The Art Of Execution - The Hunters: Hunting For The Compounding Effect by Lee Freeman-Shor
Apart from discovering that E=MC2, Einstein was also famous for saying:
?Compound interest is the most powerful force in the universe.?
John Larry Kelly Jr, a famed mathematician, showed that the way to create wealth was to invest in a manner that attempted to maximise the geometric mean of returns. By doing this you would exploit the power of compounding and become rich in the shortest possible time.
I do not intend to go into the detail of the Kelly Criterion as it is now famously called, but suffice to say this formula shows that you should invest big when the odds are great and you have an edge.
Warren Buffett is the most famous exponent of this approach. He invested 42% of Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) in American Express Company (NYSE:AXP) in 1974 because he thought the odds were outrageously in his favour and he had an edge in his assessment of how that business would perform in the decades ahead.
One of the reasons that being a Hunter works so well is that it provides you with such opportunities.
If a stock you are invested in has fallen materially in price, but nothing else has changed ? the investment thesis is still in tact ? your odds will have improved significantly and you should materially increase your stake in that company.
One of the Hunters invested 20% of the assets he managed on my behalf in Barclays PLC (NYSE:BCS) (LON:BARC) shares when they traded at just 55p in 2009, having been battered during the global financial crisis in 2008. The shares rebounded and he made a lot of money.
The key point here is that although the Hunter invested big in Barclays at the outset, he was prepared to invest a lot more money should it continue to fall, because the odds would have gone from great to extraordinary.
If you believe the way to control risk is to have a diversified portfolio, then obviously you have no choice but to invest small stakes in each company.
If you are a Hunter, though, you choose not to control risk by diversification but by thoroughly understanding the risk and returns of a particular stock or handful of stocks. Your goal is to find companies that have an unbelievably attractive, asymmetric payoff profile.
The fact that you are only investing in a few companies means that you have the opportunity to invest big on day one, and then follow up with large top-up investments should the share price fall. As Warren Buffett said in his annual letter to the shareholders of Berkshire Hathaway in 1993:
?If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favourite rather than simply adding that money to his top choices ? the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: Too much of a good thing can be wonderful.?
The Hunters often put 20% of their assets in a single stock, and had to be comfortable investing another 20% in that same stock when it was heading south.
Most of us would suffer sleepless nights knowing that we had invested 40% of our money in a single stock. One way of dealing with this is obvious. Choose to only review the position every five years or set up an alert on your trading account to inform you if the price drops by a certain threshold. It never ceases to amaze me how being ignorant of share price swings helps a person stay invested in a large position.
I would also advocate setting up standing orders in the market when you buy your first stake in a company. It is very easy to freeze with fear when shares drop ? even if it?s to a price that we said at the outset we would be happy to buy more shares at.
Mohnish Prabai talks about having a crystal-clear exit plan before you ever think about buying a stock.29 I agree ? but also advocate having a clear plan for topping up losers as well.