The Art of Execution – What to do when you’re winning
If you read the first part of this review, you won’t be expecting me to lavish much praise on this book in the conclusion.
But it turns out that The Art Of Execution surprised me in the most pleasant way.
Part II of the book is entitled “I’m Winning – What Should I Do?” and I found myself in thorough agreement with the author as he explained to his readers the virtue of running winners.
Whereas Part I categorised investors according to what they do when they are losing, Part II categorises them according to what they do when their positions are in the black.
Raiders of Lost Profits
Firstly, there are Raiders who take their profits quickly, as if worried that their gains might be snatched away from them. These investors had a tendency to sabotage their performance by giving up good investments too soon.
Lee Freeman-Shor does a great job explaining why closing a winning position is (usually) a bad idea. The key point that I was waiting for him to make is made early on. He explains the importance of participating in big winning stocks, and how selling out of them after a small gain will make it impossible to have a really good portfolio performance. This echoes points made by Lord Lee.
“In the long term, investing in stocks is one of the best ways to make money – but while this is true as a whole, if you are buying individual shares it very much depends on the stocks you buy… a few big winners and losers distort the overall market return…”
There was one statistic that I thought was particularly damning to the investment industry, among Freeman-Shor’s numbers. Of the nearly 2,000 real-life investments by professional investors in his database, only 1% of them produced a return of 100% or more.
In other words, his fund managers were chopping and changing so much that they only managed to double their money one out of every hundred times that they deployed capital! Indeed, most of the profits realised by these managers was realised within six months of entering a position.
While that could be a reasonable statistic for some mandates, it shows how rare the buy-and-hold mentality was among his managers. (Their stock-picking would have to be truly dreadful if it was to blame for these numbers!)
Other reasons not to sell a winning investment that I found myself strongly agreeing with:
- Can’t trust your next investment: selling means that you have to deploy cash somewhere else. How sure can you really be that your next investment is superior?
- Winners keep winning: technical momentum exists and can be backed up by good fundamental reasons (e.g. a business has a strong but underappreciated competitive advantage, so it will continue to surprise to the upside).
And some specific reaons why professional investors tend to sell too soon, which ring very true to me:
- Thinking that a stock price won’t go anywhere for the next six months (boredom combined with overconfidence in their ability to predict short-term share price movements).
- Having price targets only 20%-30% higher than their entry level, rather than seeking big multi-year returns.
- Knowing too much about their portfolio share prices on a daily or even hourly basis, meaning that they experience the volatility of their holdings as if it is worse than it really is. They’d be better off if they were only told the share prices once a month!
After dissecting Raiders, Freeman-Shor moves on to the last and most successful category among his investors: Connoisseurs.
These are the folks who love their investments, who nurture them for years, and sell them only after much soul-searching.
What’s special about Connoisseurs is “when they win, they win big”. They enjoy the (almost) complete benefit of their winning investments, because the only selling they do is marginal topslicing on the way up.
How to be a Connoisseur
The formula to be a connoisseur is simple enough:
- Plan to hold for 10 or more years (mainstream managers would say that anything longer than 5 years is long-term).
- Find “unsurprising” companies. These are described as “low negative surprise” companies. I would simply call them quality companies.
This is how Freeman-Shor describes the “unsurprising” companies:
“Even if in the future they had terrible management at the helm, that management would have to be extraordinarily incompetent to destroy the profit-making ability of the companies. The companies were effectively money-printing machines.”
What does this imply we should look for in an “unsurprising” company? In my view:
- Simple business model
- Persistently profitable, high return on capital
- Profits derive from asset(s) whose value can’t easily be destroyed by management, i.e. brands, copyrights, market share, proprietary technology.
But it wasn’t enough to be a “low negative surprise” company. Connoisseurs also wanted big upside potential. In my own words, I would call this open-ended growth prospects.
Connoisseurs don’t bother with price targets because they are open to the possibility that any of their investments could be a big winner, and they want companies which stand a chance of being big winners thanks to this potential for open-ended growth.
Thanks to their big winners and high conviction, Connoisseurs can sometimes be very concentrated (up to 50% of their portfolio in just two two stocks).
Finally, Connoisseurs tend to be extremely boring. They stay invested in the same old stocks year after year and generally don’t do very much, apart from reading about their existing positions and doing a little bit of reading into the occasional new idea.
This goes back to a point I’ve made before: that investors often confuse activity with productivity.
In most fields of human endeavour, it’s important to always be doing something. After all, if you’re not doing something, then your competitors might work harder than you, and end up stealing your business from you.
Investing doesn’t work like this. So long as your capital is deployed, it is working for you. And if you’ve put it into a good business, then it’s probably working very hard indeed. You can’t make it work harder simply by increasing your trading activity.
Connoisseurs understand this. They allow their capital to work hard. Meanwhile, they spend most of their time on the very boring tasks of reading and researching, so that they understand what’s going on.
I still have some quibbles with the book. For example, the author is firmly opposed to investing in illiquid stocks, for the obvious reason that they are difficult to exit from. But he does not acknowledge the existence of the illiquidity premium. And the presentation of examples from his investment database, as I said in Part 1, did not seem to achieve much (investment returns weren’t annualised, were based on capital gain instead of total return, were presented without a benchmark or target return, and included little or no explanation of the relevent fund manager’s reasoning).
All of that having been said, Part II redeemed my impression of the book, following my disappointment in Part I. It goes to show that you shouldn’t judge a book before you get to the end! Part II provides important fundamental lessons about how to win in investing. While they might not come as a shock to those who already consider themselves Connoisseurs, they should provide helpful food for thought for the majority of investors. I am happy to recommend the book.