The Raw Material of Long Term Investing

How I Build Conviction to Sleep Well at Night

The following piece was inspired by a Tweet and a few people that encouraged me to write it. It took me longer than I thought, and I shamelessly borrowed a few great ideas from fellow investors I admire. As always, thank you for reading, subscribing and sharing.

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One of the most important investing skills has the following characteristics:

1. It can’t be taught, is learned from experience and you never fully comprehend it

2. The definition is ambiguous and changes from person to person

3. It will make you at times question yourself, look wrong and make mistakes

4. Mishandling it can kill you; using it appropriately enhances your wealth

5. It forms the basis for position sizing, risk management and long-term investing

Investing Conviction is the primary raw material required to hold a stock for the very long term. Many of us have experienced that warm exhilarating gut feeling when we find a company, develop a special insight that comes with extra confidence, and proceed to put our money where our gut is. Nevertheless how that exact feeling develops is hard to pinpoint, let alone describe in detail or grasp your mind around — it’s a very abstract and philosophical concept. Which is exactly why I think it’s worth investigating further.

What is Conviction?

“A firmly held belief or opinion”

— Oxford Dictionary

It sounds to me like this definition applies to religion, politics or an ideology, but certainly not to investing. If you wanted to, you could try it, but you’d likely run into trouble eventually. I think we need a different definition.

One the few hard-set rules in investing is that there are no absolutes. As investors we’re trying to predict something that by its very nature is unpredictable, so we can never state with 100% confidence that something will happen. You could arrive at a 90% confidence level, maybe even 99%. Just be sure not to confuse 99% with 100% because it will come back biting your ass sooner or later — an event with a 1% probability of happening in any given year has an 18% probability of happening at least once over 20 years.¹

What we strive to do instead is, after a lot of research and introspection, understanding a specific subject well enough to establish a belief that something is likely to happen with reasonable confidence. Importantly, you have to recognize that there is also a chance that it will not, and that you can never assign, no matter how much you know, an exact probability to that event taking place. It sounds hard and it is!

I spent almost two weeks pondering, trying to come up with my own² definition of investing conviction. After a lot of circling thoughts, I arrived at the following:

“A differentiated opinion on a company’s long term prospects, with a high level of confidence, achieved after gaining the required knowledge while becoming comfortable with the risks and aware of the consensus view”

—Sleepwell

It’s a bit long, I know. But at least to me personally, it is when I reach this state of mind that I’m comfortable making a long-term concentrated bet on a company.

So how do I get there?

A Framework for Building Conviction

By deconstructing my definition, we can notice that there are a few simple pre-requisites to arrive at the conviction state, which I will call Stages:

1. Deep Work: building your circle of competence and knowledge base, also known as the research stage

2. What Could Go Wrong: recognizing and becoming comfortable with the risks, probabilities and unknowns

3. Most Probable Outcome: establishing a view of the future state of affairs — The Story — that you believe is most probable and gaining confidence

4. What’s In The Price: understanding what the consensus believes today

Let’s explore each stage in more detail.

Deep Work — The Research

This may seem like the simplest stage, but likely it’s the longest and most important one. It’s also never-ending, given that as investors we strive to be constantly learning. The concept of circle of competence is central to this stage: if you’re going to invest in something, you better be sure you understand it well. This has been the biggest lesson Buffett has taught the investment community.

Each person has their own process, but for me this starts by looking at places that interest me and where I am familiar with the product and consumer. This greatly reduces the number of places I’m going to be hunting in. Biotech? A quick easy no for me. Tech? Skiing? Music? I’m all ears! After that first filter and finding an interesting candidate, comes the extensive research to really grasp the industry economics, business model, customer value proposition, competitive advantages, value-chain and competitor landscape, history of the company, management, etc. At the very least you should be knowledgable enough to engage in an hour-long intelligent conversation with someone who knows the company or industry really well.

Writing your thoughts is also a helpful exercise during this stage. It’s important to realize that you undoubtedly will come with a pre-existing opinion—it’s human nature. You must be careful not the let this go its way by just finding confirming evidence and making that view even stronger, as it may not be the correct one. On the contrary, you must try to approach the problem with a fresh and flexible mindset and recognize that the more you learn, the more you should adjust your beliefs and change your assumptions (write them down as you go!). You want to do the opposite of what the dictionary definition of conviction says, that is don’t become an ideologist.

I had a revelation on the importance of doing the real work on a company a few years ago, after reading one of Andrew Walker’s great pieces. He handsomely made the point of why doing the research yourself is so important: You can’t borrow conviction!

Andrew explains it succinctly:

“If I spend weeks doing work on an idea and post it on here, someone could read the idea, say "wow, that's interesting, I agree," buy the stock, and generate the same returns as me. For a long time, that struck me as unfair, but increasingly it doesn't bother me. Over the long run, I think a person who "steals" ideas will do substantially worse than a person who develops their own ideas simply because the "idea thief" won't have conviction in the idea, and that will lead to incredibly sub-optimal trading.”

This is truly the cost of long-term investing. If you put in the required effort to understand a company, you are more likely to hold the stock over the long-run and make better decisions. Think about it, if you’ve done the work and the stock sells off 30%, you are more likely to make the right decision than someone who just copied you — whether that is buying more, holding or selling. You know the story intimately so any incremental information you’re more likely to use to your advantage than someone who doesn’t know much.

What Could Go Wrong? — The Risks

As you’re doing Deep Work on a company, you will undoubtedly start forming a view and (should also be) thinking about the potential risks. A high-conviction investment for me is, first and foremost, one that has limited downside or low risk of impairment. This is especially true because I tend to make those investments sizable in my portfolio. As someone who was trained in fixed income-land, I prefer to start by approaching a company with the question “what could go wrong?” instead of the opposite optimistic question of all the possibilities of how it could go right (which most equity analysts start with)³. This is what Charlie Munger calls the invert, always invert mental model, and it’s very applicable here.

Essentially, you should be well aware of the main risks, which could be many, and handicap the probabilities of those events taking place — while acknowledging that there’s also completely unpredictable things you aren’t thinking of (unknown unknowns). The more Deep Work you do, the more aware you become of the likelihood of those events happening and decide if they are remote enough for you to be comfortable to make an investment. Again borrowing from Munger, if you can state the opposing argument better than your opponent, that’s a good test that you’ve thought about the problem.

For example, with Spotify which is a large position for me, I’m very aware and comfortable with the main risks: 1) Label relationships 2) Big Tech competition 3) Podcasting strategy 4) User growth saturation. There’s many more, but these are the most discussed and I believe I’ve spent valuable time doing the work, speaking to people with opposing views, and deliberately thinking through each one of them and their probabilities. This idea applies to every single company out there, there’s no such thing as a company without risks.

Most Probable Outcome — The Story

Simultaneously as you’re thinking about the company’s risks while doing Deep Work, a story will be forming in your mind of how things are likely to play out in the future. Once again, the more work you do, the more visible it becomes. This story will form the basis of your opinion on the company, but itself should be an output built upon a series of inputs or key value drivers. These are the assumptions that you make, built from the knowledge you’ve acquired.

Personally, I prefer simpler stories where most of the value is derived from 2-3 variables instead of 10, and where I can build my assumptions related to those inputs with reasonable confidence. Some of the best long-term investments shared this characteristic, a few simple inputs that drove the majority of the value over the years — Big tobacco comes to mind here: pricing power, regulatory barriers and brand loyalty. Boom! 20% compounded annual returns for 50 years (no, I did not own this one). On the other hand, there’s a reason why I’ve never invested in an oil & gas exploration company: I have no idea where the price of oil is going which is precisely one of the biggest value drivers.

These inputs, based on your assumptions, should spit out an outcome: The Story. This is essentially your best educated guess of how the company will look like in a future point in time. This includes (not extensive) how the industry and total market will grow, how the competitive dynamics will play out and most importantly what the economics of the business will be like.

Another key part when you’re crafting a story, is to be well-aware that it’s never a certainty (remember: no absolutes!). Instead, it’s important to think about the likelihood of that view taking place and connecting it with the previous stage of potential risks and downside scenarios. Once you reconcile those, you can have a better sense of the potential scenarios that could play out and guestimate the probability that surrounds them —this also prepares you on how to react as they happen.

There’s also an upside or “optimistic” scenario, which some people underwrite. I prefer to focus on the most likely outcome using realistic and conservative assumptions and any upside from that be a pleasant surprise. On that same note, the really good businesses and management teams tend to surprise you more on the upside than the downside — something to keep in mind.

What’s In The Price? — The Consensus

Investing successfully mostly comes down to what your belief is versus expectations. You could have a perfectly clear view of how a company is going to look like in the future, but if all of that is already in the price, there’s not much money to be made. This is the importance of valuation (you thought I forgot about you value investors huh!).

It’s not about high multiples or low multiples⁴. You need to reconcile what your story is versus what the market thinks. Some people approach this with a reverse-DCF, which is a helpful tool: playing around with different future assumptions to arrive at the company’s current valuation. Looking at long-term sell-side estimates can be helpful too. Seeing what other investors are saying about the company can also give indication around the sentiment—a quick Twitter search will do wonders here.

For me, what it essentially boils down to is taking The Story I built of how the company’s economics might look like, discount that at an appropriate rate and compare it to the valuation today. This sounds like a simplified model and it’s exactly that. If my estimated value is significantly higher⁵ than what the market is paying for right now, then I know I’ve built conviction and proceed to invest.

You Now Have Conviction…What’s Next? 

“The first principle is that you must not fool yourself — and you are the easiest person to fool.”

—Prof. Richard Feynman

Congratulations, you’ve achieved conviction! Not so fast, it’s no time to celebrate because that could lead to complacency and that is a dangerous state of affairs. The final step is the hardest: monitoring incremental information that will test your existing assumptions (prove them or disprove them). You need to be able to separate the signal versus the noise: realizing what matters to the investment and what doesn’t, and in the words of Lord Keynes: change your opinion when the facts change.

Patience is key here as well. If your company is executing with focus and the story and your assumptions are playing out, it’s probably best to hold on to the investment. That’s how the big money is made. What I’ve found is that when you spend most of your time thinking about a company’s prospects over the very long run (which at times the market doesn’t), you end up training yourself to become more patient. This will also help you prevent making mistakes such as selling the stock because it ‘seems’ overvalued on current multiples. Always go back Stage 3 and compare (again) what the market is implying today versus your expectations of that future state. Also remember, the best companies grow intrinsic value over time, so their stock is supposed to go up, just not in a smooth up-and-to-the-right-line fashion.

It’s in this last step where you have to find a balance between being both humble and confident. In other words, you must be able to deal with mistakes⁶ and willing to look wrong. On the other hand, you must trust your own judgement, your framework and the work you’ve done. Selling a stock you’ve held for a long time is a difficult decision; but holding on to it for decades is an even tougher one, because it’s constant and for that you need conviction.

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Here’s the Tweet (and response) that inspired the piece

Greg Capital @phoenixvalue

What is your highest conviction long?

Sleepwell Capital 🛌 @SleepwellCap

@phoenixvalue I want to write a piece on my Substack titled: What is Conviction? fascinating subject

If you’re interested, I also discussed some of this topic and more in this podcast.

1. This is known as a binomial distribution

2. Emphasis here because it will vary from person to person

3. For some additional tools on thinking about the downside as an equity investor, take a look at my recent piece What The Optimist Can Learn from The Pessimist.

4. Multiples are not valuation! I have an investor friend who I admire who says that multiples are pretty useless, I’ve come to agree more and more with his view.

5. Hard to put an exact number around this one, some companies it could 50% higher, others with more potential scenarios or optionality, 2X may be more appropriate. Another highly personal situation.

6. Even the best investors are wrong maybe ¼ of the time