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Tactical trades do not make you rich in equity; Ellenbogen tells you what does

Tactical trades that many investors tend to resort to in a choppy market to make a quick buck does not create big wealth; what does is long-term investing that takes advantage of the power of compounding.

That’s market wisdom for you from master investor Henry Ellenbogen, the man who had invested in Facebook and Twitter before they went public and who always advocated growth investing to generate big returns.

Ellenbogen says growth investing requires one to identify great companies that one can hold on to for a long period with lots of patience to stay put when the investment climate turns unfavourable.

“One cannot afford to get wrongly influenced by any market hype or noise and stay true to his/her conviction,” he said.

Choppy markets would always tempt you “to trade through short-term volatility, but one needs to remain true to the bigger goal of making strategic moves, instead of constantly going for tactical trades,” he said.

Ellenbogen says financial markets are made of investors and machines, and investors tend to copy what works. Market prices reflect people’s assessment of current information, as well as historical information.

He, however, says: “Markets are very good at discounting the past, but not at discounting the future. The real world is very dynamic.”

Henry Ellenbogen is the founder of Durable Capital, which he set up in 2019, and serves as its Managing Partner and Chief Investment Officer. Prior to founding his venture, Henry was the Vice President of T. Rowe Price Associates, and T. Rowe Price Group.

In addition, Ellenbogen has also served as a member of the US Equity Steering Committee and the Corporate Governance Committee for US Equity. During his tenure as a portfolio manager, the funds his managed won several awards.

Investment strategy

In times when most investors struggled and lost money, Ellenbogen has always thrived with his disciplined and strategic approach to investing.

The star stockpicker said the key to his success was his ability to identify a select group of smallcap companies that could achieve 20 per cent total annual compounded growth over 10 years. He called these companies ‘compounders’.

Ellenbogen is known for investing in startups before they went public. Some of his big bets included Facebook, Twitter and GrubHub.

“Investing can be viewed as one of the concepts we learn in science: it is about finding the right balance,” he said. “One should come up with his own game plan for investment, and allocate time to strategise for it.”

Ellenbogen said it’s important for investors to differentiate themselves from others in order to attain superior returns.

How to generate superior returns?

One of the things that investors need to do is study a lot on how the human brain works.

“Investing requires you to maintain a mental balance. Great investors can control their emotions. Take public market investing as an example: every morning I come to work, I am flooded with so much news and so many different price points that securities can transact at. You need to be able to detect the subtle signals through the market noises. This is counter to how the human brain is wired. I fundamentally do not believe in efficient markets; the human brain is emotional. Thus, I spend a lot of time trying to understand how the human brain works,” he said in an interview with a financial website.

According to Ellenbogen, investors encounter two types of problems in investing: 1. Complex problems & 2. Complicated problems.

The main difference between the two is that complicated problems are defined, which means it is possible to clearly predict how making a few input changes can help resolve it. But complex problems are undefined like a game of chess, where each move leads to a new set of many potential responses and, thus, they are difficult to resolve.

Ellenbogen identifies growth investing as a complex problem, as investors are always dealing with industries and companies that are on the forefront of change.

“Investors must understand and deal with a continuous flow of new and often surprising data points in order to become successful in growth investing,” he said.

How to tackle complex investment problems?

Growth investing is about investing in sectors and companies that are undergoing a lot of change. So one needs to study the underlying forces of change in great detail to make sure each investment is approached with the right framework.

In various interviews over the years, Ellenbogen shared some of his investment wisdoms, which can help investors generate solid returns. Let’s look at some of these tips:-

1. Look for businesses with moats

Investors should look for businesses that have the ability to create or extend a moat in a big market. These assets must be available at a price that is significantly below its intrinsic value. Investors should be able to find a business with a fundamentally better business model that is unique and sustainable.

“I like it when the company has come up with a product, service or strategy that is unique and visionary enough to change its industry,” Ellenbogen says.

2. Invest in smallcap growth firms

Ellenbogen says one should invest in firms that are less liquid and less traded than big public companies. Such companies are more likely to be mispriced and their values can be more volatile and irrational at times. But this approach requires discipline and the ability to stay the course. Sometimes the best thing to do is nothing when the environment is not conducive.

“The appeal of the smallcap growth firms I buy is that they reward patient buy-and-hold investors. The trick is to identify companies and have the patience to hold on to them. Both parts are equally hard. Sometimes one of the best things I do is resist the desire to trade,” Ellenbogen said.

3. Spot high quality companies generating FCF

Investors should look for companies having the ability to generate free cash flow. Businesses that are not dependent on the capital market for new cash are less volatile. Investors often tend to forget that businesses may not be able to come up with new sources of cash from third parties.

According to Ellenbogen, the only unforgivable sin in a business is to run out of cash. If a company can generate its own cash, then the business is of high quality. “I tend to have a high quality screen. I focus on free cash flow per share. Those companies tend to be able to fund their own growth. That tends to make them less volatile over time,” says he.

4. Pick consistent performers

Investors should look for businesses that can grow at above-average rates of around 15–20 per cent for at least next 10 years. “Consistency is the key. I shy away from red-hot companies with soaring growth that get all the headlines. Those stocks often crash and struggle to recover when growth slows or investors find something more exciting. Sustainable growth gives me the discipline to hang on to a stock year after year,” Ellenbogen said.

5. Follow a sound investment process

It is not easy for an investor to spot companies that can grow in double-digits year after year, as these types of gems are very few in number. It requires a lot of hard work and one needs to follow a sound process to find them.

“The ability to grow revenue at a double-digit pace is a really, really hard thing to do over an extended period, and to be able to compound wealth at 20% or more is very rare,” Ellenbogen said.

6. Trust the power of compounding

Investors need to trust in the power of compounding, as it is one of the key to building great wealth.

“A company whose earnings growth averages 20 per cent a year for 10 years will see earnings rise six-fold over that time, thanks to compounding, and I expect to see its stock price rise by that much as well. Both feedback and compounding are everywhere if you know where to look,” he said.

7. Magnitude of success matters not frequency

It is not the frequency of success, but the overall magnitude that determines return. “If we can find one or two outlier companies, and — it’s a big ‘and’ — we have the discipline to hold on to them over an extended period of time, that is the majority of the battle,” he says.

8. Avoid companies with high debt

Investors should be careful about investing in companies that require a lot of borrowed capital, as they would find it hard to maintain a consistent growth rate in an economic downturn. “Markets love to loan money to companies when they don’t need it. But when companies do need to borrow in a downturn or cash crunch, the price of leverage is high. Mistakes are magnified in periods like this,” says he.

9. Look for companies having sound management

Investors should look for businesses that have the ability to become a billion-dollar company. This is possible only if the company’s management has the ability to take it to such heights.

“Does the management have the mindset to lead the company to a second act, which is what you need to become a billion-dollar company. Every once-in-a-while we see a business that can become much larger and that is run by a person who has the ability to make it larger,” he said.

10. Learn from mistakes

Ellenbogen says all investors make their share of mistakes and it is important to learn from them and move on. All investment decisions won’t always succeed and the frequency of success as an investor will never be perfect.

But as long as one doesn’t lose money as often as they make profit, they have a sound investment process and are on the right path to succeed. “Any individual failure must always be considered in relation to the magnitude of overall success,” he said.

(Disclaimer: This article is based on various interviews and speeches by Henry Ellenbogen.)

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