Top investors share their biggest investment lessons

Five of our Super 60 fund managers name mistakes made early on in their careers that they learnt from to become better investors.

There are plenty of investment lessons worth learning early on: that mining minnow probably won’t strike oil; it’s unlikely that an undiscovered technology company’s revolutionary software will actually change the world; and cryptocurrencies may not make you an overnight millionaire.

All investors must go through some pain to discover the realities of financial markets.

No matter what their marketing teams suggest, fund managers are also not born with a fully fledged investment process, but instead will need to experiment to work out their investment path. Along the way, they will make mistakes and good fund managers will learn from them. Here, some of interactive investor’s Super 60 managers share the pivotal moments that helped shape them as investors.

It is abundantly clear that crises are far more useful in helping mould good fund managers than a benign environment ever could be.

Neil Hermon, portfolio manager of the Henderson Smaller Companies (LSE:HSL) investment trust, says crises have helped inform his investment style: “Two of the biggest lessons I’ve learnt in my fund management career have come in periods of significant dislocation in markets.

“The first was the tech bubble and the subsequent tech crash in 1999 to 2002. Investors lost the ability to think rationally about how to value ‘growth’ companies. This collective myopia ended in tears. My lesson was never to overpay for a company’s growth prospects, however good the outlook appears to be.”

The financial crisis of 2008-09 brought a lesson on leverage. He says: “Pre the crisis it was very much the vogue, with low interest rates, to operate with highly leveraged, ‘efficient’ balance sheets. Why not retire ‘expensive’ equity and replace it with ‘cheap’ debt.

“All well and good when economic conditions are rosy but less so when you enter a recession. Lesson – beware companies with high levels of debt – the global economy has cycles and a downturn with high financial leverage is a very dangerous place to be.”

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Scott McKenzie, one of the co-managers of the TB Amati UK Smaller Companies fund, also drew some lessons from the financial crisis. He was initially wowed by the teachings of the great value gurus: Benjamin Graham, Seth Klarman, and others.

He adds: “The idea of buying deep value ‘cigar butt’ stocks as espoused by Graham in particular, was, at the time, seductive.” In particular, he liked the idea Warren Buffett famously described his initial purchase of beaten-up Berkshire Hathaway (NYSE:BRK.B) as an error of judgement.

However, the financial crisis changed his view. “The deep value approach prospered in the early 2000s after the first internet bubble, but it has subsequently been found wanting, and over the past decade, has been positively dangerous. The lessons I learned are clear: buying low quality companies, even with high margins for error in valuation, still requires the investor to find other investors to whom one can sell such a blemished asset.”

It also means any failures of analysis are punished disproportionately. Investors are in danger of “picking up pennies in front of a steamroller”, as a certain types of hedge fund strategy were labelled.

McKenzie adds: “The prospect of permanent capital loss becomes real and substantial when the music finally stops. Catching a falling knife ultimately becomes a fatal game if the business concerned is in a deep and structural downturn.”

Peter Spiller, manager of the Capital Gearing (LSE:CGT) investment trust, also discovered the limitations of a value approach during the years following the financial crisis, but for different reasons.

It was, he says, easy to make money in the early years of his career. “Inflation was high, but falling, interest rates were high, but falling. Balance sheets were in good shape because no one could afford to have a risky balance sheet. At the same time, price-to-earnings ratios were low, at 7x. The return on everything was pretty high, so we just brought the longest duration assets and were 100% in equities.”

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This focus on good value, long duration assets served him well through his career. There were wobbly moments, like being “three years too early” in seeing the problems of the technology bubble. However, this became a problem in the wake of the Global Financial Crisis.

He says: “One thing I appreciate now, but didn’t then was the extent to which abundant liquidity (created by low interest rates) would drive up financial assets to way beyond fair value. We are an instinctive seller at fair value and these were special circumstances.”

While McKenzie fell out of love with the gurus he had admired in his 20s, for Nick Train, manager of the Finsbury Growth & Income (LSE:FGT) trust, a guru pushed him to take a different direction. A long admirer of Buffett, he couldn’t help reflect on the differences between the way he saw money being managed in the City, and the practices of the Sage of Omaha. He saw that investors generally undervalue durable, cash-generative business franchises; they are also prone to ‘churn’, which raise transaction costs. It also taught him that dividends mattered even more than investors generally believe.

If there is a conclusion to be drawn from this, it is that some flexibility is a necessity. McKenzie says: “For me, my conclusion was not that value factors are without merit. Indeed, in current market conditions such disciplines have come back into favour as last year’s high-fliers have come crashing down to earth, overcome by the burden of unrealistic growth expectations and new paradigm valuation techniques.

“However, the message is clear – value must be combined with quality to have a chance of being a successful long-term strategy. Otherwise, we shall find ourselves taking a final puff from the butts on the pavement before they finally burn themselves out.”

For Gervais Williams, head of equities at Premier Miton Investors and manager of Diverse Income Trust (LSE:DIVI), it was a recession early in his career that highlighted the danger of being over-optimistic over profit forecasts. He says: “This has turned out to be an immensely valuable lesson. During the good years, investor confidence in certain businesses can easily morph into overconfidence, leaving them heavily exposed to extreme downside risks.” 

This helped set the priorities for much of his investment career: “Many seek insight via hours of spreadsheet analysis, because even getting a slight edge over others can identify a share price that outperforms. Meanwhile, the shares of those vulnerable to disappointment, even by relatively modest percentages, tend to get sold off.

“However, one of the features of the human psyche is that our expectations for the future are heavily influenced by recent experience. So, after years and years of detailed analysis of minute changes in corporate profitability, there’s a general expectation that future variations in profitability will typically extend over a narrow range.  

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As such, when there are larger movements in corporate earnings, it can have an outsized effect on share prices. Williams believes this is surprisingly common: “Corporate profitability is in fact the relatively tiny difference between two very large numbers – being total sales, and the company’s cost base. When economic growth is reasonably consistent, both turnover and costs can be assessed reasonably accurately. 

“But at times of economic volatility, these figures can surprise. When costs rise by even a few extra percentage points, the net effect is that profitable businesses can quickly find themselves in losses. And worryingly, sometimes loss-making businesses run out of cash and become insolvent, taking their share prices to zero.”

Trust also becomes more important over the years. Any youthful naivety is set aside once managers have had their fingers burnt a few times by poor management teams. Spiller says that the investment trusts in which he invests “must keep to their promises”.

At the same time, he believes he must do the same, delivering as promised to his shareholders: “In my early years in the City, I worked for a company that insisted on integrity and respect. This was vital. The finance industry was rather distrusted and people wanted someone they could trust.”

Mistakes are inevitable and the market can make fools of even the best investors. However, analysed well, they can be a route to becoming a better, more savvy investor. The current volatile markets may just prove a fantastic training ground.