James Montier—who works alongside Jeremy Grantham at GMO—is my favourite investing author. He writes with a verve and clarity that’s missing from most in the industry. In simple, easy to understand language he debunks many theories finance professionals hold dear (such as CAPM). He’s written a number of books including the Value Investing: Tools and Techniques for Intelligent Investment (which I reviewed here) and Behavioural Investing among others.
Here I’ll focus on his recently published paper: ‘Seven Immutable Laws of Investing’.
- Always insist on a margin of safety
- This time is never different
- Be patient and wait for the fat pitch
- Be contrarian
- Risk is the permanent loss of capital, never a number
- Be leery of leverage
- Never invest in something you don’t understand
Let’s focus on two ‘Always insist on a margin of safety’ and ‘Be leery of leverage’.
‘Always insist on a margin of safety’
That is, don’t overpay. Successful investing involves admitting you’re fallible and insisting on only buying stocks that are trading at a discount to your estimate of intrinsic value. Of course this idea didn't start with Montier but the father of value investing, Ben Graham (see Chapter 20 of Intelligent Investor).
Indeed, overpaying is what causes most permanent losses of capital. Montier provides a useful example. In 2000, Forbes published a ‘Ten Stocks to Last the Decade’ portfolio, which included Nokia, Nortel, Enron, Oracle, Broadcom, Viacom, Univision, Schwab, Morgan Stanley and Genentech. The results have been disastrous, if you’d followed Forbes’ advice you would have lost around 75% of your capital. The principal sin wasn't picking terrible businesses—most in the list have grown earnings over the past decade—it was paying far too much for them, the average PER at purchase was 347!
Investors in the recent Facebook IPO face a similar problem. There’s no doubt Facebook will be larger and more profitable in 10 years time, but it has to grow at an amazing clip (circa 40% a year) just for investors to break even, let alone make any money.
‘Be leery of leverage’
Leverage, or ‘debt’, should always concern investors. There are a few ways debt can get investors into hot water, and some are less obvious that others.
First the sheer quantum of debt can be far too high. For many businesses, such as services companies (e.g. Enero, UXC, Monadelphous) the correct amount of debt is zero—operating conditions can change swiftly and when they do the consequences can be disastrous. Balance sheets are important, and it pays to keep a close eye on gearing. The question should always be: 'Does this business have too much debt?'
A second less obvious risk relates to refinancing, what I call ‘roll over’ risk. Companies that use debt need to regularly go back to market to refinance it. And if capital markets dry up, as they did in 2008/9, a company can go under regardless of the underlying performance of the business.
This is exactly what happened in the A-REIT (property trust) industry during the GFC. The assets continued to perform—rents kept rolling in—but no banks were willing to lend and shareholders were mercilessly diluted causing permanent loss of capital.
This lesson shouldn't be soon forgotten. Whenever you're considering an investment that involves debt, check when it's due, typically longer dated debt is better. Property groups such as Stockland, Westfield and GPT Group are inherently less risky than smaller companies such as Abacus or Australand because they can lock in long dated (often 10 years ) debt.
Just following these two rules will save you a stack of money—let alone all seven. I've pinned the list up on my desk as a constant reminder. It wouldn't hurt to do the same.