rothchild & Co., one of the leading Global Advisory banks. Unfortunately, the bank was taken private last year. It was a top-notch performer.

When 80% of price movement is due to macro + sector/region, we should take advantage of that. High tide (macro) combined with strong currents (sector) can drive our boat (company) into a safe harbor but can also crash it into the rocks. Even when all starts are aligned, the odds of being wrong are present. So, remember, the risk management comes first.

Wait, buy, wait, sell

Trading and investment is 10% buying, 30% selling, and 60% waiting. Buying is easy, selling is hard, but waiting is unbearable.

It is easy to buy due to FOMO, laziness, conformism, and, most often, a combination of the above. Unconstrained access to information and markets makes us think we are always missing something. So, we fall prey to the illusion that there is always better stock to bet on.

A successful sale is tricky because if we are currently at a loss and close the position, the loss becomes realized. If we don't, that loss may become more significant. However, there is also a chance that it will turn a profit. Because of our cognitive biases, we rely on the latter.

On the other hand, when we see a profitable position, we like to sell ASAP.  We prefer a small realized profit to any potential loss. The large but uncertain profit is irrelevant here. Fear of potential loss takes over our emotions.

This fallacy is a consequence of the loss aversion bias:  the intensity of the emotion of losing $10 is greater than the intensity of the emotion of gaining $10.

The hardest part is waiting because our brains are information-ingestion machines. Everything around us fights for our attention, generating a colossal amount of informational noise. Every additional bit of information we devour pushes us to make reactive decisions that lead to actions, and those actions have consequences.

Waiting has two dimensions: waiting for a good time to buy and a good time to sell. We are good at finding reasons to buy and sell rather than waiting patiently for the right moment.

Final thoughts

The markets are hostile. We meet market participants daily who have more money, skills, knowledge, and connections—some of them possess all. Despite that, we are arrogant enough to think we can beat those people at their game.

We tend to overestimate our knowledge and skills and underestimate the market's complexity. We assume that nothing can go wrong if we pick the best stock. Eventually, everything goes wrong.

To survive in such a harsh environment, we need guiding principles. Today, I present three of mine.

Stock picking, risk management, and self-control are essential, yet not equal. The extent to which we know ourselves determines our behavior, which in turn influences our actions, i.e., risk management. Finally, there is the analytical process.

Price movement is determined by macro and geopolitics, sector/region, and company. The Big Picture is the tide, the industry is the local current, and the company is our vessel. Whatever the latter does, it always considers the influence of current and tide.

Wait, buy, wait, sell—these are four steps to describe investing. However, steps 1 and 3 are the most difficult. Successful investing loves boredom, i.e., standing around and doing nothing.

I am not that smart to formulate those models. I was dumb enough to ignore them, yet wise enough eventually to use them. The models are powerful because they are simple. Yet they are not a hack, grail, pill, or whatever marketing gimmick we may call. Consider them for tools. As market participants, we must have a well-stocked toolbox and know how to use every tool.

Every quarter, I dissect my investing themes for the present year. I start with the big picture (macro and geopolitics), then move to industry/region specifics, and eventually discuss the most enticing companies.

My goal is to help institutional investors make better decisions about obscure industries and regions. How do I achieve that goal?

By delivering comprehensive and, most importantly, actionable reports.

If you wish a sample report, feel free to contact me by DM.