Borrowed Conviction
One of the most dangerous mistakes in investing is borrowing conviction. Here's how to avoid it.
Borrowing ideas in the investing world is quite common. Finding a company or investment opportunity by yourself happens, but it’s not always common. Rather, most people find out about potential investments by hearing a friend talk about it, or by hearing an analyst talk about the stock they most recently bought.
Borrowing ideas is common (and encouraged by me), but people often go down a path that leads to borrowing their conviction, too. Have you ever heard someone say, “Well, I like [insert your favorite FinTwit account], and they are very bullish on this stock, so I am too,” or “This financial service recommended the stock, so I’m going to buy it sight unseen.” That’s borrowed conviction, and it can be costly.
Before you buy any company, you must have your own investment thesis on the company. In other words, you should have a sentence or two in your head (preferably on paper or in an investing journal) about why you’re investing in this company. More importantly, your investment thesis should contain a few things. First, it should state how the company will give back its value to you. Maybe that’s through a healthy and growing dividend or rising free cash flow per share. You should also have a few ways to monitor performance to ensure the company is executing. Revenue growth alone, in most cases, doesn’t count it. Instead, identify key performance indicators you can continuously monitor to gauge the company’s execution. Lastly, an investment thesis isn’t worth anything if it doesn’t explain the company’s competitive advantages. Sure, you may think the company can expand its free cash flow per share by 15% annually for the next decade, but why do you think it can do that?
Let’s look at what an investment thesis for Coupang (CPNG) - the South Korean e-commerce leader - might look like. One of the company’s highlights is its dominance in the region. The company had 18.1 million active customers as of December 31, 2022 - 35% of the total Korean population. But this isn’t a competitive advantage because leadership can be disrupted. What makes Coupang special is that nobody can beat its customer service because it has the infrastructure to provide incredibly fast delivery times - sometimes as short as same-day. Not even Amazon (AMZN) can provide that. That is the company’s edge.
Coupang isn’t profitable, but its margins are expanding rapidly due to its growing dominance and economies of scale, and that’s leading to cash generation.
In theory, if the company can continue to increase margins, cash will flow into the business, and shareholders can get rewarded.
Therefore, an example of an investment thesis in Coupang could be:
“Coupang’s continued dominance of the e-commerce industry in South Korea is driven by its unrivaled infrastructure scale. This scale would cost billions of dollars for a rival to reproduce, making it hard for competitors to catch up. As the company sees economies of scale from its leadership, its gross and operating margins can continue to rise, which will turn into positive cash from operations over the next five years. Its additional services stretching beyond e-commerce can also help boost these margins, giving Coupang the ability to generate cash far more efficiently five years from now than it does today.”
Full Disclosure: Nobody at Intern Investing owns shares in Coupang.
Borrowing someone’s conviction wouldn’t enable you to develop an investment thesis like this. Instead, your thesis would be, “this person owns it, so I own it.”
What would happen if that stock drops by 50%, 60%, or 70%? Because you don’t have your own thesis to base the company’s performance, it would be really hard to stick with that business. Let’s go back to our Coupang example. If you had a thesis like the one laid out above, you might be able to stick with your investment if the company sees continued margin expansion and cash generation. However, if you borrowed someone’s conviction and don’t have a thesis for yourself, how can you properly assess whether this drop is warranted? Without a base underneath your investment, your conviction can waver drastically, and you might sell - even if the company is still executing.
Borrowing conviction might not be the best idea, but the lines are blurred as to when borrowing ideas becomes borrowing conviction. After all, it’s very hard today to do investment research without getting anyone else’s opinion. I actually have a part of my research process where I look for others’ thoughts on the company. The answer isn’t clear-cut, but here’s how I see it:
Asking for others’ thoughts about a company is a great way to research, especially when talking with an expert in the field.
Talking with friends can be a great way to uncover key performance indicators or concepts that you might not have caught otherwise.
Other investors can shed light on risks you may not have seen.
In other words, borrowing ideas from others is key to developing your own thesis! However, this should only be one step of your research process. Hear about a risk that you didn’t think about? Great, but dig deeper on your own to learn about the intricacies of that risk. Learn about a potential factor that could be important to your thesis? Awesome, but take the extra step and learn how it plays into your thesis on the company.
When investing your money, it’s too dangerous to take other people’s word and conviction. Do your own research to determine where your money is best invested. Borrowing ideas is great, but go the extra mile in your research to ensure you’re not borrowing their conviction.
Disclaimer: Intern Investing does not provide financial advice. All content is for informational purposes only, and Intern Investing and its partners may have positions in the securities mentioned. Stocks mentioned are as a reference only, and a mention does not constitute buying or selling anything talked about in this newsletter. The author is not a registered advisor or a broker/dealer. DO YOUR OWN HOMEWORK.