Active vs. Passive – the debate that can’t be settled:

Should you be active or passive?  That depends.  It should also be your second question.  Your first question should be “how much money am I willing to invest for 5-10 years minimum without feeling scared if that amount drops by 30-50%?”  No one has any clue what will happen tomorrow.  You must set yourself up for success.  And success only comes by controlling your emotions and sticking to your savings/investment plan when conditions are so scary that others aren’t sticking to their plans.

The next question I would encourage you to ask is “what is the purpose of my investments?”  For some this may appear to be a silly question.  The answer is obviously to grow them.  That is my goal too, but I also really enjoy picking the companies to make investments in.  I enjoy the process of reading earnings transcripts and regulatory filings.  It leads me down a path of trying to find out the truth about the world around me.

So, I am naturally inclined to pick stocks rather than invest in ETFs. But, in my pursuit I run the risk of realizing suboptimal returns.  When my life is over there is a chance an investment in the S&P would have outperformed my stock picks.  That is a risk I am comfortable with for a number of reasons, but you have to decide whether you would be comfortable with that risk as well.

Why am I comfortable with the risk of underperformance?  For starters, my goal is to make investments where the chances of permanently losing money is low.  Therefore, my perceived risk is lower than it would be if I were in an index fund.  Is that a logical conclusion?  No, because I am not a robot and I probably am overconfident in the business prospects I am investing in.

The natural response to what I just said is “well, then why don’t you just do what is logical?”  And the reason is I fundamentally don’t trust indexing.  I may be slightly conspiratorial or illogical, but I know in my heart that if things go really really wrong and I start reading about improper index construction I would bail on my investment. Bailing on your investment because of emotion is the path to financial destruction. 

There are many studies that show the average investor in a fund severely underperforms the fund that investor is invested in.  The reason is they lack the conviction to hold when times are tough.  As a side, sometimes it is difficult to hold when your investment is performing well.  That may sound a bit odd, but it is true.  Letting your “winners run” is a skill that must be learned.  I have cut many winners short and snatched greatness away in order to secure good results.

Investing “success” comes from doing what makes YOU comfortable enough to make the process work for you.  Investing failure is destined to find you if you compare your results to someone else’s results, an index, or some other metric AND deviate from your preferred style because you want someone else’s results.  First, those results are looking in the past.  Second, you must stick with their style when that style is out of favor.  You cannot borrow someone else’s conviction.

In closing, being a good investor requires knowing yourself and committing to be true to yourself.  So take time to think about your risk tolerance and your beliefs.  Not taking that first step ensures failure.  That said, it is only the first step to success.

The importance of ROIC and Growth

I’ve seen a lot of discussion lately about whether low ROIC businesses are better than high ROIC businesses.  ROIC means “Return on Invested Capital.”  There are a couple different ways you can define invested capital but for these purposes I am going to borrow Joel Greenblatt’s definition and call it PP&E + Working Capital.  I will note, however, that I also deem any additional necessary assets or liabilities as part of invested capital.  For instance, an airline has many assets via lease.  These are obviously necessary to the airline’s operations and therefore cannot be excluded from an invested capital discussion (an offsetting adjustment to add back rent and subtract hypothetical depreciation would be necessary in this instance).

Anyway, many people say high ROIC businesses are inherently better investments over the long term than low ROIC businesses.  Why is this?  Well, it is because a business with high ROIC tends to grow earnings per share faster than a low ROIC business BECAUSE there is not a need for reinvestment.  As Warren Buffett says, you dont want to own a business that consumes all of its capital and has none to pay back to its shareholders.  Instead, the perfect business can earn capital, require no additional investment and (a) invest that money back into marketing or some other channel to grow sales or (b) return the capital to shareholders.  Why? Because all of the cash is cash for the owners rather than cash for the business then the owners.

That said, there is nothing inherently superior to a steady state high ROIC business and a steady state low ROIC business.  Why?  Because if you are paying a multiple of earnings then the income statement will already reflect the cost of depreciation (and consequently your reinvestment rate, assuming the firm is run well) in both firms.  Therefore, the multiple you pay will be much more important to determine your success as an investor in a steady state firm.

However, nothing in this world is steady state.  Ideally you are looking at a firm that is growing.  And in a growing firm, take a look at the following (elementary) example.

Screen Shot 2018-11-08 at 3.53.43 PMAs you can see, the earnings growth rate of the firm has grown by 31.6% in each instance.  HOWEVER, the free cash flow distributable to the firm grew by 2.6 more units in the firm that requires no incremental capital.  If we assume a 5% free cash flow yield on this investment, the firm that requires no incremental capital to grow its earnings base will be worth 52.6 units more than the firm that requires capital.  Which is just to say that no incremental capital, combined with growth, can be an incredibly powerful force that lifts the value of your investments.  Hence the reason software firms are worth so much more than industrial firms.