7 investing principles to generate alpha

Many of my friends have asked me why I think I can beat the market or how I have picked AMD & Tesla previously. I want to lay out my investment principles to explain the sources of alpha. Before I do that, I want to explain why investment principles are essential. There are two types of decision making:

1. Result-based decision making
2. Principle-based decision making

Results-based decision making is making a decision based on the outcome, which is helpful for things mainly in your control. However, investing, like many things in life, is not. The results are far from certain: even macro factors could overweigh micro factors of a specific company. Therefore, you can only make decisions based on your principles and hope for the best.

Without any further delay, these are my investment principles:

1 - Focusing on inflection points

Although some might disagree, the stock market prices public companies well and even growth is taken into account by the army of analysts whose sole job is to predict future earnings. Therefore, to generate more alpha than the market, one cannot simply invest in predictable stocks. Instead, to generate significant alpha, one needs to have a unique point of view and bet against the market.

Turnarounds - where a company is in decline and then thrives - is an example of an inflection point. These situations are hard to price by the market, and my previous investment, AMD & Tesla, is such an example.

Optionality, where the company enters a different market or launches a new product - where the company goes from 0 to 1 instead of scaling from 1 to n - is another excellent source of alpha. Would the opportunity be significant if true? Optionality primarily drove my investments in Razer for example.

2 - Investing within your knowledge

Research shows that 85% of money managers can't beat the market and can't outperform their respective benchmark index funds.

What makes you think you have a right to earn extra alpha over the market? Are you more knowledgeable compared to 85% of investors in this market?

Having used the product and having the perspective of the customer helps you avoid overly hyped-up companies. Beyond Meat sounds good in theory but doesn't taste any good, and their recent stock performance (in 2022) is a reflection of that. Also, avoid companies that hide behind complicated terms or obscure their business model.

Understanding the business on the technical level allows you to predict where things will go. For example, I'm a computer engineer by training, which will enable me to understand semi-conductor and software stocks. I'm also a co-founder of a Micromobity/ Robotics delivery startup, allowing me to understand EV stocks  & mobility stocks. So ask yourself this: what are you uniquely positioned to understand better than the market?

3 - Choosing high-quality companies over cheap companies

A wonderful business at a fair price is far superior to a fair business at a wonderful price - I tend to go for high-quality rather than cheap companies. I learned this principle from Warren Buffett's Cigar butt investment style (Warren Buffett's "Cigar Butt" Approach To Investing – Superior North LLC). With a high-quality business, it will constantly return you capital and will be far more profitable than extracting the last "puff" from a cheap cigar butt.

For example, a tell-tale sign of a highly differentiated business with strong moats is a high gross margin compared to peers.

4 - Investing in small companies

Large-cap companies usually have armies of investors and analysts covering them. It's much harder to find companies that are undervalued. To find 10 or 100 baggers, its much easier for a100m market cap cap to 10x to 1b compared to a 500b company to go to 5T.

5 - Investing for the long term

"In the short run, the market is a voting machine but in the long run it is a weighing machine" - Benjamin Graham

In the short term, sentiment drives the stock price - it is difficult to predict and measure accurately. We shouldn't waste our time betting on the short term. As retail investors, we are unlikely to be able to time the market correctly.

However, over the long term, the stock price would reflect the actual quality of the business and the price will eventually catch up with the business's intrinsic value.
Before investing, ask yourself:  What will the company be like in 1, 5 or 10 years?

6 - Focusing on qualitative rather than quantitative

Favour qualitative aspects such as management, moats and brand compared to financials and numeric metrics. The market does not readily understand qualitative factors, which are excellent sources of alpha.

Given a company with strong qualitative factors but middling financials vs strong financials and middling qualitative analysis. Take the former.

Also, financial metrics, in general, are also rearward-facing and not indicative of future performance.  Use financials more as a confirmation of a great business.

7 - Concentration as compared to diversification

This principle is a controversial one. To me & Warren Buffet: Concentration is for building wealth, while diversification protects it. I'm in the wealth-building stage and have the time to actively research the company. I want to concentrate my knowledge on a few companies and understand them inside and out. Moreover, the knowledge reduces the risk of risker stocks. You might be in a different position.

"You know, we think diversification is—as practiced generally—makes very little sense for anyone that knows what they’re doing...it is a protection against ignorance." - Warren Buffet

However, it is also important not to go overboard with concentration as having a portfolio of assets can be beneficial - such as pairing high risk & low-risk stocks or having dividend stocks to fund a DCA strategy.

Conclusion

These are the investment principles I use to guide my stock picks. Before investing, do ask yourself what are yours.


These investment principles are used at a high level to filter companies, however, I do have a framework to evaluate shortlisted companies: Do you have an Investment Framework?? (melvinfoo.com)

Thank you financial avocado for inspiring me to write my investment principles: 7 Investing Principles for Better Investing - Financial Avocado