Dan Brocklebank, head of UK operations at our offshore partner, Orbis, reflects on five lessons from the past two decades that investors can draw on to improve their investment outcomes over the long term.
2022 was a challenging year for investors as recession fears, rising interest rates, inflation, geopolitical risks, and other factors, took their toll on markets. Amid such uncertainty, investors should focus on proven investment principles and not be carried away by fads that can lead to mania and bubbles.
This is particularly important at a time when, just recently, cryptocurrency exchange FTX filed for bankruptcy in the USA. It’s believed the collapse of the world’s second-largest crypto exchange left US$3 billion in losses and this has shaken confidence in the cryptocurrency market.
We believe there are five lessons that are vital to investment success:
1. Face up to your emotions
Human emotions and instincts can be contrary to sound investing. Our instincts often pull us in the opposite direction to what we need to do to succeed at investing. We need to internalise this and factor it into how we invest. Having a clearly articulated plan and approach can help moderate emotional responses.
2. Be cautious when new things come along
It is a challenge, especially for inexperienced investors, to recognise that new technologies and other ideas that get people excited are sometimes just hype.
It’s hard not to get caught up, but it’s important to have realistic expectations at different stages in the cycle. For example, over the last few years the hype around crypto lured investors in at peak moments. But there's a lot of potential to make big mistakes by being too unquestioning.
3. Beware of bubbles (fundamentals matter)
Over the last few years, a bubble emerged in profitless technology companies. This has clearly started to deflate in 2022 just like the dot-com bubble of the 1990s did in 2000. In each period, investors became extremely excited by companies that were growing very fast but not necessarily showing any profits.
To take a well-known example, Amazon has been enormously successful and has generated huge intrinsic value. What is unusual compared to economic history is that Amazon was clearly growing in value and yet when you analysed its financials, it was not very profitable at all. I suspect that in recent years, a dangerous misconception crept in for many that fundamentals don’t matter and perhaps even that all companies that are growing very fast are therefore very valuable.
As a result, in recent years investors, to a degree, gave all companies a pass on their reported financials when, at the end of the day, you have to be profitable; and you have to generate cash flows. Amazon is an incredible company, but it is also a highly unusual one.
4. Don’t rely on forecasts
We believe the over-reliance on forecasting is a mistake as it can be unreliable due to the complexity of economies and the huge number of variables. Plus, no one has a crystal ball.
When forecasting and then using that to inform investment decisions, you can cause real damage to your investment portfolio. The most common forecasting mistake is people trying to get out of the market because they think there’s a recession coming around the corner.
Even if you could do this, and countless studies have shown that humans cannot forecast recessions with any degree of useful precision, you would then have to decide when to get back into the market and that requires forecasting when the market is going to stop worrying about the recession; good luck with that!
While we can’t be certain exactly where we are in the cycle, identifying when things appear to be at an extreme of sentiment, growth, or interest rates, for example, can better help inform a view.
5. Understand that the biggest outperformance tends to come from unpopular areas
In the early 2000s, the US railroad companies were widely seen as uninvestable because they had been poorly managed and were highly capital intensive. As a result, their share prices were very lowly valued. Since 2003, however, an index of railroad stocks has outperformed the US market by about five times through to today.
This outperformance shows that successful investing is not just about buying great companies. Great companies can be terrible investments if you pay too much for them in the first place. Conversely, average-quality companies can be great investments if you buy them at depressed valuations, particularly if they go on to improve in some way as businesses.
In recent years, many saw the outperformance of the technology sector and concluded that the secret to investing lies in only ever buying high-growth, capital-light businesses. There are very few rules that always work in investing. This was not one of them. One that does work far more reliably, and particularly over the long run, is that ‘you cannot buy what is popular and hope to do well’.