Jake Taylor on Investment Style, Position Sizing & Untangling Luck vs. Skill
Investor takeaways #2
Disclaimer: This article is for informational and educational purposes only. Do not interpret anything below as financial advice. Always do your own research & speak to a financial professional before making investment decisions.
Andrew Sather and Dave Ahern recently released their latest investing podcast episode with Jake Taylor, CEO of Farnam Street Investments, co-host of the Value After Hours podcast with Tobias Carlisle and Bill Brewster and author of The Rebel Allocator.
Source: Spotify
Here are 8 of my favourite takeaways from their conversation.
1/ Market cycles
“Every investor is imprinted based on whatever market environment they cut their teeth on.” - Jake Taylor
Investors are often hard-wired in relation to the market cycle in which they were raised. This can be hindrance on returns.
Take Jake’s investment style of focussing on downside protection before upside. In the long bull run between 2015-2020, it was harder for the ‘downside guy’ in a world where all stocks were skyrocketing. Upsides were endless and downsides didn’t materialise much.
Takeaway: Understand your wiring and adapt.
2/ Investing style
Over the short-term, investor sentiment and multiple are the main drivers of results. Metrics like ROE and ROA are much more important over the long-term.
In his early days, Jake was looking for run-down, cheap stocks like net-nets or stocks with low P/E or P/B ratios. Hoping for a quick 2-3 year multiple re-rate before selling and moving on to the next cheapest idea.
As multiples expanded and the universe of quantitatively cheap stocks decreased, he pivoted from what Mohnish Pabrai might call ‘50 cent dollars’ to the ‘long term compounders’, now referring to himself as a ‘value buyer’ and a ‘growth holder’.
Be open to paying a fair price for a great business and not selling just because the multiple is slightly higher than usual. This leaves more space for upside potential rather than cutting losses short based on a given multiple.
Takeaway: Be open to new investment approaches.
3/ Base rates, base rates
Investors should accumulate a set of ‘base rates’ for each stock they choose to research. If one expects a stock’s revenue growth over next 5-10 years to be 10%, one should have a base rate in place confirming that companies of the same size, in the same industry or niche have historically grown at the same clip.
Unless you know something extra special about the way the world works that no one else knows, stick to your base rates.
Rapidly identifying base rates is more of an art than a science. Buffett has a mental latticework of base rates he’s acquired over years of experience enabling him to make snap decisions on stocks in less than a day.
Jake recommends Michael Mauboussin’s white papers for more information on base rates. A quick Google search led me to The Base Rate Book.
Takeaway: Comparables are king.
4/ Avoiding mistakes
Base rates have limitations. Take Google stock, one which Jake passed up on a decade ago. The ‘Law of Large Numbers’ states that expanding companies with huge market caps have limited growth potential. In theory, after a certain point marginal returns diminish once a specific level of production capacity is reached despite adding additional factors of production.
Maubossin suggests some digital companies like Google have been able to defy such base rates and continue to scale at enormously despite their size. By wrongly assigning base rates, one can be led astray and assume a stock is fully priced with all growth baked in without accounting for cheap growth, improving margins and room for multiple expansion.
Even the greatest investors can make mistakes. Buffett and Munger watched the Google story unfold as GEICO owners and failed to pull the trigger, something Buffett would later admit he was wrong on.
Takeaway: Mistakes happen.
5/ Position sizing
Investors should prioritise ‘slugging percentage’ ahead of ‘batting average’.
If you have a wonderful pick but don’t swing big and put loads of money into it you won’t do great. Conversely, if you swing big on an idea that doesn’t do great or does average, the opportunity cost of not allocating your capital elsewhere can be hugely detrimental to your long-term returns.
That said, to overcome our behavioural biases like overconfidence, most investors should size positions appropriately and spread them across several bets. Although not the most ‘Mungery’ advice, who is well known for advocating large, concentrated bets on high-conviction ideas, Jake prioritises being realistic as investors.
If you have the temperament and flexibility to sit in cash for several years before making a large bet, props to you. But for most people, staying fully invested, a little rebalancing and some diversification is warranted in a world full of unforeseen events.
Takeaway: Opt for an investment style that aligns with your personality.
6/ Return of value?
“In bear markets stocks return to their rightful owners.” - Ben Graham
Mean reversion is a powerful, very real force that is not dead. There will be a point in the future when markets revert and trade under the mean again. Buying cheap will work over time as markets revert to the mean.
During bear markets, investors are put to the test. Several characteristics are required to weather the storm including pain, negativity, a “washout of exuberance” and a total reset.
Without trying to speculate, Jake argues the metrics point towards a fall in equity prices. The most epic bull runs don’t usually come during a time when most stocks have high P/E ratios or profit margins through the roof.
Regardless, there are always pockets of the market that are undervalued. Investors willing to turn over a lot of rocks will always find value in a given market. Tough times don’t last but tough people do. Investors who can stick out uncertain periods in the markets are the ones that have the most success.
Takeaway: Mean reversion is real.
7/ Tracking investment theses
“I know I'll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” - Charlie Munger
Since the human memory is far from perfect and continuously replays scenarios that took place, eliminating data points and making you question whether events really occurred, journalling is a clear advantage in Jake’s eyes and a habit all investors should prioritise.
The investing world is unkind because it often takes years to find out whether we are right or wrong about decisions. We are wired to demand instant answers and so closing feedback loops is even more important to deduce whether we made the right decisions for the right/wrong reasons and vice-versa.
Takeaway: Close feedback loops.
8/ Untangling luck vs. skill
My favourite takeaway from the podcast is at the end.
Jake recommends making probabilistic predictions about a company’s fundamentals to make the distinction between lucky decisions and skilful ones.
Investors should make 5 fundamental predictions (e.g. related to revenues, multiple, dividends, share count, margins) per year or however long a time frame you are analysing. In doing so, you have 5 probabilities for every price data point you analyse for stocks you own.
Having this mental framework is useful because it highlights over-confident and under-confident decisions. For example, if the price of a stock skyrockets and you made 5 modest predictions, then it’s a warning flag indicating you were way off with your predictions and were too confident. On the flip slide, your predictions may be spot on but the market could be plummeting, in which case you know you are on the right course. You just have to stomach the lows until the fundamentals catch up.
This simple exercise soon enables you to accumulate a large enough sample size to determine if you are making skilful or lucky decisions.
“Go to bed smarter than when you woke up.” - Charlie Munger
Takeaway: Focus on process and mindset. Ultimately these two components of investing are entirely within your control. Short-term price action is not.