The market has been really volatile of late and has forced investors to make unnecessary investment mistakes.
Which is why now is so important to refocus on the right investment process.
There’s a lot of noise and contradictory information out there. Here, I simplify my investment strategy to help you think through what makes sense.
- I discuss the buying strategy.
- The valuation process that you need. Boiled down as simple as possible.
- What to do when the investment hasn’t worked out.
- Two practical examples. One that’s working. One that didn’t.
- The limitations to this strategy.
The Buying Strategy
1) Find an amazing investment. Put down 2% of my capital.
2) Then I must wait 60 days before I put another 2%.
A lot can happen in this first period of buying. You will learn a lot about your business in the first 60 days. The universe has a way of bringing knowledge to you when you are seeking it. Please note: The only reason to break this 60-day buying period rule would be if the company reports earnings and the valuation remains similarly attractive.
3) In any event, after buying that second chunk of stock, you have to wait another 60 days to buy chunk No. 3 and add a further 2% to 3%.
This would bring your invested capital to about 6%-7%.
4) And now you have the final permissible capital to be invested. This should only come after you’ve gone over the last two quarterly earnings results. Bring your maximum to 8% to 9%.
1) What happens to the purchase sequence if the stock runs away and gets too expensive after the initial purchase?
Answer: In that event, you got lucky. This is a rare event. And it’s not repeatable. I’ll discuss this topic more in the Limitation section of this article.
2) What happens if the stock falls after the repeated purchase?
Answer: This mechanical buying was set up with this in mind, to give you room to average into your stock purchases.
3) What happens if you don’t want to make the position 8% to 9%?
Answer: Reduce the initial purchase to 1% to 1.5%. Then, remove invested capital at point 2.
Then, use bullet point 3 to buy another 1.5% to 2%. This will bring your portfolio to about 2% to 3% – that’s a reasonable position already.
4) What happens if you found a truly amazing pick?
Answer: Don’t fall in love with your ideas. There’s always another amazing idea. Be brutal with yourself and don’t be greedy. New ideas surface all the time. Stick to 8% to 9% maximum purchase.
The Valuation Framework
Using the following equation. Don’t pay more than 2x the FCF per share for revenue growth.
For example, a business growing at 5% per year, don’t pay more than 10x free cash flow.
For a business growing at 10%, don’t pay more than 20x free cash flow.
That being said, I’m not convinced that using this formula works linearly all the way up.
For example, for a business that’s growing at 50% CAGR, it wouldn’t make a lot of sense to pay 100x free cash flow, because nearly no business grows at 30% CAGR for more than 10 years.
Michael Mauboussin puts the base case of companies growing at 25% to 30% for 10 years at 2%, see page 22.
Of course, business growing fast can be very valuable and can’t be discarded. But thinking through this framework will put you in the right ballpark. It’s not perfect, but it’s OK. I’ll discuss this further in the Limitation section.
How To Deal With A Losing Position
You will have losses in your portfolio. The sooner you recognize your loss, the better. But you don’t want to be too trigger-happy either.
The strategy that I believe works well is to remove 30% of your capital if the stock is down 50% after six months. But again, let time do its thing. Time is your friend.
If the stock turns around and rallies higher, you still have the bulk of your capital invested.
But if the stock continues to fall, at least you got 30% of your capital out at a higher price.
In summary, if you don’t want to buy more of a stock after it’s down 50%, then remove 30% of your capital from the position.
Two Practical Examples: One Good And One Bad
I’m now going to highlight two examples where these strategies could be put to work. Please note that these are hypothetical investments. I’m not invested in either of these names.
As you can see with Roku (ROKU), I had a hold rating on the stock back in 2021.
But when the share prices had come down enough, I reverted to a buy rating. I didn’t get the bottom on the stock, but by keeping with the rule of only deploying my maximum capital allocation strategy over a 6-month period, I believe that by summer 2022 it will coincide with the stock finding a nice base to build from.
In essence, allowing time to be ”my investment partner” and work with me, rather than against me.
Essentially, it’s time in the market, rather than trying to time the market that works.
The coverage above is of Twilio (TWLO). It’s messier than Roku’s.
But I believe that since it’s messier, it shows better the practical realities of investing. But at the same time, it shines a light on the power behind my investment strategy.
Last summer, in 2021, I had a buy rating on the stock. But I left myself space, not getting too bullish. I would have put 2% of my capital to work in Twilio. And starting in November, I reverted to a ”hold” rating.
I kept this hold rating until February 2022. In February, I started again with a buy rating. I would have put a further 1.5% to 2% of my capital to work on Twilio.
Note, I would not have removed any capital from my position after six months because I was buying more (see explanation above, in How to Deal With a Losing Position).
Then, in May 2022, I would have sold my position. This would have seen my invested capital fall from 3.5%-4% of my invested capital to around 1%-1.5%.
Clearly, this is clearly a negative return. But allowing time to work for me prevented me from buying 9% of my position last summer, only to see my allocation now fall to 2.25% of my portfolio.
To repeat, even in this hypothetical investment in Twilio, which did not work out positively, I would have saved capital. The capital that I would have rescued from Twilio would be 1%-1.5% of my portfolio.
Rather than watching it go from 9% to 2.25%, without my investment strategy.
Every time you minimize your losses, you are going to be a massive winner over time.
Limitations To This Strategy
The biggest drawback to this strategy happens in periods such as the trough of the COVID period, when the market was only down for about 60 days, before rallying strongly ahead.
Indeed, any time that the market is rallying very strongly, strategies that are based on dollar-cost averaging, such as this one, will not be optimal.
The other drawback to this strategy is that it can be very difficult to sit on your hands during volatile periods when your ”favorite” stock is rallying ahead. And you ”know” that it’s undervalued, and you are only buying small positions. You will have a lot of FOMO during these periods.
The way that I believe this can best work is if one uses a calendar to buy into positions. That said, this can be a substantial amount of work. One workaround to this would be to minimize the capital allocation even further, and on the first of every month, to buy into your desired investments.
The Bottom Line
I probably read more about investing during a bear market than perhaps 50% of professional investors. I’m utterly fanatic about investing and spent so much time thinking about my investment process.
However, even in this case, I had a horrible 2021. So having been through that period, I believe that I’m now a much better investor.
While I recognize that no investment strategy works all the time. I now believe that the experience I picked up in the past year is invaluable.
Previously, I relied on my theoretical experience to navigate the market. But now I’m experienced enough to know that what works in theory doesn’t work in practice.
Here’s what I now know – an ounce of experience is worth a ton of practice. And this mechanical investment strategy to deploy capital provides for a safe capital allocation strategy. Happy to discuss this further in the comments section.