Yesterday I returned from the amazing Casey Conference in beautiful Carlsbad, CA. Once again the speakers were phenomenal…and this time I even got to interview a few of them and pick their brains on what it really takes to make money on your investments! I will of course share those with you as soon as they are ready…stay tuned.
I am always interested in how the true “smart money” thinks and invests—it’s the primary reason I started this website. I wanted to know what all of these smart people who actually avoided the NASDAQ crash that clobbered me back in 2000 knew that I didn’t know!
As it turns out, quite a lot.
I’ve discussed some “smart money” techniques I have learned from them already here on Kung Fu Finance—the power of trailing stops, the importance of holding adequate cash to take advantage of buying opportunities and help you sleep well at night, having an exit strategy in place before you buy your desired investment, and much more.
Today, though, I want to talk about something that just might be the most important “smart money” technique of all…
Developing your investment thesis.
OK, stop yawning…I know the word “thesis” immediately throws you back in time to nightmarish high school or college term papers where you spent countless hours struggling to formulate, research and support hundred-page-plus long “thesis” papers…Ugh.
But I promise developing your investment thesis is not like that…in fact, it can even be fun!
And that’s a good thing, because developing a strong investment thesis is vital to your success as an investor.
Heck, it’s vital to your success in just about any endeavor as a human being…the more you can clearly and succinctly communicate your ideas to others, the more successful you will be.
(Yes, I am still working on conciseness myself…I’ll try to keep this article to under 1000 words!)
This was evident at the conference this weekend—speakers who had mastered what Mark Ford, Matt Smith, and Craig Ballantyne call “The Power of One”, having one big idea, enjoyed an engaged audience who left the talk happy and fulfilled because they understood the one big takeaway the speaker wanted to deliver that would make an immediate positive impact on their life.
However, speakers who did not have a compelling thesis and did not understand “The Power of One” left the audience confused, bored, distracted, and disengaged. (Luckily there were only a very small number of those).
Those speakers will probably not be asked to return, and the audience did not benefit nearly as much from their disorganized talks. Instead of walking away with a clear understanding of one new big idea, they left confused and clueless and wondering what on earth they were supposed to do with all of that jumbled up information.
Nowhere is this idea of “The Power of One” more important than in your investing.
You need to understand your one main investment thesis so clearly that when the inevitable storms arise, you can expertly weather them.
This is truly what separates the “smart money” from the “dumb money”, and you know I want you to be the “smart money”!
What is an Investment Thesis?
So what exactly is an investment thesis, and how do you go about developing a good one?
Here is my definition:
investment thesis: a clear statement of how a particular investment will create value for your portfolio and your life.
It answers the one big powerful question—why are you investing in this particular asset?
(hint: “because I think it will make me rich!” is not a sound investment thesis, although it’s tempting, I know…) 🙂
You need to understand the fundamental reason why you are adding an investment to your portfolio, and like all things kung fu, your investment thesis is unique to you.
(Remember the words of Bruce Lee: “there is no knowledge other than self-knowledge”)
Let’s take gold as an example. Of course this was much discussed at the Casey Conference, and you can immediately tell the difference between the “smart money” investors and the “dumb money” investors by asking just one simple question:
“So, why do you invest in gold?”
The “smart money” investors and speakers all have a quick, concise reason, even though that reason differs from person to person.
Doug Casey: “Because gold is money and it is the one asset that is not simultaneously someone else’s liability.”
John Mauldin: “I buy a set amount of gold each month as insurance. I hope I don’t ever need to use it, but like life insurance or auto insurance or fire insurance, I know it’s there if I need it, and I intend to pass it down to my grandchildren one day.”
Bud Conrad: “Gold is an investment, and when real interest rates rise and other assets become more attractive, I will sell my gold and purchase other, cheaper investments instead.”
Now contrast that with these not-so-well-thought-out “dumb money” answers:
DM#1: “Because everyone knows you should buy gold! It’s gone up for the past 10 years!”
(Ouch…you should never buy something “because everyone else says you should” or because “it’s gone up for the past 10 years”…both of those are terrible reasons to buy an investment.)
DM#2: “Because Eric Sprott says it’s going to $10,000 before this bull run is over!”
(Eric is a very smart guy, but remember to examine his bias—he owns a company that sells gold—I’m not saying he is wrong, but “because an expert says so” is also a terrible reason to buy an investment.)
DM#3: “Because you told me to, Kung Fu Girl, and I trust you!”
(Thank you very much, and I admit I am tempted to let this one slide, 🙂 , but in all honesty, even if I recommend something, that alone should not be reason for you to buy an investment. Besides, you have read about many of my previous investing screw-ups! You must think it through for yourself and for your own unique situation, and then and only then, if it makes sense for you, add it to your portfolio.)
Anyway, I hope you get the idea. There are well-thought-out “smart money” investment theses, and not-thought-about-at-all “dumb money” investment theses.
Obviously, you want yours to be the former!
How to Create Your Three-Minute Investment Thesis
So how do you formulate a good, sound “smart money” investment thesis?
(Without spending hours and hours at your local library strung out on coffee…)
I found this great psychology site today while looking for images to use in this article, and it expertly summed up my opinion of investment theses. The Three-Minute Thesis is a psychology competition that forces grad students to summarize their dissertations, research, and findings in under three minutes so that the general public can understand it.
As I am all about keeping it simple (remember KISS…) I love this idea, and you should work at it until you can do the very same thing with your investment thesis.
Let me see if I can help:
First and foremost, you must answer the big why question…and keep answering it until you get to the very heart of the matter:
“Why am I investing in gold?”
“Because I believe all fiat currencies are in a race to the bottom, and will eventually reach their intrinsic value, zero.”
“Why do I believe fiat currencies are in a race to the bottom?”
“Because central banks around the world are printing too much funny money and destroying the value of the underlying currency.”
“Why do I believe central banks are printing too much funny money?”
“Because they are trying to solve our global
liquiditysolvency crisis and believe the answer is more debt.”
“Why do they believe the answer to too much debt is more debt?”
“Because Ben Bernanke was a serious student of the Great Depression, a deflationary depression, and swore he would drop helicopters of money down on people if he had to in order to avoid another deflationary depression—he will do anything to avoid another Great Depression.”
You get the idea…
This doesn’t have to be difficult and you only need to satisfy yourself with your answers, not your college professor—so just grab your favorite cocktail and have a nice little conversation with yourself!
Don’t be timid…go all Fight Club and play devil’s advocate, because it’s vital for you to continue to question your assumptions until you’ve gathered enough evidence that you are completely satisfied with your conclusion and can boil it down to one compelling bulletproof sentence.
Here is my Kung Fu Finance law of investment theses:
The soundness of your thesis is determined by the quality of your questions.
The better and more in depth your questions (and answers…), the better and more sound your thesis. Q.E.D. 🙂
And if you don’t know the answer to a question, that’s where the fun part comes in!
Google, talk to your favorite investor friends, post a comment or a question here on Kung Fu Finance, and sleuth out the answers you need.
This is the perfect checkpoint to see whether or not this investment class is right for you—if you don’t enjoy researching and discovering more about gold, for example (or real estate or commodities or bonds or whatever), then maybe you would have more fun (and more success!) in another area.
The world of investing is huge, and there is something out there for everyone. Maybe you’d prefer to research willing borrowers and check out Lending Club instead, or perhaps you love digging into the guts of what makes public companies tick. Perhaps you love nothing more than black gold (oil) or going rental-house-hunting…the possibilities are endless, and if you take the time at the beginning to formulate your investment thesis and ask yourself the tough questions, you won’t find yourself in trouble later if the tide turns against you.
Which brings me to the most important why…
Why do you need an investment thesis in the first place?
Because it helps you remove the emotion from your investing, and it will help you weather the storm if the tide turns against you.
Rick Rule gave a great example of this at the conference.
(If you don’t know who Rick Rule is, you have never been to an investment conference.) 🙂
Rick travels frequently and speaks at almost all of the investment conferences and works the Sprott booth personally—the guy is an amazingly hard worker, super-personable and nice, and happy to talk with you and share his insights.
He gave another great talk at the Casey Conference (you can order the slides/audio yourself here if you’d like) and I was fortunate to be able to interview him.
Rick considers having a well-thought-out investment thesis one of the most important tools you can have in your investor tool belt, and he gave a great example of how he used his thesis as fortitude during a bear market to land himself a 100-bagger (something most of us only dream of).
If you’ve never heard the infamous Paladin story, you’re in for a treat…this is truly the stuff legends are made of.
Rick is a famous resource investor, and developed a strong uranium investment thesis in the 1990’s.
At the time, the uranium industry was making 90 million pounds of uranium and burning 150 million pounds each year, so 60 million pounds of inventory was being used up each and every year…demand was outstripping supply by a healthy margin.
At the time, uranium sold for $8 per pound and cost $20 per pound to produce, so the industry was losing $12 per pound of uranium produced. As this doesn’t make economic sense, Rick knew it was just a matter of time before the price of uranium rose to match the production costs and the demand.
But it was an extremely contrarian play—people remembered Hiroshima, Nagasaki, and Chernobyl, and didn’t just dislike uranium…they hated it.
Rick had done his homework, though, and knew all of the numbers, and having formulated his thesis and being convinced uranium had nowhere to go but up, he invested in several uranium companies, including one called Paladin.
He financed Paladin at $0.10 with a 5-year warrant (he joked that he got such great terms because they couldn’t believe anyone in the world would be stupid enough to give them money). 🙂
And of course, as these things so often go, all uranium stocks promptly went down by 50% over the next five years.
And Paladin went down even more…first to $.09, then $.08, then $.07, then $.05…and Rick watched it go down all the way to $.01 before doing another round of financing at $.015 (yes, that’s 1 ½ cents per share).
Rick told me that if he had not had such a strong and clear investment thesis he would have folded. He actually sat down and thought it out and asked himself these questions as the stock was tanking:
“Has anything changed in the market?” “No.”
“Has anything changed with the company?” “No.”
“Has anything changed in the industry?” “No.”
“Do I still believe in my thesis?” “Yes.”
So, instead of folding and losing 90% of his money, he reconfirmed his thesis and did a second 1 ½ cent financing.
Three years later, the stock went to $10.00.
That is the power of your investment thesis.
Now I don’t at all mean to imply that Rick’s results are “typical” (they are not…they are truly the stuff legends are made of but do happen to great investors who have strong investment theses and lots of guts).
But what I do want to point out is the power behind this tool—it’s emotionally painful to watch your just-purchased investment immediately go down, and then go down some more (believe me, I know!).
But if you can dust off your trusty investment thesis and can adequately answer the question “why did I invest in this?” you should immediately be able to analyze whether anything material or substantial has changed, or whether you should stay the course, even averaging down as Rick did.
One last note before I let you go…(and yes, I realize my goal of sub-1000 words was an epic fail) 🙂
You might notice that Rick knew a lot about the uranium industry and the state of it when he formed his thesis—the annual production, the annual demand, the cost of production, what they could sell it for, and the inventory. He didn’t just offhandedly say, “gee, uranium sounds good, maybe I’ll try that!” like so many of us are tempted to do. In fact, he said at one point that he knew more about Paladin than any other human being on the planet, and I believe him.
So when I mention the “three-minute” thesis, I don’t mean for you to spend three minutes on your thesis…I mean for you to spend as much time as you need to make your thesis completely unassailable, and then boil it down to its essence so that you can clearly communicate it to a non-financial human in under three minutes.
What do you think? Do you use investment theses in your investing? Have they worked for you? I’d love to hear your thoughts in the comments!
To your financial success,
— Kung Fu Girl