Good reads from around the Web.

One of the many reasons I despair of the average private investor is because of their ridiculous attitude towards short-selling (that is, betting that a share will fall in value).

There’s a limited argument that can be made against short-selling in banks at times of financial crisis, because of the potential to cause self-reinforcing bank runs. There may also be arguments against “naked” short-selling, in situations where the survival of a company is precarious and based on the ongoing confidence of its investors.

Otherwise, shorting is a useful part of the market. Besides generally helping prices to stay efficient, shorters can help dampen down speculative manias and also provide more liquidity to the system.

It’s hard to see why short-sellers should be despised as cheaters. For a start they take bigger risks – because shares tend to rise, not fall, over the long-term, but also more importantly because a short-seller’s potential losses are infinite should a share price keep on rising.

Unfortunately, many stock picking active investors seem to fall in love with ‘story stocks’. They despise shorters because they believe bogus bulletin board chatter about shadowy cabals of market makers and hedge funds, and they seem to have little idea of what really drives the long-term value of their investments.

Short of common sense

You can see this in play whenever a high-profile shorter alights on a particularly beloved story stock, which is quite often because they are often the most over-valued.

Nowadays shorters tend to publish their thesis as part of their attempts to unmask the over-valuation, as they see it, at a company.

And that’s when the fun starts.

Almost immediately private investors call “foul!” They question the integrity of the shorter and anyone who gives two minutes to considering the short position, or writing about it. They even start petitions calling for short-selling to be banned.

This is ridiculous. We do not have a situation where an abundance of negative comment is written about companies – quite the opposite.

Besides, if your company is as good as you think it is, then short-sellers should be welcomed for driving down the price.

Buy more! If you’re right about your company, then the earnings will out in the end and you’ll make even more money.

Of course the suspicion must be that all their bluster hides the fact that the anti-shorters don’t really have much confidence or understanding to fall back on.

What they have are glossy and potentially bogus company presentations, big numbers bandied about by over-pushy CEOs, and some blue-sky vision of what would happen to the company’s bottom line if everyone in Eritrea bought its products.

That’s not an investing thesis. That’s a playground popularity contest.

Here’s one they did earlier

Time after time you see popular small-cap story stocks blow-up and the protestations die down.

Not every short call is right – far from it, as I say shorting is even harder than normal active management, because the market will less often bail you out. But a credible short-call allied to a lot of angry private shareholders should probably give you second thoughts about any company you own.

The chaps from Schroders just shared some thoughts on this, in the context of infamous short-seller Gotham City’s move on wi-fi firm Let’s Gowex:

Gotham City [says] it took some eight months of due-diligence work from the moment its eye was first caught by a little-known Spanish wifi provider called Let’s Gowex to the publication on 1 July of a scathing report, among the conclusions of which were “Over 90% of Gowex’s reported revenues do not exist” and “Gowex shares are worth €0.00 per share”.

Gowex’s immediate response was to come out with all guns blazing but, within a matter of days, it had been forced to declare bankruptcy and admit that its chief executive and founder Jenaro García Martín had made up its accounts for the last four years.

Channelling the spirit of its favourite superhero, Gotham commented: “It is not who we are underneath but what we do that defines us.”

As recently as February of this year, Gowex had a market capitalisation of almost €2bn (£1.58bn)  and had seen its share price rise more than 1,000% since the start of 2013 – taking it to the fringes of Spain’s principal IBEX 35 market and making it one of the best-performing shares in the world.

The average professional short-fund manager is to a noisy and angry punter in small cap shares what Superman is to your grandad in tights.

Okay, shorters are not super, nor even heroes, but it is certainly a mismatched battle of investing smarts – and I know who I’d put my money on any day.

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One of the UK’s most famous – and famously successful – private investors is John Lee (aka Lord Lee of Trafford).

Thanks to more than a decade of writing about his portfolio for the Financial Times, Lee has became one of the handful of go-to guys when it comes to navigating the woefully under-covered UK small cap scene.

Lord Lee also made headlines when he revealed in 2003 that he was an ISA millionaire – an impressive sum to amass in just 16 years, given that he made this million by compounding the mere £126,000 he was allowed to put into ISAs in annual contributions by that date.

And Lord Lee hasn’t just shared his wisdom with investors. The House of Lords peer and former MP also gave his time to agitate for regulatory changes, in particular having a key role in a tweak to the law to allow AIM shares to be held in ISAs.

At a time when many in government seem almost hostile to private investing, we’ve been lucky to have him on our side.

John Lee’s 12 rules of successful investment

Lord Lee eventually tried to distill more than 50 years of his experiences as an active investor into his own book, How to Make a Million – Slowly, which was released in late 2013.

It’s not a definitive textbook on the dark art of active investing, but it is a very agreeable summary of the principles of investing in small caps, from an amiable, generous, and enthusiastic practitioner.

Read my review of his book if you’d like to know more.

As a taster, here are Lord Lee’s 12 guiding principles to successful investing:

1. Endeavour to buy shares at modest valuations – hopefully with an attractive yield and single-figure price earnings ratio and/or discount to net asset value / real worth.

2. Ignore the overall level of the stock market. Don’t make judgements on the macro outlook – leave that to commentators and economists. Focus on your particular selection.

3. Be prepared to hold for a minimum of five years.

4. Have a broad understanding of the PLC’s main business activity – one which makes sense to you.

5. Ignore minor share price movements. Looking back years hence you will have either got it right or wrong. Whether you originally paid, say, 55 pence rather than 50 pence will be totally irrelevant.

6. Seek out established companies with a record of profitability and dividend payments – avoid start-ups and biotech and exploration stocks.

7. Look for moderately optimistic or better chairman’s/CEO’s most recent comments.

8. Focus on preferably conservative, cash-rich companies or those with low levels of debt.

9. Ensure the directors have meaningful shareholdings themselves in the PLC and ‘clean’ reputations.

10. Look for a stable Board – infrequent directorate changes. Similarly with professional advisers.

11. Face up to poor decisions. Apply a 20% ‘stop loss’ – sell and move on. However, ignore the stop loss if there is a major overall market fall.

12. Let profitable holdings run. Don’t try to be too clever, i.e. selling and hoping the market will fall to buy back at a lower price.

It sounds straightforward, doesn’t it?

You just try being so sensible for 50 years!

A slow and steady way of active investing

I’ve been lucky enough to meet Lord Lee a couple of times, and he’s just as genuine in real-life as he comes across in his book – both in terms of his passion for investing, and in his surprisingly down-to-earth nature (especially for a multi-millionaire peer of the realm…)

As always the ‘house view’ of Monevator is that most people will do best by passively investing.

But if like me you’re one of life’s inveterate stock pickers, then I think you’ll find Lee’s sensible, business-focused investment rules are worth more than any number of bulletin board tips and irrelevant CNBC headlines.

Good reads from around the Web.

Most of us know that investing works best when it’s a long-term project.

But too many people don’t appreciate that a long-term view doesn’t mean you’re guaranteed to do well, especially with an equity-heavy portfolio.

I’ve written before about sequence of returns risk, which is the danger that you’ll be unlucky and see your share portfolio plunge just before you’re set to stop contributing and to start living the high life.

What’s so hateful about this risk is that you can spend your life being the smuggest sensible investor on the block – admirably tuning out the market noise and boasting about your puny fees at parties, if you’re lucky enough to go to those sort of parties – and then wham…

…the market crashes. Overnight that annoying cousin who pumped all his money into buy-t0-let gets the All You Can Eat Deal at the retirement cafe, and you’re left hunting for bargains at Aldi.1

The incomparably consistent Morgan Housel expanded on this risk for the Motley Fool US, with the following striking graph:

US data from Robert Shiller and Morgan Housel (Click to enlarge)

Housel writes:

What amazes me is that these hypothetical investors would be considered some of the smartest around, investing steadily every month no matter what the market was doing, for decades on end.

Doing this is emotionally taxing, and few investors can keep it up over time.

In the real world, investors are more likely to buy after stocks have boomed, and to sell after a crash — which devastates returns.

Yet even with hypothetically perfect behavior, the difference in results between investors born in different generations can be the difference between no retirement and a lavish retirement.

And it’s mostly a factor of luck.

It is indeed striking to see the big differences in outcome, and it demonstrates exactly why different generations talk so variously about a particular asset class.

For instance, most people who invested through the 1980s and 1990s know little of the 1920s or 1930s – the UK market went up roughly sevenfold over the former period, and bonds did well too. Anyone who retired in the mid-to-late 1990s is likely to be an evangelist for long-term investing, but if you retired in 2008 you might have a different view.

Similarly, London property has been a winner for so long that people have forgotten it once fell in value. And people forgot in the 1990s that gold sometimes shines, to the extent that few people cared less when the UK government started flogging it off for a pittance.

Don’t be a loser

The only way to avoid being at the mercy of this rollercoaster ride is diversification across asset classes.

In particular, to avoid a catastrophic outcome you need to temper down any full-on enthusiasm for equities at least a couple of decades before you stop contributing money and start to make withdrawals.

That doesn’t mean abandoning equities or market timing, or anything like that. It means that a 100% equity portfolio should be at most a 50-80% equity portfolio say 20 years before your ‘date’, and you should rebalance from there as required.

I think rough bands are fine, incidentally– it’s better to be approximately right with this stuff then precisely wrong. And as far as I’m concerned the rest of the money can be in cash, given the weird situation at the moment, provided you’re prepared to chase higher rates. But of course classically it should be in bonds, and that’s the way to head if and when rates normalise.

Either way, you’re protecting yourself from the risk of a stock market that crashes and takes 15-20 years to get back to where it was.

If that seems fanciful, look at a graph of the FTSE 100 or Japan’s Nikkei 225.

Aim for a good result, not the best result

Sometimes diversification and rebalancing actually increases your returns, as an article from A Wealth of Common Sense this week showed:

But more often you’ll do slightly worse because you diversified. That’s the price of ensuring that you don’t do really, really badly.

Rebalancing is key, as Common Sense author Ben Carlson concludes:

In almost half of all annual periods you had a loser in the group. Each of these losses created opportunities to rebalance to boost future returns. And even though there were plenty of down years for each fund, the portfolio as a whole was still positive over 70% of the time.

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1. Okay, so I already hunt for bargains at the supermarket. But it’s fun because it’s a choice! [↩]