Let’s pretend there is no stock market.
That’s what Uncle Warren suggested in a recent interview with Charlie Rose.
The liquid nature of the stock market is a liability for most investors because they can’t handle the volatility.
Every morning, we are hit in the face by a cacophony of financial news that prompts us to tinker with our portfolio and challenges any previous decisions we have made. Yet, most of it should be ignored, and it can be challenging to separate noise from signal.
The irony of preaching the idea of tuning out the noise on a platform that covers financial news daily is not lost on this author. The news itself is not harmful. It’s your reaction to it and how much attention you pay to it.
As you look for opportunities to invest money you’ve saved, there should be no difference between buying a house, a farm, or a business. What is really at stake is to find a place for your money that will ultimately create income or capital gains for you as an investor.
If you are a homeowner, you’re probably not assessing the value of your home every day on Zillow, wondering if you should sell when the Zestimate is down 15% from its previous high. You wouldn’t sell your home because you just found one in which you have “slightly more conviction.”
Private equity investors benefit from a significant advantage because their investments are, for the most part, illiquid and remain so for years. At first glance, it may sound like a constraint, but they let the story play out, which can drive tremendous returns for their most successful ventures.
Individual investors tend to pull their money out of the market too soon, trade too much in and out of a position, and create unnecessary tax inefficiencies.
We are wired to sell at the first opportunity:
- Secure our gains when a stock is up.
- Cut our losses when a stock is down.
There is always a reason to sell if you look long enough. So we build stories to tell ourselves to feel good about our last move.
The problem? We interrupt the power of compounding, the most important driver of wealth creation in an investing process. Instead, investing should be 1% buying and 99% waiting. As best put by Charlie Munger:
The first rule of compounding: Never interrupt it unnecessarily.
So investors would often be better off pretending there is no stock market. Instead, they should assume their investment is illiquid for at least five years and move on with their life.
One of the best mental models is to invest like a business owner. Warren Buffett explains:
People would be better off if they say, ‘I bought a business today,’ not a stock today because that gives you a different perspective on it. You don’t buy or sell your business based on today’s headlines.
Thinking like a business owner can provide immediate benefits based on how it might impact:
- What you buy.
- How you buy it.
- Your time horizon.
- Your perspective.
1) What You Buy
Let’s look at stock tickers for what they are: partial ownership of a business. By doing so, instead of being excited about a stock simply because it just went down or up, you’ll be able to focus on the qualitative factors that a VC would be looking for in private markets:
- Strong culture: Look for long-term focused management teams with exceptional ratings from their employee. For example, companies like Salesforce (CRM), Google (GOOG), or HubSpot (HUBS) show up regularly among the best company culture you’ll find in America.
- Inspiring Founder-CEO: Leaders who have made their company their mission in life and have skin in the game, like Jeff Green at The Trade Desk (TTD) or Tobi Lutke at Shopify (SHOP).
- A track record of innovation: Companies that have demonstrated an ability to create new products and revenue streams like Apple (AAPL) and Tesla (TSLA).
- Exceptional competitive advantage: We are looking for businesses that can sustain their edge sustainably via a powerful brand like Nike (NKE), network effects like Amazon (AMZN), or high switching costs like Microsoft (MSFT).
- Optionality and geographic expansion: Companies that expand their potential over time with new markets like Block (SQ) or Twilio (TWLO).
Many people on Wall Street trade solely based on price fluctuations, momentum, arbitrary short-term valuation targets, macro headlines, and more factors that have nothing to do with the underlying business.
Many actively managed public equity funds work solely on quantitative criteria, an area where individual investors have a limited chance to have an edge and generate alpha.
The good news is that none of this matters if you are approaching investing like a business owner – looking first for qualitative elements and only then looking at the price.
If you want to put yourself in the shoes of a business owner, we can look at how VCs interview start-ups. Here’s an example of a checklist adapted for a public company:
- Engineering: Was the company able to create breakthrough technology?
- Timing: Is now the right time for this business to thrive?
- Monopoly: Is the company a top dog in its category?
- People: Do they have the right teams? Good management?
- Distribution: Is the company efficiently delivering its product/service?
- Durability: Is the market position still defensible 10 or 20 years from now?
- Secret: Have they identified a unique opportunity that others don’t see?
Any business plan should have addressed all the above points before a company becomes public. But even years later, without good answers to the questions above, there will be roadblocks and hurdles preventing the business from succeeding over the long term.
Answering most or all the questions above with a yes is what will truly matter in finding the investments that generate huge alpha.
Financial media focuses too much on timing, price momentum, and valuations. Speculators and day traders generate clicks and keep the light on. However, investing like a business owner has nothing to do with the idea of growth vs. value, expensive vs. cheap stocks or momentum vs. contrarian strategies. Instead, it involves focusing on quality vs. quantity.
John Neff, a partner at Akre, explains:
We are not speculators in the price movement of shares. We own businesses. The focus is on owning the most exceptional businesses we can find.
Anticipation of multiple rate hikes has generated a generational shift from growth to value. As a result, valuation is on everyone’s mind. The problem is that some investors make valuation the first criteria for selecting an opportunity when it should be the last.
Would you decide to buy something simply because it’s cheap?
- If your goal is to resell it immediately? Maybe.
- But what if you’re buying something you want to own? Probably not.
Many articles call a company “uninvestable” based on arbitrary metrics. It might make sense for a mature and highly predictable business. But otherwise, it’s not very insightful.
James Anderson of Baillie Gifford previously stated:
We’re business analysts first and foremost, so valuation is usually the last thing we look at.
As pointed out in this article by John Hempton:
A decent stock note is 15 pages on the business, one page on the management, one paragraph or even one sentence on valuation.
Spending too much time on valuation can lead to false precision. It’s a counter-productive effort that may turn you away from a fantastic opportunity for the wrong reason.
The valuation analysis can be misguiding if you look at a dying business in a secular downtrend. You might see an opportunity for a swing trade and risk being a bag-holder.
On the flip side, if you look at a thriving business in a secular uptrend, valuation can look extreme and still lead to tremendous returns if management continues to execute over many years.
Ultimately, what valuation provides is an appreciation for the margin of safety. I discuss this topic in more detail in my article How To Value A Growth Stock.
Overall, focusing on quality goes counter to common wisdom. Buffett explains:
In the academic world, there’s been a rejection of actually thinking about stocks as businesses – essentially because there’s been an enormous amount of data about price, volume, P/E ratios and dividend yields. Everybody loves to run a million statistical comparisons of this variable versus that variable. They’re looking for answers in a bunch of chicken entrails and ignoring the fact that when you buy a stock you buy part of a business. It is extraordinary to me. It is also quite valuable from our standpoint. If you’re in the sailing business, you’d want to set up a flat earth scholarship. There’s no question about it. It reduces competition like you can hardly believe.
By filtering investments opportunities based on the inherent qualities of the underlying business, you are already playing your own game. One that most people don’t have the patience or any interest to play.
2) How You Buy
We are constantly fighting two emotions:
- FUD (fear, uncertainty, and doubt)
- FOMO (fear of missing out)
Thinking like a business owner can help us fight both.
First, fighting FUD. Assuming you maintain a balanced and diversified portfolio factoring market, sector, and company risks, one of the biggest threats to your returns is the opportunity risk.
Here are typical ways public investors suffer before starting a position:
- “The stock has run too much.”
- “The company is overvalued at this price.”
- “I’ll buy if it drops back down to $40 or lower.”
You’ll find a version of these three sentences in the comment section of most articles on Seeking Alpha. Some investors never start a position in some of the most promising businesses because they are never cheap enough.
If you have found a business that checks all the boxes, there is no way to know if you’ll get a better opportunity. An easy way to alleviate this challenge is to take action and start a position. This mental model can nudge you into starting a position in a fantastic business and make it easier to increase your allocation later on.
Second, fighting FOMO. We often try to go too fast, too soon.
How would a VC approach an investment in a start-up?
There are usually many steps involved before a company becomes public:
- Seed (starting phase)
- Series A (optimization phase)
- Series B (building phase)
- Series C (scaling phase)
- and so on.
These steps can involve the same investors, adding to an existing investment. We can learn a lot from how private equity firms build up their position. The core idea is to stage your buys.
If you managed to identify an investment that fits your criteria, it would likely be a mistake to let greed take over and go “all-in.”
If you intend to own a business for many years, there is no need to immediately go “all-in” and build a gigantic position. But, unfortunately, there is this romantic idea that if you know what you’re doing, you should take jumbo positions, put all your eggs in your highest conviction, and call it a day. The Bill Ackman and George Soros of the world fuel this idea because they have been tremendously successful with this approach. The problem? There is a great deal of survivorship bias, and we tend to underestimate the importance of luck.
In a previous article, I covered the 5 Ways To Buy A Stock That Will Make You Rich (Very Slowly):
- Dollar-cost averaging: a disciplined way to accumulate shares.
- Averaging up: a way to add to the winners of a portfolio.
- Adding on sell-offs: essentially being greedy when others are fearful.
- Adding at a lower valuation: another mental model to add to winners.
- Dividend reinvestment plan: to benefit from compounding interests.
We are bombarded with the old Wall Street adage, “buy low, sell high.” It may apply to day traders but not business owners. In effect, it encourages over-trading.
The actionable mantra for long-term investors should be “start your position now and stage your buys.”
If you stage your buys using dollar-cost averaging or buying on dips, you are more likely to get a lower cost basis over time or have a more negligible exposure to what ends up being a loser. You’ll still have plenty of time to build up positions in your winners. And you are less likely to negatively perceive a drawdown in the stock price, therefore overcoming the potential risk of panic selling.
3) Your Time Horizon
The macro-environment is on everyone’s mind at the moment.
According to the sentiment survey from the American Association of Individual Investors, 48% of investors are bearish at the moment, well above the historical averages. And good luck finding anybody bullish (19% of investors surveyed).
We are facing a wide range of outcomes:
- Has inflation peaked?
- How will the war in Ukraine escalate?
- How many rate hikes will occur in 2022?
- How will earnings and guidance be impacted?
- Will there be a recession in the coming two years?
The answers to these questions will affect the next few quarters, and investors will adjust their expectations.
The truth is, there will always be something to worry about.
The market tends to be forward-looking, factoring in good or bad news long before they materialize.
- You can’t predict the economy.
- You can’t predict with certainty what the Fed will do next.
- Even with perfect information on the above, you still couldn’t predict how the market would react. So, why bother?
Reading about the macro environment can only help with two things:
- First, put the current market in historical context.
- Second, set your expectations appropriately.
We try to think and act like successful business owners that truly take a multi-year approach in our thinking, portfolio management and the all-important temperament. We are not macro investors.
Thinking like a business owner means you are playing the game with a longer time frame. Judging by the range of stock returns in the past century, the odds of success dramatically improve in the process.
The chart below shows the range of annual returns for stocks and bonds based on the holding period. Over a 1-year timeframe, the range of outcomes can be extreme, from a loss of -37% to a gain of 51%. However, the longer the time horizon, the less likely you will lose money. Over a 20-year rolling period, investing in stocks always leads to positive returns. Even the worst period tested had a 6% average annual return.
That’s why I always like to say that my hedge is my time horizon.
Since stock returns over one year are essentially a coin flip, expanding our time horizon is critical. Just like in a video game, if there is such a thing as an “easy mode” in investing, it’s for those who choose to invest over a longer time frame without predicting market tops and bottoms.
Legendary investor Li Lu of Himalaya Capital Management explained:
We view ourselves primarily as owners of businesses, and typically hold our positions for a very long time with very low turnover.
When you invest with a multi-year time horizon, you are more willing to give management the benefit of the doubt and let the story play out.
And that’s great news! Because success is not linear. And no matter how great your next investment is, it will underperform at some point or another. I discuss this topic in my article about What It Takes To Hold Winners.
4) Your Perspective
Staying focused on business performance is more critical than ever in the current environment. Our emotions are tested in real-time, and it can be challenging to keep a cool head.
The human brain is not meant to handle uncertainty very well. Our instinct is a protective mechanism. While it can benefit us when facing danger stranded on an island, it can be counter-productive for our investing approach.
In his letter “The Value of Not Being Sure,” Seth Klarman discussed the challenge of not responding to the vicissitudes of the market:
If you see stocks as blips on a ticker tape, you will be led astray. But if you regard stocks as fractional interests in businesses, you will maintain proper perspective. This necessary clarity of thought is particularly important in times of extreme market fluctuations.
It can be tough to take the 30,000-foot view when reading financial news feels like a slap in the face every morning. Stock price movements will make you second-guess yourself. And with so many opinions on the web running counter to your strategy, you need to build your own conviction. I cover this topic in more detail in my article Know What Game You’re Playing.
We are wired to judge our investments by the performance of the stock price in the minutes, hours, or days that follow our purchase, even when it shouldn’t matter at all. Buffett points out that only fundamentals matter over time:
People buy a stock and they look at the price next morning and they decide to see if they are doing well or not doing well. It is crazy. They are buying a piece of the business. That is what Graham – the most fundamental part of what he taught me. You are not buying a stock, you are buying part ownership in a business. You will do well if the business does well, if you didn’t pay a totally silly price. That is what it is all about.
The market tends to extrapolate the impact of interest rate hikes in the short term to the point that it overly discounts future cash flow. As a result, when business fundamentals remain intact, the market’s turmoil can create attractive entry points for long-term investors.
Of course, buying stocks when they are in free fall can feel like a daunting task. You have to be willing to hold your nose. It feels infuriating to buy something $100 worth $90 in the hours that follow. But unfortunately, that’s the reality of the stock market, particularly this year, and there is no way around it.
By not trying to predict interest rates or any other macro factor, you can stay focused on the business fundamentals, which are ultimately the only driver that will matter over multiple economic cycles.
The market swings like a pendulum. It overshoots to the upside and the downside in unpredictable ways. Anybody who believes they can predict what will happen next is either a beginner or a charlatan. Predicting future market movements is a fool’s errand.
As the NBA playoffs unfold, we are reminded of the role of probability in sports. All rounds in the NBA playoffs are best-of-seven series because anything can happen throughout a single game, let alone a single quarter.
You could bet on who will score the next basket, or you can zoom out and focus on which team has the best roster and is the most likely to qualify for the playoffs next season. The former is akin to gambling (completely random), and the latter is akin to investing (based on evidence of success and extrapolated over time).
There are many ways to stress test your motivation and make sure you invest with the right intentions. For example, Buffett often suggests that investors buy and hold a stock as if they owned the entire business. The implication is that you would buy as if you could never sell and solely rely on the cash returned to shareholders to drive meaningful returns.
Conversely, those following the greater fool theory will buy stocks solely because they believe they can quickly sell them off at a higher price, without regard for the quality of what they are buying.
If you look at investment opportunities like a business owner, you invest in a business today because you believe it will be worth more later based on the future cash flows. The rest is beyond your control.
Investing like a business owner has many benefits. It helps you stay calm and stacks the deck in your favor. But it’s also a way to make your investment journey a lot more meaningful.
If you treat your investment like part ownership of a company, you’ll focus on what makes a business strong, scalable, and sustainable. With the stock price eventually following business fundamentals, that’s a recipe for success. And in the process, you might even learn a thing or two.
What about you?
- How do you keep your emotions in check?
- Have you been focused on quality during this market sell-off?
- Do you try to predict the economic cycle or focus on the fundamentals?
Let me know in the comments!