The difference between a good investor and a great investor

Think back to your education. If you went to university, think back to your student days and if you did not attend university, think back to your school days. Now tell me what you learned then that you still use today and that helps you in your professional life? And before you moan about how everything you learned at university was useless in real life, let me assure you that this is not true. All of us are shaped by our education and there definitely are several things you learned at university or in school that you still use today. So, try again and think about what you learned.

In my case, the number one thing I learned at university was how to solve problems. In a previous incarnation, I used to be a physicist and mathematician. This meant solving integrals of complex functions or calculating the polarisation of sodium D1 and D2 lines in the solar spectrum (don’t ask).

I have been working in finance for roughly two decades now and it would be easy to claim that nothing I learned at university is useful today. But in truth, I use my problem-solving skills every day at work and these skills were developed during my university days. While my ability to solve integrals may have become a bit rusty over the years, my problem-solving skills have improved because I applied what I learned to an ever-widening set of problems.

One simple example is that I tend to solve problems following the approach advocated by mathematician Carl Jacobi: “invert, always invert”. Jacobi argued that many complex problems can easily be solved if you invert the problem and think about the solution you want to find and then work backwards to your current situation. If you do that, you will often find the quickest and most effective solution to what seems like an intractable problem. In mathematics and physics this inversion technique is used all the time, and I use it time and again at work when trying to assess market developments or investment opportunities. To me, this is just common sense.

However, if I look around in the investment world, I see too many research analysts, fund managers and investors who are – to stick with my example from above – able to solve integrals at incredible speed, but unable to solve any new problem they have not encountered before.

Research analysts and fund managers typically have been trained in finance and learned everything about financial statement analysis and how to calculate valuation ratios etc. Correspondingly, they know every little detail about the companies they cover, from the dividend coverage ratio to the amount of earnings growth expected in each of the coming five fiscal years. And while that knowledge may be impressive, it does not make them great investors.

How can it be that during the tech bubble, many analysts on both the sell side and the buy side assumed that technology companies would grow their earnings by 20% or more per year into eternity? Making that assumption may give you a fair value in your discounted cash flow model that is in the vicinity of current market valuations for a company, but if earnings were to grow at 20% into eternity, this company would pretty quickly own the world. Heck, analysts currently estimate long-term earnings growth for Amazon to be 37.6% per year. Assuming the PE-ratio of Amazon stays constant, this growth rate would mean that in 2050, the market cap of Amazon will be bigger than the US GDP. Research analysts who cover Amazon and fund managers who invest in it tend to know many details about the company, how it makes money and where and how it can grow in the future. Yet, all their technical expertise makes them miss the forest for the trees.

Invert, always invert.

Now think of all the great investors in history. What differentiates them from the run of the mill investors of this world? Think of people like Warren Buffett and George Soros, Seth Klarman and Howard Marks. If you go back in history, think of people like Ben Graham or Peter Lynch. While all of them have different styles and approaches to investing, they all have one thing in common, in my view: they are investment philosophers.

Look at the typical fund manager interview on TV or in the papers. Typically, these fund managers share their “wisdom” about why they love growth or income stocks or why they think the Bank of England will hike rates or not – aka talking their book. Listen to Buffett or Soros and you will find that they don’t talk about any of these technicalities. Instead they talk about the big themes and trends that drive markets today and will drive them over the coming years. They are thinking about the fundamental drivers, not about the recent data flow and they have developed investment techniques that can flexibly be adapted to a broad range of problems to understand market dynamics.

If you read Ben Graham’s books “Intelligent Investor” and “Security Analysis”, Howard Marks “The Most Important Thing” or Seth Klarman’s “Margin of Safety” you will find that they are timeless. Some off these books are decades old and still as relevant today as they were when they were first published, because they don’t focus on technicalities but rather on how to assess investments in a fundamental and ultimately informative way.

So, in the spirit of “invert, always invert”, if you want to become a great investor or research analyst you should aim to become an investment philosopher. This, in turn means honing your skills in understanding market dynamics rather than memorising data points or performing the DuPont analysis of return on equity. To be sure, you still must be able to do this if you want to become a great investor, but once you have understood the technique and how to calculate the elements there is no more added value in doing it over and over again or to an ever more sophisticated level. It will keep you busy, but it won’t make you better.