What Makes a Great Investor?
Think back to your education. Remember your university or secondary school days. What did you learn then that you still use today? Does any of it help you in your professional life? And before you moan about how nothing you learned in school has any application in real life, let me assure you that this is not true. All of us are shaped by our education and we all picked up things in school that we still use today. So, try again and think about what you learned.
In my case, the big lesson I took from university was how to solve problems. In a previous incarnation, I was a physicist and mathematician. This meant solving integrals of complex functions or calculating the polarization of sodium D1 and D2 lines in the solar spectrum. In other words, don’t ask.
After roughly two decades in finance, I could claim that nothing I learned at university helps me do my job. After all, what does calculating the polarization of sodium D1 have to do with investing? But in truth, every day at work I use the problem-solving skills I developed at university. While I may be a bit rusty at solving integrals these days, I’ve improved as a problem solver because I applied what I learned in school to an ever-widening set of problems.
One simple example is that I employ the approach advocated by mathematician Carl Jacobi: “Invert, always invert.” Jacobi argued that many complex problems can be solved if you invert them and think about the solution you want to find and then work backwards to your current situation. When you do that, you often find the quickest and most effective solution to seemingly intractable problems. In mathematics and physics, this inversion technique is applied all the time, and I use it again and again at work when assessing market developments or investment opportunities. To me, it’s just common sense.
But when I look around the investment world, I see too many research analysts, fund managers, and investors who can — to stick with my example from above — solve integrals at incredible speed, but can’t solve any problem they have not encountered before.
Research analysts and fund managers typically have been trained in finance and learned everything about financial statement analysis and how to calculate valuation ratios, etc. They know every little detail about the companies they cover, from the dividend coverage ratio to the amount of earnings growth expected in each of the next five fiscal years. And while that knowledge may be impressive, it does not make them great investors.
How can it be that during the tech bubble, for example, analysts on both the sell and buy side assumed technology companies would grow their earnings by 20% or more per year into eternity? Making that assumption may give you a fair value in your discounted cash flow (DCF) model that is in the vicinity of a company’s current market valuation. But if earnings grow at 20% indefinitely, the company would soon own the world. Heck, analysts currently estimate long-term earnings growth for Amazon at 36.8% per year. Assuming Amazon’s PE ratio stays constant, this means that in 2050 the company’s market cap would exceed US GDP. Research analysts who cover Amazon and fund managers who invest in it tend to know many details about the company, how it makes money, and where and how it can grow in the future. Yet all their technical expertise makes them miss the forest for the trees.
Invert, Always Invert
Now think of the great investors in history. What differentiates them from the run-of-the-mill? How do people like Warren Buffett and George Soros, Seth Klarman and Howard Marks, CFA, Benjamin Graham and Peter Lynch, stand out? While all of them have different investing styles and approaches, they all have one thing in common: They are investment philosophers.
Look at the typical fund manager interviewed on television or in the papers. They usually share their “wisdom” about why they love growth or income stocks or why they think the Bank of England (BOE) will hike rates or not. Put another way, they talk their book. Now listen to Buffett or Soros: They don’t talk about any of these technical details. Instead, they focus on the big themes and trends that drive markets today and will continue to in the years to come. They think about the fundamental drivers, not about the recent data flow, and they have developed investment techniques that can adapt to a broad range of problems to understand the underlying market dynamics.
Graham’s Intelligent Investor and Security Analysis, with David L. Dodd; Marks’s The Most Important Thing; or Klarman’s Margin of Safety are timeless. Some of these titles may be decades old, but they are still as relevant today as they were when they were first published. Why? Because they don’t focus on technicalities but on how to assess investments in a fundamental and informative way.
So, in the spirit of “Invert, always invert,” to become a great investor or research analyst, become an investment philosopher. Hone your skills in understanding market dynamics instead of memorizing data points or performing the DuPont analysis of return on equity. To be sure, you will need these expertise to become a great investor, but once you grasp the technique and how to calculate the elements, there is little added value in doing it over and over again or to an ever more sophisticated level.
That may keep you busy, but it won’t make you better, and it won’t make you a great investor.
For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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