Friday, August 15, 2014

Book Review #11: Invest & Grow Rich: Author: Guy Thomas

Key concepts: Change of State, Defensive Pessimism, Double Seven Shares, DVD Investing, Spider Chart, Strategic Lethargy, Tail Gating, Two types of luck, Positively Scored and Negatively Scored Activities, Core Thesis-Secondary Factors-Hygiene Factors, Kitchen-Sinking, Mispricing of insolvency risk, Illiquidity Discount

'Invest and Grow Rich' tells the story of 12 Investors who became Sterling Pound Millionaires by investing in stock market mostly in UK. Based on their approach to investing, these investors are grouped into four groups, Geographers, Surveyors, Activists and Eclectics. 

Geographers follow a top down approach. They first scan the macro economic environment to identify the potential growth industries. Once they identify the industries with potential growth, they try to find companies in the industry with potential to provide significant returns. Surveyors, on the other hand, follow a bottom up approach. They focus on companies and identify companies with significant growth potential. Activists try to build significant stakes in companies and then use their business skills to influence or force companies to unlock value to the investors. Eclectics are those investors who follow styles that cannot be classified as any of the above.

When it comes to investments, the question often asked about the role of luck. The author talks about two types of luck. One type of luck is the luck of a lottery winner. This is not the type of luck that favors an investor to become rich. That (the luck that favors investors) is reflected in the statement 'Fortune favors the brave'. The second type of luck is attracted to those who are prepared for it.

To review this book, you have to start with the Conclusion. This chapter compares the path to Financial Success of these Investors by identifying similarities and highlighting differences under the following three groups:
  • Life Choices and Chances
  • Attitudes
  • Working Methods.
When it comes to Life Choices, the focus of all the investors is on Future. They look back to the past only to reflect on the lessons that they learned. All the investors took to this perspective from young age. Almost all them took to investing before their marriage and before they had any dependents. The key characteristic of all of them is perseverance. Despite early failures with occasional minor successes, they learned lessons from their failures and persisted. For all of them investing was a full time occupation. 

All of them had enough wealth to assure them of lifetime freedom. Freedom without worrying about paying the bills was the motivator for most of them to get into investing. Once they achieved it, they continued investing since all of them enjoyed the investing process. It is pertinent to know that none of them used leverage and all of them liked working alone.  

When it comes to the working methods that they adopt, all of them adopt multiple strategies while investing. There is no single strategy that is applicable to any one of them. There are major strategies, for example Top Down Approach of the Geographers. All of them have concentrated portfolio of about ten stocks, all of them focus on small companies with good growth potential etc. While some of them are highly educated, there is very little of math they use while analyzing the companies and they all rely on their knowledge and do not depend on external advisers for their investment decisions.

The first investor in the series is Luke who started his career as a Transport Planner. At the
age of 28 he went on to do higher studies and post that transitioned as a Banker. He specialized in Oil Exploration and Production and is a top down investor. At the age of 47, he left his job to focus full time as an investor. While he spends a lot of time reading about the market, he invests very sparsely focusing on Quality rather than Quantity when it comes to investing. He talks of the concept of 'Strategic Lethergy', the habit of enjoying doing nothing. He feels that one needs just two great stocks to change one's life.

Next investor profiled in this book is Nigel, a Psychology Major who worked in the Banking Industry till the age of 47. He invests on the basis of two factors, Cyclicality and Market Psychology. He is a top down investor who believes that some investment markets moves in
cycles, with multiple shorter cycles nested within a large cycle. The cycles are irregular in that some cycles may last longer than others. Nigel tries to invest into the cycles as they start moving up and exits before the downswing begins. Another concepts he believes is in psychology of the markets. As per him, 'when many people believes that market can only go up, it means that market has hit its peak, and when many people believe that market can only go down, it means that market has hit bottom and is poised to rise'. He is also a big fan of 'Secondary Offerings' where company issues additional shares to existing investors at a discount (it is called 'Rights Issue' in India). His main approach is to sell half when a share has doubled.

The third investor profiled in this book is Bill, who is an Electronic Engineer who quit his job at the age of 41 to become a full time investor. Over a period of 9 years he had a compounded return of
30% per year on his portfolio. Based on his investing methodology, he is a surveyor, who follow bottom up stock picking strategy. He is a value investor who do not believe in paying excessively for growth. In analysing companies, he doesn't believe in the so called 'Soft' approach (Networking, Attending Company AGMs etc) and only listens to what the financial numbers tell him. He uses the concept of 'Value Spider', a spider chart showing different aspects of a company plotted on a single page. Bill believes in tracking a few simple matrices like P/E, EV/EBIDTA etc. He finds value in investing based on the ideas of a few people whom he trusts. He calls this 'Tail Coating' on the ideas of experts. He also follows 'Defensive Pessimism' as his investment philosophy. As per this, you should try to find all the reasons for not buying the shares of a company and buy it only when you can live with those reasons.

John Lee, the next investor in the series, follows the basic principle of investing that he calls 'DVD Investing'. DVD stands for 'Defensive Value and Dividends'. Defensive Value means that you
should not pay significantly higher than the value of assets. When it comes to Dividends, it is the trend in dividend rather than the actual percentage that matters. John looks for companies that increase dividends. Another aspect of DVD Investing is investing in 'Double Seven' shares, where the P/E is less than or equal to Seven and Dividend Yield is greater than or equal to Seven. Like Bill above, John also looks for simple matrices. Finally, John looks to buy companies where owners and directors have significant ownership.

Next investor profiled in this book is Sushil, a highly qualified Economist with a PhD in Econometrics. Sushil moved full time into investing at the age of 35 and has built an enviable
portfolio over the years. Sushil's investment philosophy is to 'Invest into a Change of State'. What this means is that whenever a company goes through a change of state (Increase in dividends, Restructuring, Mergers etc) the company offers potential for significant returns. Sushil's portfolio of about 60 stocks contain mostly UK Small Cap stocks. As per Sushil, the big difference between retail investors and professionals is as follows. Due to their large holdings, every time a professional takes an action, he wants the market move to be counter-intuitive to the same decision were to be taken by an average investor. For example, when he buys a stock, a professional wants the prices to go down (unlike a normal investor) since he plans to buy more and vice-versa when he plans to sell. Another key aspect of his approach is that Sushil always screens his ideas through the filter of 'Post Tax Returns'. In other words, he considers tax as an important component in investment decision making.

Among all the investors profiled in this book, Taylor, our next investor, is the only one without any structured financial education. He is a self taught investor having taught himself by reading a number of investment books. He maintains a very concentrated portfolio of about 6 to 10 stocks
often having 'Plunged' (taken significant position) in one or two stocks. Over a period from 2000 to 2010 his portfolio grew by 25% per year. Even though he keeps significant long positions in various stocks, he does not have any compunctions in selling the stocks at the earliest sign of trouble ('Change of State' as discussed by Sushil above).

The next investor, Vernon, adds so much value that I have to dedicate more than a paragraph for him. He holds a PhD in Science and stopped working at the age of 38. His style is 'Contrarian' who, as he calls it, 'Buys the Glitch'. In a period of 18 months between 1998 and 2000 his portfolio value increased by 15 times. Vernon is only one of the two (Other is Sushil) who made and kept money in the Technology Boom of the late 90's.

His investment approach is to consider the company in terms of three sets of factors, that he calls as Core Thesis, Secondary Factors and Hygiene Factors. Core thesis puts forth the main reason from buying the stock. Secondary factors are positive factors that support the decision. Hygiene Factors are negative factors that are potential deal breakers. Core thesis is similar to 'Two Minutes Drill' mentioned by Lynch in his book One Up on Wall Street.

The various glitches that prompt Vernon to research the stock include Profit Warning, Index Demotion, Mistaken Sector read across and bid failure. Once a glitch appears, Vernon waits patiently for the management to do what is known as 'Kitchen Sinking', where all the bad news associated with a company are released in one go. This will drag down the prices further at which point Vernon initiates purchase.

Vernon is acutely aware that time is a limited resource with strongly diminishing returns. The first hour you spend in researching a company is much more important than the tenth hour. Given his focus on effective utilization of time, he focuses only on a few sectors. The advantage is that this could lead to 'Economies of Scale in Knowledge Production'. Once you research one company in a sector, researching other companies becomes easy. The drawback is the 'Risk of getting stuck at Local Optima' which loosely translated means 'Missing wood for the trees'.

Vernon avoids new stock issues, also known as IPOs (Initial Public Offerings) here in India.

Vernon considers the decision of selling the stock as a decision to switch to alternative investment. Since timing of sales is difficult, he uses Heuristics like 'When it doubles, sell some' and 'When it is tipped, sell some'

Vernon considers investment as a game being played in the mind of the investor. Mental skills in Investing include the following:
  • Investor should cultivate the ability to be happy alone since investment is a solitary activity.
  • Investor's thinking should be in search of the truth rather than reinforcing prior affiliations. 
  • An investor should be able to keep conflicting ideas in mind in parallel, accepting uncertainty for long periods, and choosing between them (conflicting ideas) at the last possible moment. This is called working with 'Multiple Mental Models'.
  • In investing, 'Avoiding a mistake' is more important than 'Winning'. Investing is a 'Negatively Scored' activity. Activities can be divided into 'Positively Scored' and 'Negatively Scored'. In 'Positively Scored' activities like Selling, Leadership etc, attributes like 'Bravery', 'Having a go' and risk-taking gives a better chance of success and downside of making errors is low. In 'Negatively Scored' activities like driving a car, Giving Anaesthesia and Piloting a plane, the successful person is the meticulous one who avoids making big mistakes. Relevance of above to Investing? Ease of online investing makes people behave as if investing is a positively scored activity, but arithmetic of compounding dictates that it is negatively scored.
Next investor, Eric, falls into the category of Activist. If I have to pick one person who, in my opinion did not belong to this book, it must be Eric. It is true that he last worked in a job at the age of 28 and sold off his business at a handsome profit at the age of 39 and he has made more than a million by investing in UK stock market. However, to me as an investor, he does not add any conceptual value. He uses his concept of 'Strategic Naivety' by acting naive while hiding his shrewd business sense. To some people it could come off as trifle unethical.

There are two types of activists. Passive activists try to influence management action through their queries and power of persuasion. Eric, discussed above, falls into this category. Active activists like Owen and Peter (by the way, Peter and John Lee are the only two investors whose real names are used in this book) try to influence the management action by taking direct and significant stakes in the companies they invest in. A review of their methods is beyond the scope of this review.

The final section in the book discusses the Eclectics. First of the two eclectics profiled is Khalid
who is different from all the other investors discussed in this book. For one, Khalid is a day trader unlike all the others who are fundamental analysts. Khalid's typical holding period is minutes to hours (never more than a day) unlike others who buy and hold for the long term. Another difference is that Khalid uses leverage while others avoid it. That he has made more than 40% compounded over a period from 2004 to 2010, trading 30 shares on an average per day alone merits his being mentioned in this book.

Final investor profiled in this book is Vince. He is an eclectic because he does not restrict himself to a specific approach. He invests in equities and real estate. That he buys in to beaten down UK Small caps demonstrate his 'bottom up' approach. That he felt that German real estate will perform better that other European real estate displays his 'Top Down' approach. His typical holding period can be from a few hours to years. Once he finds a good idea, Vince buys significant holdings in that company. He holds 3% to 29% stake in many UK listed companies. According to Vince, small companies offer two benefits vis. mispricing of insolvency risk (institutions will sell at any price if the company appears to be in any sort of Solvency Trouble, and this provides opportunity to buy) and excessive discounts of illiquidity (an institution with a good holding will sell at any price if it wants to divest its holdings in the stock).

This completes the summary of the book. The 12 investors profiled are similar in many aspects including risk aversion, preference for small cap stocks, dislike for diversification etc. They are also different in aspects like the approach followed, reliance on Financial theory, knowledge and expertise in Finance etc.

There is no drama in this book, says the author in the introduction. This book provides a detailed look at the investment habits of 12 highly successful investors in UK and Europe. Reading this book can be a tedious exercise (much like reading this blog post, do I hear someone mutter?). Both the book and this blog post are content rich. Being content rich, they have to avoid all the drama and emotion and focus on raw data, which in this case is the successful investment habits and lessons.

The concept of 'Value Spider' propounded by Bill is a very useful tool for any amateur investor venturing into the market. In one diagram, it gives all the information necessary to make decisions. The beauty of this chart is that it is a 'progressive' chart. Every time you compare the chart of a company with a previous chart of the same company, you will get a clear view of the movement of all the parameters that are relevant to your investment decision. The guy who developed 'Spider Chart' should get a Nobel Prize or something, in my opinion.

Another concept that I found potentially useful is the Core/Secondary/Hygiene factors concept of Vernon. This is a very good approach for an investor to use since it provides a quick snapshot of why one should buy or avoid a stock. And it is evolving. By reviewing the factors regularly, one can easily validate ones assumptions and ensure that one is on the right track.

Third concept that I learned (again from Vernon. The  guy is concept rich. It is not for nothing that I devoted enough blog space for him) is the difference between 'Positively Scored Activities' and 'Negatively Scored Activities' and that investing is a 'Negatively Scored Activity' where avoiding mistakes is more important than winning substantially.

Every investor faces the choice of timing the sell. The investors in this book follow heuristics like 'Sell when the shares become popular', 'When it doubles sell half', 'When it is tipped, sell some' etc. It was eye opener to know that only two investors in the book (Sushil and Vernon) both made and kept money that they made in the Technology boom of early millennium.

Life lessons abound. Lesson one is about how investing is more about achieving freedom and less about making profits. Another lesson is about the importance of perseverance. All the investors profiled in this book has spent more than 7 years investing with minimal profits before they learned to make significant money through investing. Lesson three is about the the value the investors place on time in comparison to the value placed on money.

All in all a valuable book. The lessons learned in this book will stand you in good stead on your arduous journey to become a successful investor.

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