130 - How to invest during a crisis?

Want Investing Research Directly to your Inbox? Sign-up for my Free Substack: https://diyinvestingstocks.substack.com/subscribe? Mental Models discussed in this podcast: Delayed Gratification Time Horizon Personal Responsbility Compounding

Want Investing Research Directly to your Inbox? Sign-up for my Free Substack: https://diyinvestingstocks.substack.com/subscribe? Mental Models discussed in this podcast: Second-Order Effects Mean Reversion Factor Investing Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing Show Outline Selling Series A lot of time is spent on buying stocks. Yet, almost just as important, if not more is knowing when to sell stocks.  I find this area relatively underexplored, so I want to begin a long-term series on selling stocks from the framework of a value investor.  Previously talked about selling in a single episode on Ep. 106 Today’s focus: Strategy matters There is no one-size fits all approach How you buy stocks will influence how you sell them Your portfolio allocation strategy will matter THe number of stocks you review in a year will matter Whether you plan to own a cash position or not will matter. Excluded from this series: Won’t be discussing momentum investing Won’t be discussing trading or technical analysis investing (except as a marginal part of value investing when relevant) Entire focus assumes that you are a value investor of some sort (whether deep value, compounder, graham value, quality, etc…) Deep Value: Buy at 2/3rds of value and sell at “full price” Compounders: You want to hold for a long-time.  Sell when compounding ends, plateaus or you were wrong Net-Nets Hold a year then reassess Waterfall Stocks:  Hold so long as dividend yield is sufficient to provide target return Dividend Growth Investing: Buy companies that pay dividends and grow them and sell them when they cut or eliminate their dividends Buy and Hold “Never sell” Works for a subset of stocks Tends to overlap well with compounders and Dividend Growth investing

Want Investing Research Directly to your Inbox? Sign-up for my Free Substack: https://diyinvestingstocks.substack.com/subscribe? Mental Models discussed in this podcast: Second-Order Effects Mean Reversion Factor Investing Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing Show Outline Today’s podcast will focus on a single precept: You can’t predict the future First and Second Order Effects Margin of Safety Preference for cash now vs cash later (Plays into want for profitable companies) Time value of money.  Growth is important because it can correct for mistakes, but you know you can’t predict it Some of what you “know” about investing may not be true Importance of Zero-Based Thinking (what is the best decision today based on what you know today) Wrong because past price performance can’t predict the future (it may, but it may not) Wrong because it assumes that winners will keep on winning and losers will keep on losing “Don’t catch a falling knife” “Hold onto winners, trim your losers” The central problem with rebalancing It is definitely true that successful rebalancing CAN add value It is also true that it is IMPOSSIBLE to know if your rebalancing will be successful How then do you behave? How do you invest in the face of uncertainty? First order: Second order: Investing in the face of uncertainty You cannot assume business momentum. You plan for it and buy stocks you think will have it, but your strategy cannot assume it will continue. You cannot assume reversion to the mean. You plan for it and buy cheap stocks because it offers the opportunity of reversion to the mean, but your strategy cannot assume stocks WILL mean revert in the time frame you want. You cannot assume that growth will continue. You cannot assume a specific growth target will be hit. You cannot assume that your predictions about business quality will be better on company A than on company B.  The only thing you can know to be true is that the future is uncertain.  I personally use some absolute rules (like no margin debt, no options, and no shorting). Not because they’re optimal, but because they limit my risk and allow me to take risks in other areas.  Some of your decisions will be a mistake. That doesn’t mean you don’t make a decision. Indecision is a decision.  Selling some winners may be correct and selling others may be a mistake. Your strategy needs to incorporate that understanding. “Absolute rules” can be helpful to limit mistakes, but they will inherently be suboptimal.  What is my point: It would be a mistake NOT to trim when I am given the opportunity to do so. Failing to take advantage of opportunities that ignore zero based thinking will result in me having lower returns across an investment lifetime.  You want to build a strategy that follows this precept: “If I lived my life 10,000 times, what strategy would result in a favorable outcome across the most possible lifetimes?”  Don’t optimize for the “perfect” scenario. Don’t optimize for the “worst case” scenario.  Optimize for uncertainty. Prepare for the worse, plan for the best, and adjust daily.  There are aspects of my strategy that go against established norms. However, there are clear reasons for that. I know that I cannot predict the future.  Therefore, I am willing to sell or trim my winners when I believe it improves my potential returns and reduces my risk.  Summary:  You cannot predict the future. Be more humble. 

Want Investing Research Directly to your Inbox? Sign-up for my Free Substack: https://diyinvestingstocks.substack.com/subscribe? Mental Models discussed in this podcast: Look-Through Earnings Dollar Cost Averaging Earnings Yield Opportunity Cost Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing

Mental Models discussed in this podcast: Dead Money Opportunity Cost Time is Money Intrinsic Value Compounding Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing Show Outline The Dead Money Problem and Solution “If you remember only one thing today: Time is Money”  What is Dead Money?  Any asset you own that is not growing intrinsic value over a period of time.  The focus here is on the fundamentals of the business. NOT the stock price. We can’t predict stock prices. We’re not going to try. Why is this a problem?  The longer you hold a dead money position the worse off you are. Principle: Time x Position Sizing x Expected Return of Alternatives = Lost value  By using this formula you can anticipate how much exposure you have to dead money losses. The Solution:  The impact is large (Big “lost value” bucket) [>> 1%] The likelihood of success is high (Big difference in expected return between opportunities) At least 10% Passivity is better than action. Action leads to errors. Always remember that you had good reasons for your original buy decisions. Summary: Time is Money! Investors lose value on any asset they own that is not growing intrinsic value over time. This episode provides value investors with my solution on how to optimize their portfolio in the face of dead money assets and potential opportunities

Mental Models discussed in this podcast: Incentives Skin-in-the-Game Accredited vs non-Accredited Investors Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing Show Outline Key Concepts for thinking about compensating a Portfolio Manager Management Fees  Management Fees are priced a percentage of the assets under management.  A 1% management fee means that you will pay 1% of your assets being managed to the investment manager regardless of the returns you receive on your investment.  If you have $100k invested at the beginning of the year, you’ll pay $1k in fees, if your investment doubles, and $1k in fees if your investment gets cut in half. (ignoring the weighted average effect) Management fees can be charged to both accredited and non-accredited investors Performance Fees  Performance fees are priced as a percentage of the profit earned on investments over the course of a year.  For instance: A 10% performance fee would provide the manager with 10% of the total profits earned during the year. If you invested $100k, and the $100k grew to $200k, then the investment manager would earn $10k. (10% of the 100k gain).  However, if the investment fell to $50k, the investment manager would earn nothing.  Performance fees can be charged only to accredited investors. Hurdle Rates  Hurdle rates are often paired with performance fees to ensure that investment managers only earn performance fees above a certain level of return.  For instance: A hurdle rate of 5% would mean that the profit sharing only kicks in after 5% returns have been earned for the year. In our prior example, if you invested $100k that doubled to $200k, then the “profit pool” is instead $95k, because the first $5k is exempt. The investment manager then only earns $9.5k. High Water Marks  High water marking is where hurdle rates are compounded across multiple years.  In this case, let’s assume you invest $100k, and the hurdle rate is 5% per year.  In year 1: your investment declines to $80k. You pay no performance fees.  In year 2: Your investment grows to $110k. You still pay no performance fees because despite earning 37.5% rate of return in year 2, the hurdle rate of 5% compounded in each year, so the investment manager only starts to earn fees after 10% (5% + 5%) on the original $100k. So they would only earn returns above $110k in year 2.  In year 3: They only earn performance fee returns above $115k (ignoring compound growth here). The Buffett Model  0 % management fee, 6% hurdle rate (w/high water marks), 25% performance fee  I think this is an attractive setup and I’d prefer to structure any future fund of mine with a similar arrangement.  This is the best alignment of incentives in my view. You don’t get paid for AUM growth (directly), and only get paid for performance that beats a certain hurdle rate.  However, to do so excludes non-accredited investors. Therefore, if I want to serve non-accredited investors I’d have to charge a management fee at least for them. What is the right answer then? Non-accredited: You only have management fees. You obviously want a manager willing to charge them, or you don’t get that manager at all. Accredited: Performance Fees may be your instinctual first option. They tend to align your interests with management. However, there are also downsides for you. May encourage managers to take more risk. Unless they beat a hurdle, they don’t earn anything. They’ll never be 100% aligned with you.  Without a management fee, you are limiting yourself to investment managers who are already financially independent and can afford to have years without income. Personally: I would be willing to pay or charge both sets of fees. My ideal setup is the Buffet arrangement: 0, 6, 25%. However, this isn't ideal for all investors. I could see the benefit of a 0, 10, 50% setup. I can see the benefit of only charging management fees (especially for retired investors who are seeking wealth preservation, not growth) As always: The answer is it depends. But, I hope that I have given you the information you need to understand how it applies for you. Summary: As an investor, you want to properly align your interests with your portfolio manager. A key consideration is how to compensate and incentivize that manager with either management fees, performance fees, or both.

Mental Models discussed in this podcast: Opportunity Cost Alpha Superpower of Incentives Competitive Advantages Process vs Results Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing Show Outline Key Concepts for selecting a Portfolio Manager Choosing an investment manager is a lot like choosing a stock Don’t invest in anything you don’t understand - this includes managers What is their process? How do they earn alpha? Do you need alpha? What are your financial needs? Wealth preservation? Wealth Growth? Do you need alpha? Not every manager can provide alpha.  Not every manager seeks alpha Not every investors NEEDS alpha Value Cost - How are they paid? What is the expense structure? How does it compare to alternatives? Management Fees  Performance Fees  Next podcast will be a whole podcast on fee structure, so I’ll limit my discussion on it here. Growth Investment managers inherently benefit from growing AUM. This is unavoidable. Regardless of pay structure. However, you want to understand what drives them. Is investing a passion or a money seeking endeavor? Are they trying to grow AUM? Do they plan to shut down growth at some point? Quality Competitive advantages? How are they different from other investors? Communication? How do they communicate with clients?  Do you understand their process? Are you comfortable with them? Style Size of stocks Liquidity Value vs Growth vs Quality?  Overlooked companies? Index hugging? Concentration vs Diversification   Custom Portfolios vs Investment Fund  Some managers will setup a customized portfolio just for you Or do you simply want to own a portion of a mutual fund or hedge fund. Past Performance - Luck vs Skill It is difficult to analyze a portfolio manager based on past performance Instead, focus on their process.  If you understand their process you can potentially understand the odds of future outperformance (if you even need outperformance) Summary: Choosing an external investment manager for your wealth is a difficult decision. In this episode, I outline the key concepts you should consider when evaluating someone to be your personal portfolio manager.

Mental Models discussed in this podcast: Stress Testing Time Horizon Stoicism Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing Show Outline The full show notes for this episode are available at https://www.diyinvesting.org/Episode130 Key Concepts for Investing during a Crisis Stress Testing - Bankruptcy Risk? Goal: Survive Stress test businesses not stocks Focus on Fundamentals Long-term is where all of the value is at The next 1 or 2 years is only 10-20% of the value most of the time. War somewhere is not inherently a crisis for your portfolio Are your specific businesses being affected? Land war in your country? Destruction of infrastructure owned by your companies? Sanctions against your companies? There has been almost constant war for the entirety of the last 100 years somewhere in the world Doomsday Scenarios It is usually worth betting on optimistic outcomes If you're wrong, you likely won't be around to deal with it. (Nuclear war) Summary: The Russian Invasion of Ukraine has created a situation where three crisis grip the world: War, Inflation, and COVID-19. How should investors think and act during such a crisis?  Stress test your portfolio. Focus on the Fundamentals. Does the war affect you directly? Avoid doomsday thinking.

Mental Models discussed in this podcast: Catalyst Activation Energy Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing Support the Podcast on Patreon This is a podcast supported by listeners like you. If you’d like to support this podcast and help me to continue creating great investing content, please consider becoming a Patron at DIYInvesting.org/Patron. Show Outline The full show notes for this episode are available at https://www.diyinvesting.org/Episode129 Catalysts in Value Investing Catalyst Definition Trade vs Hold Return Free Call Option Catalysts speed up the rate of multiple expansion leading to a high IRR "trade" return Business Catalysts vs Stock Catalysts Solitron Devices Example   Summary: Catalysts can supercharge investing returns for value investor if utilized properly OR they can distract from a central thesis and cause you to make poor decisions. A catalyst should be seen as a free call option that boosts a "trade" return. 

Mental Models discussed in this podcast: Investing Ratios Break Points Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing Support the Podcast on Patreon This is a podcast supported by listeners like you. If you’d like to support this podcast and help me to continue creating great investing content, please consider becoming a Patron at DIYInvesting.org/Patron. Show Outline The full show notes for this episode are available at https://www.diyinvesting.org/Episode128 Key Investing Ratios P/E: Goal: Max: P/S Max: ROA: Goal: >10% Ideal: >15% ROE: Min: 10% Goal: >15% Ideal: >20% Gross Margin: Higher the better (>50%) Stability is more important than the absolute number Focus: Limits and Break Points Source: https://twitter.com/solvealways/status/1486992514196324354?s=20&t=xGDVCwWNDXmL9VM7hpQN2A   Summary: The important thing to remember about the key investing ratios is to understand that they are always relative. What you're looking for is understanding the limits you don't want to pass, and key break points that signify certain things about the business. Above all, stability is critical when evaluating a high quality business.