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Mistakes that can ruin your quality stock portfolio

& how to avoid them

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Cunningham believes the goal of every investor should be to be both smart and wise to avoid big mistakes.

Synopsis
Cunningham says one should look for some key qualities in a business that can stand the test of time and
help it fend off competition.
By Anupam Nagar, ETMarkets.com
3
Mar 20, 2021, 02:26 PM IST

Renowned nancial author Lawrence A Cunningham says it is essential for

investors to have a quality-focused long-term investment strategy if they want

to achieve success in the investment world.

In the same breath, he says it is very challenging to follow such a strategy, as it

involves resisting the temptations to respond to short-term attractive

opportunities and standing by decisions that may not be looking very right at a

particular point of time.

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Cunningham believes such challenges can lead investors to fall in the trap of

making unacceptable mistakes, leading to permanent loss of capital.

Lawrence Cunningham is a famous nancial author with more than a dozen

books on Berkshire, arren Bu ett, value investing and nance under his belt,

and many of them have been labeled as top investment books of all time.

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One of his books, Quality Investing: Owning the Best Companies for the Long

Term outlines the investment philosophy of London-based hedge fund, AKO

Capital, and the lessons its portfolio managers, Torkell T Eide and Patrick

Hargreaves have learnt over the years.

The rm generated returns more than double the market (9.4% per annum

versus Europe's 3.9%) since inception more than a decade ago.

The book contains tips and strategies for investors to build an investment

checklist that can dramatically increase the chances of outperforming the

market on a long-term basis.

hat is quality investing

Cunningham says one should look for some key qualities in a business that can

stand the test of time and help it fend o competition.

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According to him, Warren Bu ett was the master of using this approach and

became one of the richest men in the world by following this strategy on a long

term basis.

He says three things indicate the quality of a business: strong and predictable

cash generation, sustainably high returns on capital and attractive growth

opportunities.

“Each of these nancial traits is attractive in its own right, but combined they

are particularly powerful, enabling a virtuous circle of cash generation, which

can be reinvested at high rates of return, begetting more cash, which can then be

reinvested,” Cunningham wrote in the book Quality Investing: Owning the Best

Companies for the Long Term.

He says investors make two common mistake in investing:

1. Those made when buying and

2. Those made when deciding to continue to hold, instead of selling, a stock

Mistakes made while buying stocks

Cunningham believes the goal of every investor should be to be both smart and

wise to avoid big mistakes. “The best thing to do after making or observing a

mistake is to acknowledge it and absorb the relevant lessons to avoid repeating

it. In the case of quality investing, to paraphrase Mark Twain, while scenarios do

not repeat exactly, they do rhyme,” he says.

Several mistakes can a ect the initial purchase decision of an investor.

Cunningham lists out the common ones into a few categories that, if kept in

mind, can signi cantly reduce the probability of repeating them in the future.

Consider quality investing as a 'top-down' approach

Cunningham says investors should consider quality investing as a ‘bottom-up’

exercise and should focus primarily on a company and its industry, taking all the

microeconomic factors into account.

He feels although many investors do follow this approach, there are some who

engage in ‘top-down’ analytics by looking at the broader environment, which

includes considering the state of international trade, the rate of in ation or the

relative strengths of currencies. Cunningham says investors can make mistakes

if they give more importance to and follow a top-down approach over bottom-up

analysis.

This is often the case when large macroeconomic factors start a ecting stock

prices, leading to investors questioning their exposure to factors such as trade,

in ation or currency values.

“Although these macroeconomic trends warrant close attention, as they bear on

given companies and industries. However, when top-down factors trump

bottom-up analysis, it often leads to choosing companies and industries for the

wrong reasons," he says.

Another risk of using a top-down investment approach is weak conviction, as

investors who want to hold an investments for the long term require conviction

upon buying stocks to withstand volatility.

Cunningham believes when an investment idea is dependent on

macroeconomic factors, it is far more di icult to have a conviction about a

company or even an industry.

"When adversity or surprise strikes — for example when commodity prices fall

or currencies reverse — it can be harder to stand by the thesis. The result is often

not only a mistake on buying, but a mistake on selling prematurely — even the

dreaded syndrome of buying high and selling low,” he says.

Being over-optimistic

Cunningham says over-optimism is a common source of making errors in

investing, and it can a ect portfolios of quality investors.

He says investors often fall in the trap of believing companies, which assure

investors that good times are around the corner. One needs to be cautious of

such companies as they frequently lead to making mistakes.

“Most next-Monday industries and companies continue to disappoint, because

their in rmities are due to external factors that no management can

permanently overcome. Even for investors able to pinpoint the time when a

structurally challenged industry is due for its moment in the sun, they still must

time the sunset. That means, timing both the decision to buy and the decision to

sell, which makes it twice as likely to make a mistake," he says.

Staying overcon dent

Cunningham says overcon dence is the root cause of many mistakes, as

investors often overestimate their knowledge and abilities.

"Straying beyond the boundaries of one’s knowledge and experience increases

the risk of making an error. For instance, any investment in a stock that depends

on the outcome of external factors beyond a company’s control is on shaky

ground,” he says.

Cunningham feels investors should stay alert to the risks of venturing into

unfamiliar zones, which can help recognize and respond to surprise events or

disruptions rationally.

Overlooking the downside risks of debt

Cunningham feels many investing mistakes crop up when investors overlook the

downside risks of debt or its sources. “Debt can be seductive, because even those

wary of excessive leverage can be deceived into stressing its upside more than its

downside. After all, leverage can readily be rationalised, with managers and

advisers alike explaining how unconventionally high debt levels are either under

unusually tight control or insulated from the usual risks of calamity amid

business adversity,” says he.

Cunningham believes debt-oriented mistakes are most likely during periods of

economic expansion as amid prosperity, even mediocre companies appear to

perform exceptionally well. “Such an environment leads to making mistakes,

more dangerous than overlooking the downside and sources of debt," says he.

Mistakes while retaining stocks

Quality investing means owning the best companies for the long term, and

investors often make mistakes as they get complacent and fail to recognise when

a 'once-great company' is falling out of favour.

Cunningham says as no rm is invincible, investors should devote considerable

e ort to monitor and notice signs of deterioration to prevent further damage to a

portfolio.

Ignoring the gradual decline of a company

Deterioration of a company takes place gradually over a few years or more and

does not happen all of a sudden. There are only a few rare cases when the decline

of a company is so rapid that it is easy to sell as quickly as a ‘frog might jump

from boiling water’.

Cunningham advises investors to detect the gradual decay of a company and

resist complacency and denial even if it had given great returns in the past.

He says the overall deterioration of a business generally begins with small things

not going according to the plan, like growth not materialising, unexplained

pressure on margins, more discussion of competitive pressures or gradual

increases in capital expenditure.

“A material pro t warning, even from a company in a relatively stable industry,

can indicate that serious internal problems are brewing and suggest the need to

fully re-evaluate the investment thesis," he says.

Cunningham feels investors should monitor even small setbacks and evaluate a

business rigorously as a string of setbacks later can signal a larger set of

problems, which can emerge as it is too late for a business to make corrections or

for the investor to mitigate losses.

Remaining unperturbed to changes to market conditions

Cunningham says since quality investing chooses great companies for long term,

investors may get complacent and fail to sell ahead of a decline.

"It is tempting to interpret adversity as transient—to see sagging growth as a

blip rather than a structural issue, or a new competitor as unthreatening to a

company’s core business. This attitude promotes a long-term view, but can also

create blind spots. While each change warrants individual scrutiny, a few

categories of change seem to account for a large portion of mistakes," he says.

Failing to spot accounting irregularities

Over one- fth of public companies misrepresent earnings by an average of 10%

by using premature revenue recognition, in ating gross margins, improperly

capitalizing expenses, depleting reserves and manipulating cash ows.

Many times investors choose to ignore accounting red ags, which are a

powerful indicator if the underlying business is healthy or deteriorating.

Cunningham says investors should study the nancial reports of a company

carefully to spot whether all the nancial parameters will remain healthy in the

future.

"As accounting is the language of business, every investor must be conversant in

it. Beyond assessing the fundamentals of asset turnover and margins to evaluate

business quality, nancial reports often contain innumerable subtle clues about

the sustainability and predictability of earnings growth, cash ows and return

on capital. They also occasionally reveal chicanery, eliminating a company from

contention as a quality investment," he says.

Falling for the 'Endowment E ect'

Cunningham says as quality investing involves conducting rigorous

fundamental analysis and holding stocks for the long term, it creates an

endowment e ect, which is an over-appreciation of things already owned

compared with other opportunities.

According to him, quality investing is particularly susceptible to the endowment

e ect because the considerable upfront and extensive research increases the

e ect as the investor’s sense of ownership con nes not just the stock, but also

their analysis and judgment.

He feels the longer a stock is owned, the more the emotional connect with it.

“The endowment e ect may manifest itself when an investor continues to own a
stock despite a drumbeat of negative events revealing a deterioration of the

company’s fundamental economic characteristics. One strategy to combat this is

to ask whether, with a fresh start, you would still buy the same company today,"

he says.

Cunningham feels the endowment e ect can also play a positive role in quality

investing as it strengthens resolve amid constant but erroneous pressures to sell.

How to reduce the chances of making a mistake

Cunningham says the best way to avoid investing slip-ups is to design an

investment process to overcome obstacles and reduce mistakes. He lists out few

steps that one can follow to avoid such mistakes:-

Have complete knowledge about a company

Cunningham says to take error-free investment decisions, it is important for

investors to know a business very well. Hence, he suggests investors to conduct a

detailed fundamental analysis to know a business better.

This, he feels, can be done by a meticulous review of all public information, such

as nancial reports, as well as mining other independent sources.

Collect information from various sources

Cunningham says investors should gather information about a company from

various sources in order to be able to form a full picture of a target investment.

To execute this approach properly, one needs to have an inquisitive mind, a

desire to read widely and a willingness to gather information broadly, he says.

Make checklists

Cunningham says checklists can help focus on rationality and confront the

important questions about an investment. “A good checklist should enumerate

all the desired attributes for an investment and, ideally, the steps required for

full due diligence. It should also incorporate lessons learned from previous
mistakes and be regularly updated accordingly,” he says.

Perform inertia analysis

He says investors should compare the hypothetical performance of an

unchanged portfolio with actual performance to check how much value trading

decisions add.

“The exercise is an acute reminder that doing nothing can be a positive action

and weighs every decision against this," he says.

Dissect past mistakes

Investors should dissect past mistakes to detect causes, context and patterns.

“Such autopsies are most e ective if they address a wide range of mistakes,

realized and unrealized — for example, by assessing both purchase and sale

decisions that should, or should not, have been made," he says.

Recognise and counter biases

Cunningham believes investors should be careful of not letting biases dictate

their investment decisions. “A primary technique for mitigating the in uence of

biases is to focus as far as possible on the process rather than the outcome:

adhering to fundamental investment principles in the face of inevitable market

gyrations," he says.

So Cunningham feels a long-term quality investment strategy must be nely

balanced against the recognition that things can, and will, change. He believes

all companies evolve to some extent, and closely monitoring such evolution is an

essential part of the investment process.

(Disclaimer: This article is based on Lawrence A. Cunningham's various

interviews and his book Quality Investing: Owning the Best Companies for the

Long Term.)
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3 COMMENTS ON THIS STORY

2 hours ago
Deepesh Sao
It is practically just not possible to possess all the traits. Inspite of all the qualitie...
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4 hours ago

srigiriprakash
.......a very good & valuable information ....tq.Sir....
6 hours ago
liverindia Rajasekar
If all these rules are applied less than 20% of the listed companies in India will be
wort... Read More

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