Looking back at stocks from the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) over the last year, we have Blackmores Limited (ASX: BKL) at one end, delivering gains of 250%, and Slater & Gordon Limited (ASX: SGH) at the other, with a crushing loss of 96%.
So, which one was the better investment?
Clearly Blackmores had the better outcome! But to always assume the best investment is the one with the best outcome may be to think about investing the wrong way.
Consider this simple matrix:
Process vs Outcome
(Adapted from Winning Decisions: Getting it Right the First Time (Russo & Schoemaker))
What is a good process?
To invest well is to use an effective decision making process to determine: which companies to invest in and when, how much to buy, and when to sell.
According to the matrix, an investment in Blackmores was either deserved success, or dumb luck, depending on the process used. An investment in Slater & Gordon was either bad luck, or poetic justice!
Wilson Asset Management describes the process for their high-performing WAM Research Limited (ASX: WAM) fund as:
"Research driven investing, where we undertake extensive research (over 1,000 meetings with companies per year), focusing on the free cash flow, then rating the company with respect to management, earnings growth potential, valuation and industry position. We buy when we can identify a catalyst or an event that will change the valuation the market gives to the company. We sell once the company reaches our valuation."
Example of a bad process: Following a hot tip from some bloke at the pub.
Rewind 12 months
In March 2015, Slater & Gordon was selling for around $7.50. Recent returns to investors had been solid. The business had earnings momentum and was beating revenue forecasts. It boasted high returns on equity and low debt. Its acquisition of Quindell in the UK promised to be 'transformative'.
Blackmores shares were selling for around $45. It had recently announced record sales and profits, had high returns on equity, and improving margins. Sales in Asia were strong, with the potential for further growth in China.
Based on the information available at the time, it is easy to see how an investor with a sound process may have chosen to invest in, or continued to hold an investment in either business.
Proof of my point?
Wilson Asset Management applied their process (described above) and chose to invest in Slater & Gordon. Although they acquired it much earlier, it was in their portfolio in February last year, and was actually their largest position at the time.
A focus on growth stocks also meant they started acquiring shares in Blackmores in March at around $47.
Further evidence of a good process – based on their reports to the ASX, it appears WAM changed their view on Slater & Gordon and sold in May, avoiding nearly all of the decline.
What is the worst/best investment you have ever made?
These questions are redundant if you are focused on the process. Although the individual outcomes will vary, if your process is sound, and you followed your process, every investment was a good one. When you lose money on an investment, all you need to ask is:
- Did I follow my process?
Developing and following a decision making checklist for both buying and selling is a good way to make sure you do.
- Is there something I can learn from this to improve my process?
To just call it a 'bad investment' and move on is a missed opportunity to improve. Investors in Slater & Gordon who are focused on their process now have an opportunity to improve it going forward. Those who are well diversified will have escaped relatively unscathed, despite the large loss on an individual investment.
Foolish takeaway
The worst thing about a bad process is, even if it works once, it is not repeatable. You can't review it and improve it and continue to apply it over time. This is why blindly following a 'hot tip' is never a good idea.
Therefore, as investors, we should try to develop and apply a good process, and we are more likely to end up in the 'deserved success' category, despite the occasional 'bad break' outcome. Repeatedly applying a good process to investing will always win out in the long run.
