7 investing principles to generate alpha
These are the investment principles I use to guide my stock picks.
Many of my friends have asked me why I think I can beat the market or how I have picked AMD & Tesla previously. I want to lay out my investment principles to explain the sources of alpha. Before I do that, I want to explain why investment principles are essential. There are two types of decision making:
- Result-based decision making
- Principle-based decision making
Results-based decision making is making a decision based on the outcome, which is helpful for things mainly in your control. However, investing, like many things in life, is not. The results are far from certain: even macro factors could overweigh micro factors of a specific company. Therefore, you can only make decisions based on your principles and hope for the best.
Without any further delay, these are my investment principles:
1 — Focusing on inflection points
Although some might disagree, the stock market prices public companies well and even growth is taken into account by the army of analysts whose sole job is to predict future earnings. Therefore, to generate more alpha than the market, one cannot simply invest in predictable stocks. Instead, to generate significant alpha, one needs to have a unique point of view and bet against the market.
Turnarounds — where a company is in decline and then thrives — is an example of an inflection point. These situations are hard to price by the market, and my previous investment, AMD & Tesla, is such an example.
Optionality, where the company enters a different market or launches a new product — where the company goes from 0 to 1 instead of scaling from 1 to n — is another excellent source of alpha. Would the opportunity be significant if true? Optionality primarily drove my investments in Razer for example.
2 — Investing within your knowledge
Research shows that 85% of money managers can’t beat the market and can’t outperform their respective benchmark index funds.
What makes you think you have a right to earn extra alpha over the market? Are you more knowledgeable compared to 85% of investors in this market?
Having used the product and having the perspective of the customer helps you avoid overly hyped-up companies. Beyond Meat sounds good in theory but doesn’t taste any good, and their recent stock performance (in 2022) is a reflection of that. Also, avoid companies that hide behind complicated terms or obscure their business model.
Understanding the business on the technical level allows you to predict where things will go. For example, I’m a computer engineer by training, which will enable me to understand semi-conductor and software stocks. I’m also a co-founder of a Micromobity/ Robotics delivery startup, allowing me to understand EV stocks & mobility stocks. So ask yourself this: what are you uniquely positioned to understand better than the market?
3 — Choosing high-quality companies over cheap companies
A wonderful business at a fair price is far superior to a fair business at a wonderful price — I tend to go for high-quality rather than cheap companies. I learned this principle from Warren Buffett’s Cigar butt investment style ( Warren Buffett’s “Cigar Butt” Approach To Investing — Superior North LLC). With a high-quality business, it will constantly return you capital and will be far more profitable than extracting the last “puff” from a cheap cigar butt.
For example, a tell-tale sign of a highly differentiated business with strong moats is a high gross margin compared to peers.
4 — Investing in companies you want to exist
As investors, our jobs are capital allocators, providing capital to great companies that positively change the world. We should therefore use our money to vote on which companies we want to exist in the future.
Sometimes this can mean missing out on great business models with significant negative externalities like social media, fossil fuels, and tobacco. Often, these industries also have substantial negative branding & government regulation risk that can negatively affect the stock.
On the other hand, meaningful companies will always have people who want to work and invest in them.
5 — Investing for the long term
“In the short run, the market is a voting machine but in the long run it is a weighing machine” — Benjamin Graham
In the short term, sentiment drives the stock price — it is difficult to predict and measure accurately. We shouldn’t waste our time betting on the short term. As retail investors, we are unlikely to be able to time the market correctly.
However, over the long term, the stock price would reflect the actual quality of the business and the price will eventually catch up with the business’s intrinsic value.
Before investing, ask yourself: What will the company be like in 1, 5 or 10 years?
6 — Focusing on qualitative rather than quantitative
Favour qualitative aspects such as management, moats and brand compared to financials and numeric metrics. The market does not readily understand qualitative factors, which are excellent sources of alpha.
Given a company with strong qualitative factors but middling financials vs strong financials and middling qualitative analysis. Take the former.
Also, financial metrics, in general, are also rearward-facing and not indicative of future performance. Use financials more as a confirmation of a great business.
7 — Concentration as compared to diversification
This principle is a controversial one. To me & Warren Buffet: Concentration is for building wealth, while diversification protects it. I’m in the wealth-building stage and have the time to actively research the company. I want to concentrate my knowledge on a few companies and understand them inside and out. Moreover, the knowledge reduces the risk of risker stocks. You might be in a different position.
“You know, we think diversification is-as practiced generally-makes very little sense for anyone that knows what they’re doing…it is a protection against ignorance.” — Warren Buffet
However, it is also important not to go overboard with concentration as having a portfolio of assets can be beneficial — such as pairing high risk & low-risk stocks or having dividend stocks to fund a DCA strategy.
Conclusion
These are the investment principles I use to guide my stock picks. Before investing, do ask yourself what are yours.
These investment principles are used at a high level to filter companies, however, I do have a framework to evaluate shortlisted companies: Do you have an Investment Framework?? (melvinfoo.com)
Thank you financial avocado for inspiring me to write my investment principles: 7 Investing Principles for Better Investing — Financial Avocado
Socials:
Firstly you can subscribe to the email letter, its free and would help me a lot.
You can follow me on Twitter: https://twitter.com/meoweenfuu
LinkedIn: LinkedIn
Medium: Melvin Foo — Medium
Instagram: @melvin.travels • Instagram photos and videos
Youtube: https://www.youtube.com/channel/UCS8pOlQHemXJ-2NrPJtDLaw/
Goodreads: Melvin Foo — Singapore, 00, Singapore (104 books) | Goodreads
Substack for general content: Melvin’s Newsletter | Melvin Foo | Substack
Substack for investing content: https://techanalyst.substack.com/
If you’d like to donate to me, here’s my patreon: https://patreon.com/melvinfoo. I’m looking to get to $10 a month so I can justify the commenting system!
Originally published at https://www.melvinfoo.com on June 4, 2022.
