The only real mistake is the one from which we learn nothing

The only real mistake is the one from which we learn nothing.” ~John Powell

Even the best asset managers make more mistakes than is commonly acknowledged.Take a look at Warren Buffett’s portfolios over the years and you will be amazed by how many dogs he has owned, to the extent that you will be inclined to ask, what was he thinking? What Buffett has done so well is to generally have a very high hit rate and, in particular, to allocate proportionately more capital to those good calls.He has also taught an entire generation about the virtues of owning high-compounding businesses for long periods of time.

In its basic form, an investment process is all about putting together a method of identifying good potential investments - where the odds of success are more likely to be in your favour than not - and effectively allocating capital to those investments after considering the likelihood of you being wrong.

There is a huge array of factors that impact share prices including: economies, competitors, management and investor sentiment.Most of these factors are very difficult to forecast and it is often futile to even try.What we prefer to focus on is the controllable parts of our investment process in order to ensure that we give ourselves the best odds of producing better than average returns over a reasonable investment horizon.

As part of the evolution that is the building of an investment process, we have given a lot of thought to the mistakes that we have made in the past.Many of the tweaks we have made to our process have been orientated towards learning from these mistakes.

I thought it may be interesting to discuss the three most common, and fixable, mistakes we believe we have made in recent years.They are:

1. Selling higher quality compounding stocks too early.

High quality compounding stocks form the core of our portfolios.Due to a combination of competitive advantage (moat) and excellent management, they generate high returns on capital which they can choose to reinvest in their franchise or return to shareholders as a dividend.The problem is that quite often these businesses are optically expensive but after compounding earnings at a high rate for a few years they grow into their rating pretty quickly.

We ensure that our process caters for these compounding opportunities by determining an estimated intrinsic value that incorporates the value of future growth for companies with a sustainable competitive advantage.This should prevent us from selling quality compounding stocks too early, a mistake we were often guilty of in the past.Typically, we would expect to own these companies for many years unless the share trades materially above our estimate of intrinsic value or the company fundamentals change.

2. Insufficient Margin of Safety for mean-reversion opportunities.

In our quest to find under-valued stocks, we also seek out stocks that are trading at a significant discount to the value of their assets or their normalised earnings power.We refer to these as mean-reversion opportunities.Typically, these are businesses without a moat and, unlike our compounding investments, it is our objective to only hold these stocks until the gap to our estimate of a conservative (or margin of safety) value is closed.

With the benefit of hindsight, a year like 2008 showed us how rigorously we need to stress test our margin of safety values. Lower quality businesses need to be very cheap for us to buy them, and we also are careful to analyse the strength of the balance sheet before buying.

1) Giving poor or untrustworthy management teams the benefit of the doubt.

A careful assessment of management to assess their competency and alignment with shareholders is a key pillar of our stock analysis.Competent management teams run the business efficiently, understand market dynamics, and manage the business accordingly.If they are effectively aligned with shareholders they will make decisions that will benefit the sustainability and returns of the company over the long run.Here, we pay particular attention to whether management teams have material shareholding and how their incentivization is structured.

Most of our bad investments over the years have been in companies where the management team has been poor, untrustworthy or not appropriately aligned with shareholders.

In life, the good thing about making mistakes is that you get a chance to learn from them.In investment markets they are an invaluable part of trying to become better at what you do.We believe that tweaking our process to cater for mistakes made in the past results in a more robust process going forward.We will make plenty of mistakes in the future.We like to believe they won’t be the same ones.