Strive for simplicity

Doing more with less, elegant engineering, concepts that are foreign to investing.  In seemingly every other professional discipline praise is bestowed on the one who can distill something complex down to a simple solution.  The investment world seems to work with different rules, simple investments are disdained, complex investments are glorified.  I want to push forward the idea that simplicity in investing produces higher results.

There is no one standard measure of simplicity, it's different for everyone.  The key is to "Know Thyself".  For some investors a simple portfolio is one with a half dozen holdings.  For others like myself a simple portfolio is dozens of simple companies.  I prefer the simplicity of small caps, but to others large caps are simple, with their venerable brands they can't help but make money.

The argument for simplicity is...well...simple; The easier something is, or the less assumptions one needs to make and the less room for error.  In my view the key to investing isn't having years where my portfolio is up 45% when the market's up 25%, it's not losing money, or losing very little when the market is down.  I believe maximizing gains comes through minimizing losses.  It's a lot easier to recover from a 10% loss verses a 40% loss.  It doesn't matter how hard anyone stares into the crystal ball, no one knows the future of the market, and anyone who thinks they do is a fool.  When I talk about avoiding losses I'm not talking about short term volatility, I'm talking about a permanent loss of capital.

If a company drops 30% on bad earnings but has a solid balance sheet and a history of higher earnings I can sit on my investment and wait for a recovery.  If a company is highly leveraged and falls 30% on the report of bad earnings they might trip debt covenants and etch a 30% (or more!) loss into stone as they enter the bankruptcy courts.  The company might ultimately recover, but it would be creditors who benefit.

The biggest gain from simplicity is a reduced set of assumptions.  The future never turns out as anyone expects.  As investors we build our portfolio around our model for the future.  Reducing the set of assumptions one needs to make for an investment to work out increases the chances that the future might work in our favor.

If my entire investment thesis rests on the idea that a company shouldn't trade for less than net cash I only have one working assumption.  I can spend all of my time proving or disproving my assumption.  I'm not worried about the growth in widget volume, or the executive compensation, all I care about is my one assumption that a particular company shouldn't sell below net cash.  I might be wrong on everything about the company, but if my assumption is correct the investment will work out.

A complex investment is the opposite of this, take JC Penny for example.  Turnarounds are not simple, they're like billiard balls, the second you move one  the rest shift, and it's impossible to know if they'll shift for or against you.  JCP eliminated coupons which led to a decrease in sales, yet simply re-introducing coupons won't bring their customers back, the billiard balls have shifted.  For an investment in JCP to work out well many things need to go right.

So what's the best way to introduce simplicity into an investing routine?  Start at the bottom, and start small.  As you research look at companies differently, try to determine if there are one or two data points that would make or break the investment and focus on those.  When researching ask the question if more information would help or hurt.  There is a minimum amount of information necessary for an investment decision, after that point the value of the data begins to experience diminishing returns.  I don't need to know how an airplane works to invest in an airline, and while I do find those things interesting, they aren't critical to an investment thesis.

After introducing simplicity at the company level introduce it at the portfolio level.  Do you have a portfolio that's maintainable if you take a break and go on vacation for a while?  Does the portfolio "make sense"?  Can you explain in three sentences or less to your mother-in-law why you own each position?  For some mother-in-laws you might only have a sentence to get the point across before she chimes in, can you do it?

The rewards for simplicity are reduced errors, and a maintainable portfolio.  It's a lot easier to stick with an investment, or an investment philosophy if you understand it well rather than second guessing it when the market hits a rough patch.