Reading letters from other investors can be a great learning experience. Reading about the investment approach and process of other money managers has helped me a lot in enhancing and defining my way of investing over the years. Many letters also provide an invaluable source of investment ideas and evaluations of different business models. Take for instance Sequoia Fund, one of the long term success stories in the fund industry. On their website you can find all the reports to investors and investor day transcripts back to 1999. About one year ago I read about their take on Rolls-Royce where they described the industry and business model in just a few sentences. Given the fund managers’ ability to make complex issues seem simple, just a few paragraphs were sufficient to put across a good understanding of the company’s strengths, some of its weaknesses and its future growth potential.
However, here the easy part ends. Reading investment cases and discussing companies with fellow investors can be part of the process, but this will not suffice to take a balanced investment decision. To the contrary, at the end of the day each investor follows his own agenda. Therefore, following other investors is not giving you a short cut in constructing your portfolio. Thorough analysis including working through the financials and validating the business case on your own is still imperative. In addition, though there are defined concepts in valuing companies the execution can differ widely. Sometimes, I get the impression that some investors take a liberal approach for instance by keeping off-balance sheet liabilities or pensions out of the equation or by using EBITDA as proxy for the company’s free cash flow generation. Consequently, companies appearing cheap after reading an investor letter, might provide a much lower margin of safety or none at all after applying your own valuation methodology.
Coming back to Rolls-Royce, I started analysing the company about one year ago after reading through Sequoia Fund’s publications. I came to the conclusion, that shares of Rolls-Royce at the current price were not an attractive investment for me. Nevertheless, I like the company’s business and therefore put it on my watch list. During the third quarter 2015 the stock pooped up on my screen after reaching a certain price level. I revisited the company and based on the information available I took the decision to invest.
Now something interesting is happening. Almost every second fund manager publishing his quarterly report is making a case for Rolls-Royce. I highly regard these fund managers, otherwise I would not invest the time to read their writings. And normally it feels nice to be in good company. However, investing is different. The only way I can achieve above average returns in the financial markets over the long term is to stay away from the crowd.
So is the recent accumulation of positive buy side comments on Rolls Royce a contrarian indicator? Yes, it should be. However, I would be more concerned if this affected a small cap company. With a market cap of EUR 16 bn, a company like Rolls-Royce is drawing more attention from market participants than my median investment with a market cap below EUR 500 m. There are other companies like Google/Alphabet which can be found in many fund manager portfolios, but might still qualify as good investments. Moreover, shares of Rolls-Royce have been fallen almost 50% from their peak in the beginning of 2014. So of course, value investors might be attracted by a potential multiple contraction. In addition, sell side research indicates a negative view on the stock with 8 sell ratings, 15 hold ratings and 3 buy ratings, which is generally a good sign. This at least indicates that the short term headwind the company faces is reflected to a large extent in the stock price giving less weight to the company’s potential long term success.
Nevertheless, just assume we all read Sequoia’s reports, came to the conclusion that the stock is not cheap enough and waited until the stock price fell further, revisited the company and then decided to invest. As we all know the investment industry is a very competitive landscape. One of the major tools an investor has is to think independently. From this perspective, following other investors is counterproductive despite doing your own research as an investor. That’s also because reading through investor letters with most of them only focusing on the potential rewards and only to a smaller extent on the risks is going to influence the reader’s thought process. Consequently, it becomes more difficult to get to a dispassionate conclusion on your own.
Still, I believe that reading other investors’ letters can be beneficial. Especially at the beginning of an investment career it can be very helpful to gather knowledge. For instance, it can be a good exercise to analyse a company first and read the write up afterwards. It is also a nice approach to transfer a company’s virtues written about in an investor letter to other jurisdictions (e.g. from the US to emerging markets) or the small cap universe to find comparable companies. The crux is to always treat the writings of other investors with critical engagement. As many things related to investing this can be a great learning experience.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!