knowledge bank

Dec 21 2016
Lawrence Lam

Beware of the one-trick pony

Investors' mentality

Trending companies often have high short term growth potential but limited long term prospects. Distinguishing these businesses from those with increasing long term “staying” power is how we produce long term returns.

To produce long term returns, start by avoiding big investment mistakes

The key objective for an investor is to make money through investment decisions that result in gains over the long term. To achieve this, an investor must first not lose money, but then also ensure that the good decisions outweigh the inevitable mistakes. We have found that good returns come to us when we first focus on avoiding big mistakes, rather than focusing on making big gains. Our defensive approach and focus on risk minimisation, we believe, shifts the investment odds in our favour. It means that we will not participate in fads and trends, and it means that we may pass the opportunity to invest in the “once-in-a-lifetime” companies, but it also guarantees that we have a greater chance of producing higher than average returns over the long run.

As we have observed recently with Bellamy’s (ASX: BAL), and overseas stocks such as Crocs Inc. (Nasdaq: CROX), companies can initially appear to grow at a rapid rate but soon peter out as they are unable to consistently perform over the long term whether it be due to change in consumer sentiment towards their products, regulatory change or erosion due to competition. These “flash-in-the-pan” companies are bad investments can lead to significant loss of capital.

Distinguishing between the sprinters and the stayers

Avoiding one-trick ponies can be hard if the investment focus is on maximising returns. In the chase for superior returns, it is tempting to buy into the hype and to invest ahead of the pack to catch the wave before the rest of the market. These pundits often use projections and assumptions around growth potential to justify the decision to buy into the stock. It is possible that these investments turn out to be the next Google (Nasdaq: GOOG), however we would argue that this is a risky approach. The probability that these investments turn out to be next Google is low and we prefer to avoid these investments all together. Even if the initial investment thesis for that company is proven correct, the possibility of sustained long term growth, we have observed, is rare.

Instead, we maintain a defensive approach to stock investing – we err on capital preservation rather than profit maximisation. We prefer to seek out businesses with proven long-term track records of success and we do not trust our own assumptions enough to rely on them. We have found that this approach minimises our chance of making big mistakes and losing significant amounts of money. It also has the pleasant effect of producing solid returns over the long run.