“The strongest of all warriors are these two – Time and Patience.” (Leo Tolstoy)

The proprietary trading operations of the big brokerages on Wall Street generate huge profits from high-frequency trading. Therefore, it’s not surprising that brokers aren’t paid on the basis of the accuracy of their buy and sell recommendations. Rather, they’re paid for flogging investment products.

Paul B. Farrell at MarketWatch paints an even bleaker picture: “Bottom line: The last thing Wall Street wants is 95 million investors wise to Wall Street's con games. Wall Street revenues would drop substantially if financial literacy really did work. Like a chess master, Wall Street will always be several steps ahead of the Main Street investor.”

Industry insiders quietly concede that the average investor hasn’t got a hope of beating the pros at their game. But is this really true?

KNOW YOUR ENEMY'S WEAKNESSES

Sun Tzu in The Art of War advises: “If you know the enemy and know yourself, you need not fear the result of a hundred battles.”

You have to formulate a game plan before going into battle. Especially if your enemy is bigger, stronger, faster and more cunning than you are. Studying your enemy will reveal weaknesses that you can exploit to good advantage. But you must also know your own weaknesses.

Most investors overestimate their ability to go head-to-head with the professional investor (PI). They think that they have some special insight or knowledge. They believe that the secret to victory lies in a secret that they can uncover. But it doesn’t.

THE ENLIGHTENED INVESTOR'S ADVANTAGES

Like everyone, professional investors are concerned about job security. In the investment business, staying gainfully employed depends on being able to blend in with the herd. Five millennia ago, when our ancestors were scavenging the Savannah dessert, there was little incentive to wander from the group. If you stuck out from the pack, you might end becoming some animal’s dinner.

In nature, blending in gets rewarded and risk-taking gets punished. Jeremy Grantham says “Being wrong on your own, as Keynes describes so eloquently in Chapter 12 of The General Theory, is the cardinal crime for an investment manager. To avoid this, the professionals try very hard to ensure that if they are going to run off any cliff they will: a) have a lot of company; and b) that most of the company will be one step ahead.”

If everyone makes the same bad investment bet, no one is singled out. However, if a PI makes a bad investment bet by reaching for an extra bit of return, there is a price to pay. This explains why a short-term trading mentality is so pervasive on Wall Street. Grantham adds “In short, the management of career risks results in very destructive herding.”

This reality leads to very predictable institutional behaviour. But is also affords the enlightened investor (EI) four important advantages.

ADVANTAGE #1 – Time and Patience

The EI is not measuring performance on a quarter-to-quarter basis. There are no short-term performance targets to meet. Therefore, he can he take a long-term equity investment position in a fundamentally sound company that is experiencing short-term hiccups.

By holding a stock for five, ten or even twenty years, an EI gains a huge edge over the PI who has to restrict his investments to companies that are firing on all cylinders. The PI is a slave to quarterly earnings estimates and management guidance (how a company is expected to perform).

The typical Wall Street portfolio contains high-growth companies that have the potential to deliver outsized short-term results. The PI loves story stocks and market darlings. He has no patience for a company that is going through temporary challenges.

The EI, however, is happy to pursue the wallflower that nobody wants to dance with. He is looking for a committed marriage, not a one-night stand. The PI tries to capture short-term gains and avoid short-term losses by constantly churning his portfolio. He is focused on trying to get ahead of the market.

The EI knows that “time in the market” and not “market timing” is his best friend. He can blithely ignore the noise in the marketplace. He has a list of desirable dance partners in his head and when she becomes available he swoops in to claim his prize.

He understands that the ability to “out-wait” the PI is an enormous equalizer. Patience and the stamina to slowly grind down the resolve of an opponent is highly underrated as an effective weapon. The last man standing is always the winner.

After flagging Colgate-Palmolive as a stock that I wanted to own, I waited patiently for five years until the purchase price entered my “strike zone.” When it did, I acted decisively.

It was like an old friend that I knew intimately. I had digested its financial statements and studied its movements as it expanded its global footprint with its ubiquitous products. Annual Reports, press releases, research reports, articles and investor websites all provided me with insight into how it makes money. It was marriage-worthy as an investment.

ADVANTAGE #2 – Margin of Safety (MOS)

In his never-ending quest for a fast buck, the PI will buy any stock, at any price and at any time. This of course is heresy to the EI who, by definition, is a well-informed value-investor. Insisting on a Margin of Safety (MOS) offers the EI another source of advantage over the PI.

Buying a stock with a MOS of fifteen or twenty percent built into the purchase price protects an EI from the consequences of making a bad investment decision. Regardless, errors of judgment WILL occur. This is a reality of investing that can’t be avoided, no matter how thoroughly an investment candidate is researched and analyzed. Even the master investors, by their own admission, make mistakes.

For example, buying a stock for $40 that has an “intrinsic value” of $50 offers an EI a MOS of $10. If the price of the stock drops by 10% he can still sleep at night. A MOS acts like insurance against a loss of capital if something unexpected goes wrong.

Intrinsic value represents what an investor thinks a stock is truly worth. It’s based on subjective judgement. As Buffet says, “Price is what you pay, value is what you get.” Buying with an adequate MOS ensures that value always exceeds price.

There is no shortage of information on the mechanics of calculating intrinsic value. But like everything else about investing, it’s more art than science.

The argument is often made that the purchase price of a stock is irrelevant because it will eventually appreciate in price. This is nonsense. An EI knows that the return from a stock always depends on the price that he pays for it. It’s a fact that price has a bigger impact on return than the growth rate.

This is demonstrated in the following example.

EI thinks that Dynamo Corp. is an interesting investment candidate and assigns it an intrinsic value of $100 per share. The stock is currently in the market trading at $110.

A disappointing earnings report which falls short of market expectations causes the price to drop to $80. EI, who has been following this company closely, pounces on the opportunity to buy it at a MOS of 20%.

Over the ensuing ten years, the share price of Dynamo Corp. grows to $200. EI calculates that the Compound Average Growth Rate (CAGR) on his investment over that period of time is 9.6%. PI earns a CAGR of only 6.2%.

What explains the huge difference between the CAGR earned by EI and PI? The price paid for the stock. EI patiently waited for a 20% MOS. PI jumped in and paid the full price of $110 per share.

This difference in CAGR between 9.6% and 6.2% might seem insignificant, but it has a huge impact on the terminal value of a $10,000 investment.

EI’s investment has grown to more than $25,000 while PI has to be content with a terminal value of $18,249, or 37% lower!

This demonstrates that a value-investor gets paid to wait for the “perfect pitch.”

ADVANTAGE #3 – Investment Profile

An EI wants to invest in companies that share certain qualitative and quantitative characteristics, making the stock-selection process much easier.

Here is the profile:

 Operates in an industry with favourable economic fundamentals: high barriers to entry, low fixed-cost structure and low capital replacement requirements.

 Has a sustainable competitive advantage over the other players in the industry (called an “Economic Moat”). The source of its competitive advantage can’t be easily copied or rendered redundant.

 Is not vulnerable to major disruptors: social, political, legal, demographic, regulatory, and technological factors that can have an adverse and sustained impact on profitability.

 Can increase prices without adversely impacting sales volume. It’s products and services have brand recognition (#1 or #2 in their product category) and have successfully avoided commoditization. Innovation plays an important role in driving growth and protecting its leadership position.

 Operates with a business model that is simple and easy-to-understand. Profitability is not dependent on an individual, concept, product or technology. The company’s business strategy is not constantly shifting to meet an ever-changing marketplace.

 Sells products and services that have a fast replacement cycle. Product demand is continuous and largely insulated from economic cycles.

 Run by a management that is honest, competent and shareholder friendly. The company has a long and consistent track-record of paying dividends and buying back shares.

Which companies meet these criteria? These are the twelve companies that an EI can’t afford to ignore. They represent the very best of the best. They are the tried and true.

Abbott Laboratories (ABT)

Apple Inc. (AAPL)

The Coca-Cola Company (KO)

Colgate-Palmolive Company (CL)

Ecolab Inc. (ECL)

Johnson & Johnson (JNJ)

McCormick & Company, Incorporated (MKC)

McDonald’s Corporation (MCD)

Microsoft Corporation (MSFT)

PepsiCo, Inc. (PEP)

The Procter & Gamble Company (PG)

Waste Management, Inc. (WM)

Every one of them, with the exception of two, sit in my stock portfolio. Can you guess which ones they are?

ADVANTAGE #4 – Hurry Up and Do Nothing!

Trading commissions and capital gains taxes that characterize the PI’s frenetic trading activity are avoided by the EI. Over time, these “investing levies” exact a substantial toll on returns. They are unseen and insidious, but are largely avoidable by remaining inactive.

FINAL THOUGHTS

Putting your portfolio on auto-pilot is the smartest thing that you can do, assuming that you hold the right stocks. Resist the urge to tinker with it. As Buffett says, “Inactivity strikes us as intelligent behaviour.”

Let the miracle of compound-growth make you rich!