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  5. Lessons From The Trenches

Lessons From The Trenches

In this 5i Research educational article, we’ll highlight some of the major investment lessons we’ve learned over almost 25 years as a Portfolio Manager and Analyst. Maybe we haven’t yet “seen it all”, but it’s hard to imagine what else the markets could possibly throw at investors to surprise us: We’ve survived: The 1987 market crash; the 1991 real estate crash; the 1997 Long Term Capital hedge fund crisis; the 1998 Asian Crisis; the dot-com boom and bust; Y2K worries; the 2001 recession and terrorist attacks; the cheap-credit bubble; the 2007-08 credit crisis; Lehman Brothers’ bankruptcy; the Flash Crash; numerous wars; epidemic scares (SARS, H1N1, bird flu and countless others); the U.S. housing collapse; Japan’s decline and China’s growth.

Through all of these events we’ve learned that (a) a crisis is indeed bad; (b) a crisis always ends; (c) investors panic unduly and (d) good companies are always good companies, good times or bad.

Every time there is a crisis, investors re-discover the fear of the unknown. As investors, of course we do not know when the current crisis—whatever it may be—is going to end. The problem, though, is that investors act as if the crisis will NEVER end. They sell on the belief that prices will keep going down, wars will keep going forever, or a small flu scare will run amok and take over the world like in the new movie Contagion.

Twenty-five years in the business, though, has at least taught us that a crisis always does end. It is painful, sure, but end it does. In the 2008 credit crisis, for example, S&P reported than more than 1,100 companies actually traded below their net tangible cash balances. Investors were so scared, effectively, that they were willing to give away cash, literally. At the time though, because of money market problems, it looked like cash wasn’t even worth anything.

When the next crisis hits—and there most certainly will be one again someday—keep in mind that it will end, either sooner or later. If you have some time and some liquidity in your portfolio, then hang on to your good companies, or buy more shares of the good companies. Stay calm, and let the other investors panic into giving away quality companies.

The Single Best Idea

The single best investment theme we can provide after 25 years is this: When a company declares its first-ever dividend, pay attention. Buying first-dividend payers has provided the portfolios we ran with so many gains that if we were to do only one thing in the future, it would be to scan the world for companies initiating dividends.

A first dividend tells you so many things: the company is doing well, the company has excess cash; and the company’s board respects shareholders and probably owns lots of shares themselves. In addition, a first dividend is only done after careful consideration by the board of directors, and its initiation likely means many years of steady, if not rising, dividends. Two companies that recently initiated their first dividends are: Primary Corporation (PYC on TSX, yielding 5.5% right now) and DSW Inc. (DSW on NYSE, yielding 1.3%). DSW also decided to pay a special $2 per share dividend at the time it declared its initial $0.15 quarterly dividend. The result: The stock is up 89% over the past year.

Another lesson learned over the past two-and-a-half decades is to try to avoid listening to the mainstream financial media, especially if you are trying to act rationally. As you know, bad news sells more newspapers and gets more viewership on TV. When the stock market plunges, it always gets more attention than when it goes up. TV commentators, in particular, get all excited and breathless in a market decline. Thus, as a reader (or TV viewer) you might think that a market drop is more important than a market gain. It’s not, though, unless you are a buyer. A market decline typically only represents an event in the macro economic environment. It is often due to portfolio managers simply changing their asset allocations, and has absolutely nothing to do with a strong company’s performance. In other words, good companies stay good companies, despite a 2%--5%--10%--20% market drop. Don’t let the media convince you to sell a good company.

It pays to be a cynic

A similar investment lesson involves brokers and research analysts. In our cynical viewpoint, changes in brokers’ recommendations and target prices are designed to do only one thing—generate trading activity. For the life of us, we don’t know why an analyst would put out a price target on a fast-growing company. If the company keeps growing and/or the market simply goes up, your price targets are meaningless. Let’s look at a few laughable analyst targets from the past: RBC Capital Markets had a $31 target on Bank of Montreal stock in 2009, during the last stage of the financial crisis. With BMO stock at $28 at the time, you as an investor might have sold at the $31 target, missing out on an additional $28 per share gain to today’s price, and more than 5% annual dividends along the way. Or how about Netflix: Credit Suisse told investors to sell the company, with a $31 target price in January , 2010, well after the financial crisis ended. Eighteen months later Credit Suisse’s target price was $310, and they wanted you to buy it.

Not to pick on analysts, but this does highlight the limitations of recommendations and target prices. Rather, instead of acting on recommendations or target prices, we’ve learned you should try and buy good companies, and keep your shares until you need the money or they cease being good companies.

Finally—for this piece at least—the last lesson we can share with you is to watch out for conflicts. Everyone makes money in the investment business, except the individual investor. Advisors earn fees, investment bankers earn fees, fund managers earn fees, traders earn fees, and analysts get bonuses. Whenever someone is paid, the potential for conflict exists. We can’t tell you how often we’ve met a company management or research analyst who extolled the virtues of the company, only to get a phone call a few days later asking us if we wanted to participate in a financing for the company. Now, was the management team or analyst saying good things so we would buy the deal? How much does the broker make in commission off the deal? What’s the investment banking charging the company? How much is the analyst’s bonus? With such a conflict of interest, we basically learned never to trust anyone. It was a cynical environment, but saved us and our investors tons of grief. Anyway, we’ve discovered over the years that the best companies to invest in are those that need no money, and get no attention. But that will be covered in a separate piece.