The Traits of Great Investors

Motley Fool contributor John Maxfield joins Michael Douglass on Industry Focus to take things back to basics. What makes a good investor, or a great one? How can a new investor hope to succeed when going up against high-powered Wall Street professionals?

Discover the personality traits every investor should cultivate, and how to go about picking and purchasing your first stocks. Calling on some sage advice from Warren Buffett and a story illustrating what not to do, Industry Focus looks at the fundamentals of great investing.

A full transcript follows the video.

Michael Douglass: How to be a great investor; this is Industry Focus.

[INTRO]

Hi Fools, Financial Analyst Michael Douglass here for the financials edition of Industry Focus. I am on the phone with John Maxfield today, our senior banking specialist. John, welcome back to the show.

John Maxfield: Thank you very much Michael, and just for the record, we're not on the phone! We're Skype calling.

Douglass: Well, OK. This isn't tech, John! I'm not going to be perhaps as precise. I'm sorry, you're right. We are Skyping, we're not technically on the phone!

We wanted to talk today a little bit about going back to the very basics. We spend a lot of time here talking about arbitrage and about dividends and just about a lot of different things in banking and in financials; REITs, mortgage REITs, all sorts of things.

We wanted to take a step back and just talk first about the fundamentals of great investing. You can take all these numbers and, before that, we really need to get back into what are the characteristics of someone who is a great investor, as you're thinking about your temperament and how you handle things?

John, to your mind, what is crucial to being a great investor? Let's start with your first, most important trait.

Maxfield: Just really quickly, let's orient everybody so we all are in the same mind-set of what we're talking about.

Douglass: Yes.

Maxfield: When we're talking about great investors, we're talking about active investors. When you break it down, you can be passive investors, you can be dollar-cost averaging into an exchange traded fund, you can be owning mutual funds, things like that. What we're talking about here is actively investing in individual stocks.

The one thing that we know is that when you go into the market ... I know that you've been to Disney World, Michael, and I actually know that you don't like it very much. You're like my wife, you're a curmudgeon! This is a horrible time of year, I know, with all the joy ...

Douglass: I have a sad existence when I'm the Grinch, yes!

Maxfield: My condolences that it's near Christmas time -- sorry about laughing!

But when you go into the market, you have to understand this is nothing like Disneyland. Disneyland is happy, everything is going well, things pretty much go as planned, because that's how it's set up.

The market is a much more treacherous place than that. It's like a pool that's teeming with sharks. That shouldn't mean that you shouldn't go into it, but it means that you should go into it with the proper protections. You should go into it and maybe submerge yourself in one of those cages.

That cage, that is constructed with a number of individual characteristics. First and foremost -- and this is something that you and I have talked about a lot, Michael -- first and foremost is humility.

When you go into it, you have to know that you will that you are probably one of the people that are sitting at the proverbial table who knows the least about what's going on.

There are people with extremely fancy degrees sitting in extremely expensive offices on Wall Street, who have a lot of experience taking advantage of investors like you and I, so when you go into it you have to know that from the get-go, and that is all part of humility.

Douglass: Yes. I think it's Warren Buffett who said, "If you look around at a poker table and you can't identify the fish, you're the fish."

It's interesting, because when you first start out investing -- I always tell the story of the first stock I bought -- you think that you've done your research and you think that you're coming at it adequately humbly.

And yet, you're just like, "Wow, this is just such a great value opportunity. It's so low valued. It's got such a huge dividend. It's a screaming buy." Then it turns out that it's a Greek dry bulk shipper and you didn't know something pretty fundamental about that industry. I'm speaking from personal experience here!

But I think that's something that's really crucial, is that you have to understand that chances are pretty good that everybody else has as much information as you, perhaps more, and certainly a lot more experience.

Then the question of course is, how does someone coming in with those handicaps, let's say, in the market, how do they succeed?

Maxfield: Well, the real key to investing is ... You have two different sides of investing. You have the technical side of investing, where you're looking at price movements and things like that, what the news media's saying about certain companies and about the market; it's too high or too low.

Then on the other side you have the fundamentals of it, and you're looking at the fundamentals of an actual company. Let's say you're looking at Wal-Mart (WMT 0.46%). You're looking at same store sales, you're looking at revenue growth, you're looking at gross margin, things like that.

What we've found is that, over time, stocks will track the fundamentals over time, but in the short run they'll go up and down based upon market sentiment and things like that. The real key ... there's actually multiple "real keys" to investing!

Douglass: The most important thing! Marx picked 18 of them, right, so it's hard to just pick one, but go ahead.

Maxfield: That's right. In addition to humility, the real key is knowing that you have to focus on the fundamentals of the company. What you want is really good companies, and you want to purchase them at a relatively decent price.

Then that brings into the whole question, how do you determine a good price? That's based along valuation. Your price to earnings ratio, your price to book value ratio, things like that. But fundamentally, it's about ... fundamentals.

Douglass: I saw you trying not to chuckle when you said that! No, that's good.

I think, as you noted, when we're buying really great companies, how to identify a great company really comes down to your sense of curiosity. You have to really look at your thesis, and at whatever company you're looking at, from a lot of different angles to try to understand whether it's a great company and whether you're getting it at a good value.

I'll give the example of Wells Fargo (WFC 2.74%). This is a great company that has consistently outperformed a lot of its peers because they've had -- as you've noted ad nauseam, John -- that they've had a good risk-bearing culture, they've been really great about their efficiency ratio, basically keeping their costs under control.

That said, when you look at it, maybe it looks a little strongly valued right now. It's, what, 2 times book, 2 times tangible book, something like that? Not exactly the cheapest bank stock out there.

Maxfield: That's exactly right. The other thing to keep in mind is that, particularly with the Internet now, there's a deluge of information that we have to weed through to pick out. There's a pretty well-known book called "The Signal and the Noise" by a guy named Nate Silver, who founded a blog, 538, which is an excellent blog if anybody likes market or sports news.

It was all about, "Look, you have this mass of information. How do you weed through it to pick out what really, really matters?" That's one of the biggest keys to the individual investor, is figuring out from all this noise that's going on, what really is picking up the fundamentals of a company.

Then, on top of that, what you have to know is not only the fundamentals of the company, but what's going on in the market, to know whether or not it's a buy at any one time.

If you look at the great investors, Warren Buffett is the guy we quote all the time, and one of the reasons we quote him all the time is because he writes these excellent shareholder letters for Berkshire Hathaway (BRK.A 1.18%) (BRK.B 1.30%) every year, and in those shareholder letters he is talking in large part to individual investors because he knows how many people read them.

One of the things he says is that, "Look, you should only be making buy orders one or two times a year, or three times a year, or something like that" because there are not a lot of times when stocks are so mispriced that they're a good value. You have to understand that.

There's a theory called the Efficient Markets Theory that says basically, stocks are appropriately priced at all times. Now, I don't believe that -- in fact, I believe that stocks are inappropriately priced at all times -- but then it's just a matter of degree.

But you have to be able to identify the difference between the fundamentals and the actual price, and you have to be able to do that by weeding through all the noise and picking out the signal in order to determine which stocks are good buys at particular times.

Douglass: Yes. I think that it can be a real struggle, because you'll look at a stock and you'll say, "Well, it's trading at," let's say a forward price to earnings of 11 or 12, and you'll say, "Well, that seems like a pretty good value."

Then the stock craters, the market craters, let's say, and the stock's down 20%. You're like, "Well, OK, did I miss something here, or is this the market overreacting to some important piece of news, or is the market correctly reacting to some piece of news that I didn't know previously?"

If the entire economy is tanking, is this retailer really going to be a good place for me to park my money right now, or is this a case of, "I liked it at 12 times forward earnings. Should I like it a lot better at 9 times forward earnings?"

That's where I think we get into this temperament but also humility issue, because on the one hand, we have to be humble. We have to recognize we don't know everything, and that there are going to be things that we miss. There are going to be stocks that are mistakes.

If you go to, I think any portfolio, you will find it littered with companies that the thesis hasn't panned out, or maybe the thesis wasn't as great to begin with. But then at the same time, you also find, often, a lot of great portfolios littered with a stock that did not look great to the general market, but this one person or this group of people, whoever, had an insight or had what they considered an adequate risk/reward opportunity to go for.

How do you navigate that, John?

Maxfield: I think you are onto the exact right thing. In my opinion, the way to invest successfully -- if you're investing actively, again -- the way to do that is to identify really good companies; say 10 really good companies. Do all your research, do all your due diligence.

Figure out the ones that are excellent, and then watch their price. Stocks go up and down all the time. Morgan Housel, he's one of our colleagues at The Motley Fool, one of the things he's tracked is how often stocks have fallen 10% from a recent high.

I think he found that, over the course of I think it was around 100 years, they fall at least 10% from a recent high once every 11 months, on average. Then they fall 20% from a recent high, I think once every year and a half or somewhere around there.

If you go into it with a plan, you say, "I like Wells Fargo. I like American Express (AXP 6.22%). I like Pfizer (PFE 2.40%). I like Wal-Mart," whatever those great companies are, and then you just watch them and you just wait for the market to go down, that's when you're going to have a buying opportunity for those types of stocks.

But there's one other factor that's working against us, and that is in fact ourselves. There's this whole discipline called behavioral finance that looks at the decisions we make, how we make those decisions, and whether or not those decisions are rational.

What the psychologists have found is that as a general rule, humans make a lot of really irrational decisions when it comes to money, and there are two general reasons that we do that.

First, because we make decisions with our emotions; when things are going really, really well, our neighbor's getting rich, they're buying new pickup trucks, doing things like that, we get greedy. We buy into the market. Typically by then the market is really high, so we're buying high.

Then when the market craters, as it does every 11 months or a year and a half, we get scared and we sell, so we sell low. We're making emotional decisions. That's one thing, and that's the principle reason why Warren Buffett says that temperament is more important than intelligence when it comes to investing.

The second thing to keep in mind is that our brain, because we have so many decisions we have to make on a daily basis -- literally thousands of decisions; what time we're going to get out of bed, are we going to brush our teeth, are we going to take a shower?

Those don't seem like decisions because we're on auto-pilot, but that's the point. Our brain, it defaults to these heuristics which are shortcuts in order to make decisions.

Well, those shortcuts are really great in most aspects of our life, like getting dressed and what to wear and all of those things. But they are horrible when it comes to the market because they can lead to irrational decisions.

You really have to keep in mind that you've got to be wary of not only the other competitors in the market, but also of your own emotions and the decision-making process that you use when you buy or sell a stock.

Douglass: I think that's a really, really good set of points. To wrap up what that's looking like, to my mind then humility, as you've noted, is really probably the most important thing that particularly new investors need to be thinking about.

That really will help you become a good investor, a great investor -- let's say a market-beating investor, because that's the goal. Let's face it, if you're going to put this time in, you want to out-perform the S&P 500 because otherwise you could just put your money in an ETF that tracks the S&P 500 and you'd be fine; SPDR with Vanguard, or something like that.

Then it comes down to that curiosity and that research. It comes down to that temperament, and it comes down to that, as you noted, willingness to see a stock price falling with a company you really like, and to say, "Now I think is a buying opportunity," even when everybody else is selling.

I think there's a lot more we can go into on this. I want to avoid a two-hour podcast for our listeners today, so I think we're going to have to cut it a little bit short there.

One thing I do want to note to folks is here at The Motley Fool we have an investment product that is actually specifically for new investors. It's called Stock Advisor. It's our flagship investment service.

When I talk about outperforming the S&P 500, it's done it by a factor of more than 2:1 over the past 20 years. When you think about that, that is really quite the metric for success.

If you email us at [email protected], then we'll send you a special offer on Stock Advisor. This is a really simple product that's really easy to help get new investors started in the market, and understanding what the real opportunities are there.

John, as always, thanks for your time. For The Motley Fool, I'm Michael Douglass. Check back with Fool.com for all of your financial, investing -- and anything else we're writing about -- needs, and Fool on!