Tomorrow, And Tomorrow, And Tomorrow

One of my favourite stock market quotes comes from the great American Financier (or robber barron, depending on your view) - J.P. Morgan. When asked what the stockmarket will do next, he responded that, "It will fluctuate." And that is about the most prescient answer anyone could ever give on the subject.

Anyway, investing isn't about peering into a crystal ball and seeing what will be. It's a search for opportunities where, on balance, the likely reward of an investment outweighs the potential risks. You can concentrate your risk in a few high-potential investments, or spread it over more ideas that collectively should give you less volatile returns. All this balancing of risks and rewards is a tricky business. This past week or two being a case in point.

One of my favourite stocks at the moment is a little minnow that I now have a reasonable amount of shares in called Lo-Q (ticker LOQ). From looking at the annual report, reading information on the internet, reading the available broker note, talking about the business with friends, thinking about the business lots and finally speaking to the founder on the phone recently, I have formed a strong view on the likely fair value of the business. And my valuation (around £40m) was just a little bit higher than the market cap of the company as quoted on AIM last week. Just a little bit being £30m higher (or a potential 300% rise from the current £10m market cap)!

Back in October I sold out of two business I thought it wasn't worth being in - Umeco and Severfield Rowen. They both seemed undervalued still but my other ideas just seemed better. Plus I was starting to really understand the concept that it's hard to think about more than, say, 6 ideas at once as I was having trouble thinking very deeply about the 11 ideas I had in my portfolio at the time. So I sold out of those two stocks in favour of Lo-Q and Staffline (ticker STAF).

Of course Umeco promptly rallied from 290p to 350p, which just reminds me (again) that my short-term market timing skills are rubbish to say the least. In consolation Staffline managed a 42% rally in November, which was nice.

So this LOQ then. At the end of the analysis I just saw a great, growth business with relatively few issues to derail growth over the next couple of years at least. And at 75% undervalued, a fairly compelling prospect. What to do. Hmm. I thought about selling out of the larger issues I have that are less undervalued (BRK.B at 20% and EMG now at 40%). Probably a good idea, but that's not how a balanced portfolio would look. And there's the rub.

If I'm managing this mini-portfolio with a view to showing others how I would manage their money one day that's one thing (and being somewhat diversified to reduce volatility and avoid potential value traps makes good sense). However, it is a little different to what I should be doing if I were just managing this tiny amount of capital with the very pure goal of maximising post-tax returns in mind.

Recently, it's begun to sink in that I'm going to struggle to get any sort of investment business underway without some fairly huge levels of confidence in me from a set of very well capitalised supporters. And the types of people who would back me would basically ask themselves, "If he's so good, why is he so poor?" Which ends up with the slightly tortuous conclusion that, to be in a position to manage money away from the crowds, I first have to have enough behind me so that I basically don't need to work. Well, if that's what it takes, then so be it.

There's some freedom in the above, though. I was fixated on making my portfolio work in a way that would be operationally viable with a much larger sum than I am currently managing. And the case in point, LOQ, is not something that anyone with decent sums of money could invest much in. If you're managing £100m or so and want to get a decent return, you've got to start looking at companies with market caps broadly in excess of £100m to avoid owning more of the company than you can get in and out of easily. Any smaller and you're going to end up owning such a large chunk that you'll move the price significantly on your way in and out, thus eliminating the potential profits that a smaller fund could benefit from.

Happily, mini-investors with the time and skills can look in this sub-£100m market cap universe and find a wealth (literally) of undervalued gems to put their money to work in. Frankly, it seems like a decent investor with small sums of money should be able to totally destroy the market averages by investing a concentrated portfolio in this universe of stocks, so that's where their attention (and mine while not working for anyone else and managing miniscule sums) should be focussed.

It's been a year since I started this blog now, so I may post less frequently from now on. Here's the current portfolio and performance since inception, as at 30 November 2009. Hopefully I'll be able to update the portfolio and performance and check back on how the likes of LOQ are progressing in the future. It's good to get ideas down before the event, and check back later to see how things are panning out. As Buffett says, "In the business world, the rearview mirror is always clearer than the windshield."

Portfolio

BRK.B - 19%

HMS - 18%

MTEC - 18%

LOQ - 12%

EMG - 11%

ISG - 9%

WMH - 6%

STAF - 6%

GMG - 5%

Returns

(Compound)

Since Inception 3 years 1 year

Portfolio 59.2% 38.4% 7.1%

FTSE 100 26.0% -2.4% 26.8%

S&P500 -0.3% -16.4% 26.7%

(Annualised)

Since Inception 3 years 1 year

Portfolio 10.3% 11.2% 7.1%

FTSE 100 5.0% -0.8% 26.8%

S&P500 -0.1% -5.8% 26.7%

Inception was on 10 March 2005. Portfolio returns are calculated after all costs (paying the spread, stamp duty and dealing costs) but uses the mid-price for current valuation purposes. Index returns assume dividends are reinvested and do not take any costs into account (meaning the actual returns from investing in such indexes would be lower).

A Bright Future

As the investor awoke from his deep slumber, the masks he had been trying on for size during his European sojourn fell away to reveal his true self. The sun was rising in the sky as he stretched his arms high above his head and his now expansive vision of what was to come filled his mind with wonder, excitement and no small degree of trepidation.

There is now a fairly unshakeable belief in me that I can outperform markets in general by a wide margin over time. That belief (and the expected outperformance) is large with small amounts of capital and shrinks with larger amounts. I think that most professional investors would say the same thing, but few probably have personal investment accounts that show they have been able to actually do this. Sadly, only a minority will have professional performances that beat the market averages over time - especially once fees are taken into account.

It may sound egotistical to say you are better than the professionals at an activity, especially one regarded as being so difficult to master, however, for the enlightened at least, the investment game is surprisingly simple and easy to outperform in. That is, before you take behavioural biases into account.

Plato once said, "For a man to conquer himself is the first and noblest of all victories." This couldn't be more prescient in the field of investment management. The only way I know to overcome the inevitable biases is to stick with one strategy and not be swayed by the emotions of the market. Whether or not this will be possible is entirely dependent on temperament. By understanding exactly why you should have an edge in investing, and checking each time you make an investment decision against a list of credentials for making investments, you can alleviate many of the biases that lead to poor performance.

The simple process of finding undervalued stocks may involve a vast amount of hard work, but happily this will neither feel hard or like work if you love what you are doing. You only need to sit and think carefully for half an hour or so on a given company to have an edge on many of the people who will end up buying or selling shares in that company's stock over the next few years. Some will be depressed at it's prospects and offer you very favourable terms to sell you shares in the enterprise at a low price, and some will be highly enthusiastic about the future for the company and willing to pay you a compellingly high price for a share in its expected future profits. It is the induced hope and fear of others that creates such rich opportunities for those with the right temperament, who are also willing to do a bit of work, to profit from their folly.

Sadly, many investors decide to invest for reasons other than a perceived gap between price and value. Exploiting the difference between the two is the lynchpin of the value investing process and has worked over and over again through a variety of markets and with clearly understandable and repeatable results (perhaps more in direction than in magnitude). That few appear drawn to the process seems odd, but when you factor in career risk for professionals and the extreme short-termism of many investors, it is more understandable.

So, opportunities abound for those able to be reasonable at assessing the fair value of businesses, and then exploiting the difference between price and value by buying where a sufficient margin of safety exists.

I look forward to a future where I will be able to help people invest more wisely. I look forward to a future where I can help people by compounding their capital at rates of return that will warm their hearts by helping them to meet their goals and fulfill their dreams. I look forward to a future where I will be able to think about investments all day long and teach others of the plentiful opportunities available in markets; to help them understand the mechanics of valuing businesses and profiting from the market's inevitable bouts of greed, fear and folly.

The road to this point has been rocky at times, and I've had to learn from mistakes that thankfully were never so large as to divert me from the path which I am still on. I will definitely seek out people who I feel I can learn from, but in the final analysis the real rewards of fulfillment and satisfaction will arrive as long as I can immerse myself in an activity I take real pleasure from, and by performing well in an activity that I, personally, attribute value to.