Note to Reader: Apologies in advance to all you sports fans. I know very little about most all sports and so will probably butcher many concepts you hold dear. You can address all written complaints to compliance@mssinvestments.com. This inbox is not currently monitored but the act of writing a complaint should be quite cathartic.
The Field of Financial Markets
I often like to think of markets as one big sports field in a state of pandemonium. Filled with different players playing different games with a variety of balls, goals and hoops. Everybody has a scoreboard and can switch games at will. The goal is to score points, whether its a basket, a field goal or a soccer goal doesn’t really matter. So while the different players have their own special skills, you see them go outside their circle of competence as they seek easy points. In this analogy, you would see basketball players trying to kick soccer balls, tennis players attempting rugby field goals and a very confused badminton player wondering where his friends are (spoiler: he has none).
In this field, the best way to actually score points is to find your specific sport and play it better than everyone else, accumulating points steadily based on your skill differential and ignoring the noise. However, given the variety of activity, it takes a lot of discipline to remain focused. Especially when that one guy keeps getting a hole in one from sheer dumb luck and you think you can do better. Add to this metaphor some extreme financial payouts for those scoring the most points (with no distinction in payout between those who are lucky or actually skilled) and you have our financial markets.
In markets these players include the day traders, investment banks, Mrs. Watanabe, pension funds, growth investors, value investors, friends and family of company management (with no inside info, of course), algorithms, bond investors, hedge funds that don’t hedge, “chartists”, macro investors and of course, the dentists with 15 minutes free between their patients. These players are all trying to outsmart each other in the scrum as they interact with all the financial investments on offer. Out of this chaos comes a single output: the set of prices reflecting the herd’s expectation of the future, with a strong financial incentive for this expectation to be as close as possible to reality. It really is quite fascinating to observe.
The Game We Choose To Play
Based on our own skills, temperament and capital structure, we believe that a form of high quality value investing is ideal for us. Why we feel we have an advantage here is a good topic for a future blog.
This strategy is focused on buying high quality businesses (i.e. Businesses generating high returns on their capital, with runway to reinvest their earnings at the same high returns, and a moat to prevent competitors entering the market and eroding their profit margins) at prices significantly below a reasonable fair value. We then just hold them (ideally forever) as they compound. This sounds like an obviously good thing to do, but is harder in practice given all the confusion, distraction and temptation in the field.
There are, of course, other games which are also valid ways to consistently generate a good return. I will refrain from talking about them as they are outside my circle of competence. You can learn more about them here.
The Rules of This Game
Warren Buffett has a wonderful baseball analogy for the game of investing he is trying to play. I will attempt to clumsily adapt it to cricket (even though my knowledge of cricket is only slightly better than that of baseball, I believe this will be more useful for my Sri Lankan and English friends).
Imagine a game of cricket, with the following tweaks to the rules:
You cannot get bowled out or dismissed for LBW (but you can get run out going for one or two runs or caught)
There are unlimited overs
Why is this similar to markets? Nobody forces you to invest and you don’t get penalised for missing opportunities (except for the opportunity cost of sitting in cash, which is much less once you already holding a good portfolio). The game of investing will also last the rest of your life, so there is no hurry to invest now. In a more technical parlance, the penalty for errors of commission are significantly higher than the penalty for errors of omission.
The Fat Pitch
If you are the batsman in this game, the only way you get knocked out is from swinging the bat. Unfortunately that is also the only way you can score. However, the lack of penalty for not swinging the bat is the key here. It means you need to wait with extreme patience for the perfect pitch from the bowler. The ball that is coming to you at just the right speed and angle that you know you are going to smash it out of the park. No matter how frustrated your teammates and spectators are (there will likely be someone yelling “swing, you bum”), you should still hold steady, passing on ball after ball until that perfect Fat Pitch comes in. You don’t want to risk the ones and twos, and you don’t want to risk getting caught by overextending on a tough ball.
You would expect a game like this to take a very long time, and be extremely boring to watch. You would also expect that good players would be scoring much higher scores than the average players who would get knocked out early. (i.e. There will be more dispersion in outcome)
Markets too throw pitch after pitch at us. Dogecoin, Tesla, Expolanka, 10 year SL treasury bonds at 30% PER YEAR and so on. It is our goal to independently evaluate these using first principles and only swing hard at the ones that we truly understand and are convicted on. It doesn’t matter if others are swinging at it, they have different skills and may even be playing a different game. It is key to realise, if you are not comfortable, you don't have to swing, and if it is a fat pitch, you got to swing with all your might.
The Challenges of Waiting for the Fat Pitch
The theory of how to invest is actually quite simple:
Buy good companies
Don’t overpay
Do nothing else to upset things
The hard part is dealing with the psychological and institutional pressure while you wait for the Fat Pitch. You will face this pressure from multiple angles:
From your investors, who want results. This is especially hard if the market is frothy and others are showing gains. This is why getting the right capital base is so important. It is also why institutional investors and fund managers are not so good at swinging at Fat Pitches and avoiding Curveballs. They have to act like they are doing something to justify their salaries and hence swing far too often.
From your peers, who regularly accumulate one or two runs on risky swings and will encourage you to join them. In the short term, they will look like great players, but in the long game, it takes one bad swing to fall behind in the game.
From yourself. I have found that this is the most common source of failure and the hardest to overcome.
Out of boredom and impatience: Some of the best investors would only do one or two investments a year. This can be quite dull unless you get fulfilment from the act of searching for Fat Pitches, not from the act of swinging.
Out of the Sunk Cost Fallacy: You will often spend weeks or months on an investment thesis, before realising that one small issue means it is not a fat pitch. It is very tempting to still swing given all the work you have sunk in.
Out of a Fear of Missing Out: As you see far less qualified and disciplined investors/speculators make eye watering gains in a frothy bull market. It is highly tempting to join in and swing at every ball like they do, in the belief that you can get out before the house of cards collapses.
Often investors who do make losses would, on careful analysis, admit that it wasn’t a Fat Pitch they swung for and that their standards had slipped for one of the reasons above.
How Does This Apply to General Decision Making?
As is quite common, the lessons of investing, can also be applied to decision making in life, since both share such similar domains. See below for a few interesting takeaways:
Life is also chaotic, with different people playing different games. Figure out what game you are good at and stick with it, ideally getting better over time. Aim to succeed by consistently taking advantage of your skill differential, not just taking big gambles and hoping to get lucky. You don’t want to be the badminton player in the rugby field.
Avoid playing whatever flavour of the month game that the crowd is playing.
Be wary of actions you take due to boredom, the sunk cost fallacy, or FOMO.
Life will also throw many Fat Pitches (and also some very hard curveballs) at you. You don’t have to swing at everything but it is important to recognise these once in a lifetime Fat Pitches, and swing for the fences when they come. This requires
A sense of mindfulness and awareness to detect them.
Strong preparation so you can really swing at it with all your resources during the short periods when it counts. I know many people who missed incredible investment opportunities, not because they didn't see and understand them, but they didn't have liquid funds available to swing with.
Life is also a long game. Be patient, don’t feel forced to swing at the curveballs even when bored spectators are yelling at you to swing. You are here to score, not entertain others.
Don’t risk getting run out chasing the marginal one or two runs. The reward isn’t worth the risk and effort, even if it feels easy. This is of course only for the long game. In specific sub games where you are time constrained, you may have to take the one and two run hits.
If you are a dentist, don’t try to outperform the market during your breaks. You will be outgunned and any success will be down to luck, which is not replicable over the long run. Just like how you would not expect a fund manager to drill his own teeth, you should delegate the job of investing to a professional.
So have we found any of these Fat Pitches as we explore the murky swamps of the Sri Lankan markets? That, dear reader, is a topic for another time.
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