Exposing some Fallacies in Investment Wisdom

Unicorn Portfolio Update 17

When you start your investing career it can all seem a bit overwhelming. Soon you will be getting different advice from everyone, but they usually have one argument in common, you have to pick a strategy and stick to it. So how do we pick a strategy? Probably our best bet is to learn from the greats. 

You go online and you see a lot of recommendations for Benjamin Graham (The father of value investing). You read his legendary book The Intelligent Investor and you are convinced that you are ready to pick your first stocks. You are now a value investor and ready to find undervalued stocks.

As you scroll through Twitter you are bombarded with Warren Buffet quotes and soon you find yourself down the rabbit hole of investing like Warren Buffet. Next, you are debating on some online community how Graham's ideas are antiquated and that you simply have to buy and hold quality, letting time arbitrage do its thing. A few years later all of this becomes a bit boring. You become more greedy since you clearly have an edge and you are convinced you can generate some serious alpha.  

You discover a fellow by the name of Stan Druckenmiller, one of the greatest hedge fund managers on the planet that averaged 30% CAGR for 30 years without a single down year. You follow in his footsteps by making concentrated bets in your highest convictions plays and you forget all about diversification. P.S. we sincerely hope that your all-in moment was not in NFTs.

Our advice is to find a strategy that works for you, just like dieting or fitness there is no one-size-fits-all. If you are going to invest in individual stocks, you will have to devote significant time to defining your strategy. You will also have to continually fine-tune your strategy as you become more experienced and your risk appetite changes. Below we are going to expose some caveats in common investing advice.

Diversification is Protection Against Ignorance

A lot of great fortunes in the world have been made by owning a single wonderful business. Most investors rarely have more than 20 great ideas in their lifetime so why do you waste time and capital on choosing 40, 50 or even 100 stocks?

Caveat: Yes there is definitely some truth in this statement but it is not quite as easy. This has a bit to do with hindsight bias, we seldom have the foresight to know when we have our best ideas. A significant proportion of investors tend to be uninformed, succumb to various cognitive biases, and overestimate their intellect, insight, and conviction. Regrettably, novice investors are even less informed, having not yet crossed the valley of despair and realising that "this is difficult".  As such, it may be advisable for retail investors to hedge against their lack of expertise until they grasp that diversification goes beyond merely owning multiple cybersecurity stocks. Going all in sure is the fastest way to lose the shirt off your back

Large Caps are Safe as Houses and Small Capps are Dangerous

Large caps tend to be more secure businesses, with established operations, and trade more efficiently on account of the fact they are so well covered by analysts. Small caps are usually more volatile and have a higher risk.

Caveat: There are many instances where this is not the case. Large-cap companies are often more complex and diversified than small-cap companies, which means they may be impacted by a wider range of factors. In contrast, small-cap companies are often more focused on a particular niche, which can make them less vulnerable to market shifts. Another factor to consider is that large-cap stocks may be overvalued due to their popularity and visibility, which can lead to a higher risk of price corrections. Large-cap companies are typically well-established and widely followed by analysts and investors, which can lead to higher valuations that may not be supported by their actual performance. 

In an environment where the average retail investor has limited advantages, searching for undiscovered small-cap stocks can result in identifying potential multibaggers. These companies can benefit from both business growth and an influx of investment when they become large enough to attract funds. However, because small-cap companies are often overlooked, there is a higher risk of encountering landmines in one's investment journey. With fewer analysts scrutinising small-cap stocks, it's easier to overlook potential risks and pitfalls.

Comparatively, it may be more challenging for a young investor to bring new insights to a well-established large-cap company like Apple, where the company is widely covered and analysed by experts. However, the potential to gain an informational edge in a small-cap stock is higher due to its inherent inefficiencies. As a result, the stock can be significantly undervalued or overvalued, which poses both risks and opportunities.

Therefore, while it's commonly assumed that investing in large-cap stocks is safer, this may not always be the case. Although an inexperienced analyst may be more susceptible to landmines in small-cap stocks, the "safety net" provided by large-cap stocks is not always as secure as it seems.

Time Horizon of Forever

There is a common conception that you should hold a stock forever and let compounding do its thing.

Caveat: The average lifespan of a company within the S&P 500 index has fallen from 35 to 20 years since the 1980s. Also, most stocks don't always go higher.

Stick to Your Circle of Competence

Your greatest advantage is likely to be in the narrow field of your relative expertise, so it's best to focus on that.

Caveat: It's important to note that staying confined to a single area can hinder your ability to grow and develop. As an investor, it's crucial to gradually and thoughtfully broaden your sphere of knowledge and competence over time.

Ignore Macro if you are a Long-Term Investor

Invest in quality businesses and ignore the macro and share price fluctuations. The reason behind this is that the majority of macroeconomic data is backwards looking and the successful projection of said data ranges from difficult to impossible. Focus on fundamentals.

Caveat: The relationship between the stock market and the economy fluctuates over time, but it is widely recognized that the two are closely interconnected. If you are an investor in cyclical industries, it is advisable to keep an eye on macroeconomic trends. We are now also enduring a growth stock bear market for the first time in more than a decade. And we are sure that many people, including us, wish they took a deeper look into the macro before investing in cloud stocks with a P/S ratio of more than 20.

A few more quick ones

DCA cures all: DCA'ing into terrible companies does not.

Stocks always go up in the long run: What is your definition of stocks?. This mostly relates to US indices like the S&P 500 as a proxy for everything related to the stock market. A dangerous mentality to possess. Many stocks, I repeat many stocks go down and never return.

Using outliers as confirmatory evidence: Just don't. The only person you are hurting is yourself.

Sell when the thesis changes: Often used as a scapegoat to sell underperforming stocks. 

Portfolio Update Summary

The Unicorn Portfolio has definitely achieved some Alpha since we started nearly a year ago. There are two black sheep at the moment, Digital Turbine (APPS) and PubMatic (PUBM). Unfortunately, these two stocks are in the wrong industry. Advertising is one of the worst performing industries during recessionary periods since marketing budgets are usually the first to get cut. In a previous article, we warned about the synergy problems that Digital Turbine is facing due to the three acquisitions they completed in 2021. And for now, it seems like these issues are going to take longer to resolve than what was previously hoped for. We must admit that this has been a rather disappointing hold and our investing thesis is definitely being tested. Yet, we believe the share price has enough margin for error to warrant a wait and see approach. We are sitting on about 12% demo cash in this portfolio and we will deploy it in the coming months when opportunities present themselves. 

Disclosure

This is not financial advice and is only based on the author's opinion. This is not buy or sell recommendations of any stock.  The $10K is not real money and only a demonstration of a typical portfolio. The Unicorn Portfolio is a high-risk portfolio and should always remain a small allocation of your overall assets. This is an actively managed portfolio where we will buy and sell positions as we deem fit without any regard for taxation. Remember, all selling of stocks triggers a tax event in most countries and it is the investor's personal responsibility to always remain tax compliant.