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There are many different ways to make money in markets: day trading, momentum investing, technical analysis, or passively holding a diversified portfolio of blue chip stocks are all valid investment methodologies; valid for those that deploy them successfully. Our approach is what we call high-impact, low-probability investing or venture capital in public markets. Our philosophy is based on our background and experience, and more importantly, what has proven successful with us. Our purpose here is not to convince anyone that our approach is better or more valid than others, only to explain what we do and why it works. If after reading this section you feel like our investment philosophy resonates with you, we encourage you to consider a membership to Domino Analytics.
What is High-impact, Low-probability Investing? In short, it is venture capital investing in public markets. The high impact comes from a focus on emerging growth stocks that offer highly asymmetrical rewards for the risk we are taking. We are looking for wealth creation events which as a rule of thumb means we want see potential returns of at least 10x our capital. In order to achieve those types of returns we are looking for companies with highly disruptive products, technologies, or business models that have the potential to disrupt established markets.
Low-probability refers to the infrequent nature of discovering emerging growth opportunities that are truly wealth creation events. The challenge in discovering these high-impact opportunities is what led us to create Domino Analytics, which allows individual investors with varied backgrounds and research interests to share their ideas and perspectives while simultaneously learning about opportunities in areas where they have no personal experience or expertise.
Stock Selection. As noted, our focus at Domino Analytics is on emerging growth stocks. Because of this much of our portfolio and research universe is naturally comprised of companies in the technology and medical fields; however, we are in fact sector agnostic. In fact, the power of the Domino Analytics service is that it connects investors with disparate backgrounds and interests in an attempt to find the highest quality emerging growth opportunities regardless of industry sector. Regardless of industry sector the stocks we focus on have a few common traits: 1) large addressable market; 2) clear path to market with a new product, technology or business model; 3) strong intellectual property and/or competitive advantage which is manifested in high, durable gross margins; 4) cheap valuation (i.e. current market cap) relative to market opportunity which will strongly support an asymmetrical risk/reward set-up; 5) early-stage opportunity as evidenced by market cap, price action, and limited Wall Street sponsorship or ownership.
Portfolio Construction and Position Sizing. Portfolio construction is very much a 'to each his own' endeavor and should reflect an investor's risk tolerance. Our own view of portfolio management runs contrary to most conventional wisdom on the subject. To wit, we are not fans of diversification, rather we prefer to be concentrated in only a few stocks. By limiting the number of stocks in a portfolio an investor must force rank his holdings against new investment opportunities as they become available. Without this discipline a portfolio is likely to grow larger in names but poorer in quality over time as high-conviction ideas are diluted with marginal new positions.
In addition, excellent stock selection will be somewhat muted in a broadly diversified portfolio if the best stock ideas only command a small single digit allocation of the portfolio; returns will actually suffer through diversification while real risk is not necessarily mitigated (more on that below). Alternatively, if portfolio allocation reflects research conviction - and not an arbitrary need for diversification - portfolio returns and wealth creation will be greatly enhanced. The key to this portfolio strategy is, of course, excellent stock picking.
Defining Risk. Portfolio management theory teaches that risk is measured by portfolio volatility (the standard deviation around expected returns). While this may be appropriate in the academic world (and the CYA world of fund of funds investing) in the real world risk needs to be defined in more tangible terms: i.e. failing to meet your long-term investment goals or a permanent loss of capital. It goes without saying that a concentrated portfolio of emerging growth stocks will experience far more volatility across all time periods than will a diversified portfolio of 30 stocks. But is that actually an important concern to an investor with a long-term horizon? Probably not. The concentrated portfolio will have larger draw-down periods in declining markets but it will also experience more upside volatility in rising markets and as company fundamentals develop. Clearly, periods of dramatic drawdowns can feel uncomfortable to an investor but it is the returns over a full investment cycle that matter most. To achieve outsized returns and create wealth over a portfolio's lifecycle excellent stock picking, not minimizing volatility, is paramount.
On the Use of Margin. On this subject we have pretty strong opinions. It is tempting for an investor to view a highly skewed asymmetrical set-up as an ideal time time to buy stock on margin, press the bets and really go for it. This is usually a mistake. Consider: over the very long-term the value of an asset will approximate the net present value of the free cash flows that the asset will generate. To generalize this concept for emerging growth stocks we can say that long-term stock price performance is highly correlated to fundamentals. And as emerging growth investors with a focus on disruptive technologies and high-impact wealth creation opportunities this is our focus: the fundamentals for the very long-term.
However, in the short-term - no matter how compelling the long-term fundamentals - price action is far more random (i.e. less correlated to corporate fundamentals) and is impacted by any number of exogenous factors. And the shorter the investment timeframe (quarter, month, week, day, or intraday) the more random and less correlated to business fundamentals short-term stock price action is. On any day stock prices can be influenced by macroeconomic data, sector trends, geopolitics, regulatory machinations, market flash crashes, and countless other factors.
While an investor who uses no margin can ignore these short-term random price action (noise) and focus on long-term business fundamentals, an investor who uses margin can't, as the risk of margin calls makes him sensitive to short-term price action. By using margin the leveraged investor thinks only that he is maximizing his exposure to the long-term upside opportunity but what he has (probably unwittingly) done is assumed all of the short-term exogenous market risk. Leverage can certainly amplify returns in bull markets but it also makes portfolios very susceptible to liquidity risks when stocks or markets decline in the short-term. This raises the possibility that an investor may correctly identify a long-term emerging growth stock and yet failed to participate in the long-term rewards because he was forced out of his position due to a margin call at some point along the way. Investing in emerging growth stocks is inherently a high-risk endeavor there is no sense in compounding the risk by adding exogenous market risk into the investment equation.