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That Kool-Aid Might be a Killer

 

There is nowhere in the world outside of casinos that provides as much promises of quick and easy riches as the financial markets. Your co-worker keeps telling everyone how much money he/she is making in cryptocurrencies or marijuana stocks. Your spouse sees Tesla’s stock going up over 1,000% since 2010, or Snapchat’s shares soaring 44% on its IPO debut, and wonders out loud why you didn’t invest in such an “obvious” investment.  Stock brokerages and banks put out ads telling you that you’re richer than you think, and that you’re just one investment away (with them) from living the rest of your life in the Bahamas.

The lure of easy money plays to powerful psychological biases that affect everyone. Many people capitulate and end up investing their money into things they don’t fully understand. This behavior is often described as “drinking the Kool-Aid”, a reference to the tragic Jonestown deaths. The issue at hand is not whether cryptocurrencies or weed stocks or Tesla or Snapchat shares are good investments, but rather the reasoning behind the investing. The rationale for many of these investors is as follows:

1) Everyone is making so much money in this, and it’s obviously the next big thing

2) I must get in (either to this stock or the next one) or else I’ll miss my chance at riches

Note that there is no careful consideration of the potential risks or valuation, but a mere hope that what is going up will continue to go up.  This is much more like gambling at a casino than rational investing.  Ultimately, history has shown time and time again that speculating in this way is a disaster. Both the dot.com bubble in 2000 and the Nifty Fifty stocks in the 1970s demonstrated that paying high prices for the future is a terrible way to invest.

At Baskin Wealth Management, we try to avoid getting carried away with investing trends and “drinking the Kool-Aid” in the following ways:

We view all of our stocks as actual businesses, and evaluate them based on their cash flow generating capabilities. Many people view stocks merely as numbers on the screen with no consideration that each stock represents an enterprise with employees that provides real-world products or services that people buy. Our focus is not on whether the stock price will go up (although obviously we hope it will), but rather on whether the underlying business is doing well and making money. Our belief is that the share price and dividends that are paid out in the long-run will ultimately match the performance of the business.

We only invest in what we understand, and in what is working The corollary to point 1) is that we only invest in companies that are profitable today. We never invest in “lottery-ticket” companies, such as a junior gold mine or internet startups, since it is impossible for us, or anyone else, to predict the success of these ventures. We prefer to find companies with stable economics where we can clearly identify the key drivers of the business. As such, most of our companies do not need a specific catalyst for the stock to go up, since they are constantly making money and either returning the cash to shareholders or re-investing it in the business.

We employ strict valuation criteria. We keep a careful view of the valuation of both potential new investments and of existing holdings, both relative to the market and on an absolute basis, but most importantly based on the cash flow we expect the business to generate. We expect to buy more of a stock if it gets cheaper and hold or even sell those that get unreasonably expensive.

We utilize an investment committee approach to security selection. Each potential and existing idea is thoroughly debated between the members of the committee. As it happens, there are some members of the committee who tend towards optimism while others tend towards the other side. This provides for healthy debate about each of our holdings, and once again helps us invest based on the true merits of each idea.

Obviously our approach will likely prevent our clients from experiencing the 677% YTD return that Bitcoin has generated this year. At the same time it avoids disasters like the 50% drop in Snapchat in the few months since its initial public offering.  Our strategy helps us and our clients sleep well at night, knowing that the companies we invest in are going to continue to make money this year and into the future.

Ernest Wong