Why investing always requires a leap of faith
We should be honest about what we know, and what we don't know
I'm working on a new stock analysis in the area of cybersecurity. This crucial and growing area has become an essential service within the tech world. I was hoping to send the analysis last week, before the long Easter weekend, but there's still some important due diligence to do. I'll send it in the next couple of days.
Specifically, I don't write about any stock (let alone invest in them) without going through the company's latest full annual report, which tends to run to many hundreds of pages.
It's amazing what you can find buried in the footnotes. It's equally amazing how few investors, including supposed professionals, actually bother to spend sufficient time on this essential activity.
Anyway, as I was drafting my analysis, most of what follows just flowed from my fingers into the keyboard. It would make the report too long if I leave it in. But I still think it's worth sending to you. So here goes.
Why investing always requires a leap of faith
I don't pretend to understand all the nitty gritty of the tech involved in cybersecurity. There are loads of acronyms and jargon, and the tech sands are always shifting. But that doesn't necessarily rule out investing in such companies.
To justify that statement, allow me to take a brief detour into my own background and investing.
The industry sector that I probably understand best is banking, especially investment banking, wealth management and asset management. That's having spent fifteen years working in it at UBS Group, a global market leader in those fields.
Most of the time was in corporate strategy roles that involved working closely with board level management (CEO, CFO, and divisional and regional CEOs, etc.). That was across all of the bank's businesses, and all around the world.
At one point I was head of strategy for the vast Asia Pacific region, based in Hong Kong. That took in projects involving mainland China, Japan, India, Indonesia, Vietnam, South Korea and more. Incidentally, those were all very different places, that were at very different stages in their economic and financial development. They still are.
(Nowadays I believe stock investors should avoid Greater China, which includes the mainland, Hong Kong and Taiwan. This is because of the political risk. Sooner or later I'd expect mainland China to make a move on Taiwan, and sanctions to be imposed by the US and others. Any foreigner investing in those places would probably find their assets frozen, and effectively face a 100% loss. Note that most emerging market investment funds will have a large weighting to China and Taiwan. Something to check if you own any such funds.)
A large part of the strategy job was assessing investment proposals. That was whether to build businesses from scratch, acquire other companies, or form joint ventures. Sometimes it also involved guiding decisions on whether to close things down, or try to turn them around. (I think I saved a few from the chopping block, with some cool-headed and rational analysis.)
In the bank's small strategy team, we had our own in-house valuation techniques. They were applied consistently across all competing investment proposals from around the world. The idea was to ensure that finite bank capital was deployed into the best opportunities, and never into proposals that would destroy value.
This required understanding all the various elements that drove revenues, costs and capital needs of different businesses. Also, it was often on a pretty long-term view. The best investment opportunities, in terms of value creation, weren’t necessarily expected to make profits overnight.
For example, we reckoned that the ground-up build of a new wealth management business, in a new country, would typically take about seven years to reach profit breakeven. That's despite wealth management being UBS's main business, meaning the bank had vast resources, investment products and expertise to deploy.
Many competitors would try to build wealth management businesses from time to time. That's because such businesses are highly profitable once established, and require relatively little ongoing capital.
However, almost all of the competitors gave up after making losses for several years. This was a great example of the protective moat around UBS's wealth management division. It was very hard to breach.
Trust me, there are very, very few people in the finance industry who get to enjoy a role that was as broad and interesting as the one I had. Most finance roles are fairly narrow and repetitive, even dull, and most finance people that I know are the first to admit it. (But it doesn't take Einstein to figure out why they stick around, often for three or four decades doing more or less the same thing.)
You may wonder why I left such an interesting job in strategy. Well, apart from the long hours and corporate travel, which aren't really compatible with family life, eventually I got bored of all the big company bureaucracy, office politics and other corporate mierda del toro.
That said, I'm still very grateful for all that I learnt and experienced over time. But I decided to choose personal freedom above corporate status, and ended up moving from London to Buenos Aires fifteen years ago.
(Argentine voters have recently decided to try out freedom as well, this time from oppressive government. Better late than never. See my recent, on-the-ground summary here. There will be updates on this exciting political and economic development over time.)
Getting back to the investment industry, what most people don't realise is that it's also a technology business, and most of that technology is hidden from customer view. It all grinds to a halt if crucial technology systems are offline or sub-par. Personally, I don't have a clue about the nitty gritty of how that software is programmed, integrated and maintained.
None of that puts me off investing in financial companies. In fact, my own personal stock portfolio has about 40% of its value allocated to seven, very different companies in the financial sector. Five of them are what I refer to as "fringe financials", meaning they're not mainstream banks, insurance companies, stock brokers, wealth managers or fund managers.
(Very few banks have really good business models, although I do invest in some of them from time to time, when they are very cheap. But it's a specialist area where P/E ratios and the like can be deeply misleading for the uninitiated. It's an area that I'll cover in a later chapter of the investment book that I'm writing. Meanwhile, complex life insurance & pensions companies tend to be "black boxes", in that the true business risks are impossible to understand for outsiders, despite very detailed financial disclosures. The more you dig, the more unanswered questions you come up with. This is not a good basis for investing precious capital into a company.)
Aside from financial companies, there are plenty of other sectors that I invest in. Most of the time I don't understand the nitty gritty of their processes, or how they produce their products and services.
This is true for pretty much all investors, unless they operate only in one tiny niche where they have deep understanding. Even then it's doubtful that they really know about all aspects of what's going on. Deeply specialised people are unlikely to comprehend the full complexity of a modern multinational corporation.
That's why big companies are run by multi-disciplinary executive boards. That way, it's hoped that there's enough variety of experience around the table to have a reasonable combined understanding of what's important for the business. Even then, it's far from guaranteed that the board really knows what's happening beneath their feet, especially in more complex sectors.
This is a reality faced by investors. We can't know everything about how an industry or company works. It's doubtful even if the senior management is fully appraised of all the details. So should we still invest?
Personally, I've owned shares of oil & gas companies without fully understanding the extraction processes. I've owned manufacturers, without being a production engineer that understands how they optimise their production lines. I've owned retailers, without fully understanding the magic psychology of how they lay out their shops to enhance sales, or maximise the results from price promotions. And so on...
This imperfect knowledge is just a fact of investing life. It's not a reason to avoid investing.
If I can see that a company has strong brands, and is great at generating profits and free cash flow, and is in strong financial shape (such as no or low net debt), and the price is right, and management appears competent, then there's a good chance that it's a decent investment choice.
In short, to some extent, there's always a leap of faith involved with investing in any stock. Even great investments, that work out well in the end, can severely test our faith along the way, as stock prices drop, often for no good reason.
Successful investors do what they can to ensure that each individual leap is a sensible one, by weighing up a variety of factors. Generally speaking, it's a good discipline to be self-critical, and admit what we know and what we don't know. There is always a hell of a lot that we can't know, including the vagaries of future events.
Which is why we diversify just enough to ensure that any accidental leap into a chasm doesn't result in our financial damnation.
If you invest only, say, 5% of your portfolio into a single company's stock, then you can only lose 5% if it goes bankrupt. If you avoid companies with big debts, or that are serial loss makers, then the risk is highly likely to be far less than that.
Please send comments or questions to the email shown below.
Note that next week I'll provide a further update on a handful of companies in the ex-UKIW portfolio, some of which reported financial results recently.
Until next time,
Rob Marstrand
email: ofwealth@substack.com
The editorial content of OfWealth is for general information only and does not constitute investment advice. It is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Appropriate independent advice should be obtained before making any such decision.