Imagine you are an airplane inspector for the FAA. You job is to certify the flight-worthiness of a plane. You check the planes annually and certify that they are flight-worthy until the next inspection. This particular day you happen to be flying in the plane you are inspecting and therefore take extra precautions to do a good job. This plane will travel from Los Angeles to Chicago, where you will get off, and subsequently fly to New York City. Your inspection is complete and the plane passes with flying colors…ready for take-off. You have a nice flight to Chicago, catch the latest Liam Neeson action flick, Taken 12, and then head off to your activities in Chicago. The plane continues its journey to New York. En route to New York, everything that could go wrong with the plane does. Please use your own airplane malfunction creativity to describe a complete failure of the airplane. 90% of the items you inspected and cleared for operation turned out to fail.
Did you fail? At first blush, it seems obvious that you failed your job, right? BUT, you made it to your destination in Chicago?
Being an investor isn’t much different. The difference between an investor and a trader is the former is focused on studying the long-term future of the underlying business, not the short-term price movements of the stock. But, isn’t your job as an investor to make money? Yes, making money is the job, but in the short-term, luck may be the reason you made money and that’s not a very good investment strategy.
Imagine the following line from an investor letter: “Last year, I was completely wrong about all my business analysis, but in the short run, the stock prices of these businesses went dramatically higher and we were able to sell at higher prices, therefore our investments results were very good. We hope to repeat this process again for the next 20 consecutive years.”
Let’s take a specific case over the past few years. About 4 years ago, a certain company was trading on the OTC markets. Lots of Buffett devotees and “value investors” got behind the idea that this small company was going to be a great investment. The basic thesis was as follows: the company has cash to do deals, a lot of NOLs and a management team with lots of skin in the game and great track record, oh and don’t forget the eventual up-listing to Nasdaq. When this thesis really started to take hold, the stock was around $1.50. As the company began to execute on some acquisitions (using its cash and additional debt), the stock rapidly increased to $5 and change. Some of these investors sold their shares, noting the great investment in their annual letters. Fast forward to today, and the deals that propelled the stock to over $5 have failed to create any meaningful profits and the stock is back around $1.50 and looking at the balance sheet, the company has a high likelihood of bankruptcy in the next few years. About the only part of the thesis that did work out was the up-listing to Nasdaq.
Was this a success? Did these investors get off in Chicago and declare victory while watching the plane go down in flames on the way to New York?
If you sold this investment at $5, your short-term results will look great, but you should really judge yourself on the long-term prospects of the businesses you invest in, whether or not you still own the stock. Allan Mecham once had a slide in his investor presentation that detailed the stock returns of his investments after he sold the stock. I think this was one of the most telling pieces of strategy I have ever seen from an investor. If you are a “trader”, then the business prospects of your investments are of little consequence after you sell the stock (and sometimes the business results don’t even matter to the stock price while you own the stock). However, if you hold yourself out as an investor who thinks about the underlying businesses of your investments, then you should pay careful attention to how the businesses perform even after you sell the stock.
The reality of investment returns is investment managers should spend much more time detailing the business results of their investments instead of the stock returns. The business returns not only drive stock returns over the long term, but convey the quality of investment analysis to current and potential investors.
**I should note that two of my early investments that had great investment returns were horrible investment decisions on my part (one went bankrupt 3 years after I sold the stock and the other is about 50% lower than my original purchase price, after doubling shortly after I bought the stock).
Matt Brice is the portfolio manager at The Sova Group and can be reached at email@example.com.