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We are in volatile times and volatility is unsettling. Inflation and recession concerns are continuing to batter the US and global stock markets. In May 2022, a lot happened. S&P 500 briefly entered the bear market category. Also, disappointing earning reports from big-box retailers to social networking giants. Inflation was the highest since 1981. The probability of recession has increased to 35% per JP Morgan economists. All of these and much more uncertainty have created chaos in the markets. Before I continue to write, I want to make a few things very clear to my readers. I am no economist, I am not an expert in stock trading or market valuations. I write this article as a person who believes in the magic of mathematics, logic, and conviction.
Today I am going to focus on Conviction and its importance in the world of investing. Mathematics and Logic are very important but they are not the topic for today. Conviction allows us to identify opportunities and capture those opportunities with both hands. I intend to keep this post short and crisp and allow all the readers to understand the depth of conviction investing.
What is High Conviction Investing?
Merriam Webster defines conviction as: “a strong persuasion or belief”. It is a strong belief that is not likely to change. Applying this principle to stock investment is all about being convinced to invest big and not diversify your portfolio. Conviction comes after going through a vetting process that allows you to be confident in that investment. Conviction investing works best when you have selected companies that are on the path of growth trajectory.
High conviction investing adds value in terms of returns and risk and validates the mathematics of compounding. The strategy is to hold very limited companies in your portfolio. But these companies have a strong moat, the ability to generate free cash flow and keep the rise in operating costs lower than rising operating income. They are usually growth companies that have the potential to do multi-X returns. Having said that, the due diligence in buying such companies should be very strict and below the intrinsic value of the stock.
Conviction Investing = Go big with a handful of stocks
Let us take an example, We have all known the names such as Amazon, Apple, Microsoft, and Micron technology in the last 5 years. They had achieved the fame of great companies before this. There is a specific reason I want to focus on 5 years because almost everyone was certain about the potential of these companies then. With the principle of conviction investing, if you had invested in one of these names in the last 5 years and kept the money invested (letting the compounding work), you would have beaten SP500 by a huge margin, see for yourself.
These five companies are just examples, you can certainly select your best companies with the potential to return 10x or 20x, but if you want to follow the principle of conviction investing, go big on those companies and skip diversification.
Here is my criterion to select convincing stocks
- Concentrated portfolio – limited holdings (I have only had eleven holdings in the last four years while selling four).
- I only invest in easy-to-understand businesses with predictable cash flows.
- I make sure that the business has a moat and is not easily copyable.
- I tend to choose companies that are either top one or two in their domain.
- I bet on amazing leaders, who challenge the status quo.
- My quantitative analysis involves, predicting whether Operating income will continue to grow while keeping operating costs the same or decreasing.
- I convince myself to only buy companies that I will support during the ups or downs in the market. In fact, high conviction investing promotes buying the same holding when markets are down. Even if the markets are not down and the stock is trading at a discount, I am willing to buy more. It’s called Dollar-Cost Averaging.
- Lastly but most importantly, believing in companies mission and vision as to why this investment makes sense for the next 10 – 15 – 20 years. The only reason you will hold your investment in a company is when you believe they can grow with their mission and bring in more dollars.
Why the Current market is ripe for conviction investing
We are living in uncertain times. We witnessed a black swan moment in 2020 when COVID hit all of a sudden. We also witnessed crazy valuations that companies achieved in 2020 and 2021. And now we are back down. These are good opportunities to enter the market and practice conviction investing. The market situation as this (in H1 2022) is a perfect opportunity to score and score big. One cannot deny the “Luck Factor” when trading in stock markets so you need to make your god happy (whichever one you believe in). Outside of luck, one needs to be convinced of the opportunity or company, or investment they are about to make. The current market situation provides us with a great opportunity to practice conviction investing. Great companies like Amazon, Apple, Google, and Disney are trading below their intrinsic values. It’s time to pick your favorite horse and bet big on that horse.
Conviction investing is not for you if
- Your risk tolerance is low, in this situation betting most of your money on one company may not be the right direction
- Stock evaluations are tricky and require a lot of time commitment. If you do not have time to investigate or create an hypothesis that supports the investment decision, its better to say away
Writing such short essays without much backing is nerve-wracking for me, I was tempted to provide an example as I wrote this. I will do a follow-up to this article and provide a detailed process of my analysis and also share the spreadsheet that I use to calculate intrinsic values. Coming soon.
In the mean here are some great books I would like to recommend on investing, Check them out in your if you are interested in investing.
- Intelligent Investor by Ben Graham
- Common Stocks with Uncommon Profits by Phillip Fischer
- The Black Swan by Nassim Nicholas Taleb (ONE OF MY FAVORITE BOOKS, 2020 WAS ALL BLACK SWAN, it makes a little better in black swan scenarios and how to achieve more in such situations)
- The future for investors by Jeremy Seigle
- Noise by Daniel Kahneman
- One up on wall street by Peter Lynch
- A Random walk down wall street by Burton Malkiel