I used to race sailboats on Lake Michigan with an 80-year-old sailing legend -- known respectfully as "the Old Man." He taught me about the wind, weather, stoicism, persistence, and patience. While the wind and weather haven't helped me much in my investments, I find that stoicism, persistence, and patience are must-haves in volatile financial markets.
What does sailboat racing have to do with investing? Both activities demand that you anticipate uncertain future events. Sailors evaluate the weather, positioning their boat to gain advantage from anticipated future wind. Investors in small-cap stocks, like the folks at Motley Fool Hidden Gems, search outside of the mainstream in the market, looking for well-run companies and anticipating situations where future cash flow growth will lead to superior returns. Value investors select stocks they believe to be underpriced, anticipating that the market will eventually recognize the full value.
Patience pays
As investors, we need to recognize that it can take years -- even decades -- for investing stories to unfold, with plenty of rough times in between our purchase date and possible future success. Take Starbucks (NASDAQ:SBUX), for example. If you'd purchased shares soon after the 1992 IPO, you needed to be patient and stoic in order to achieve the huge gains that followed. Over the past 13 years, shares swooned with several corrections of 30% or more. There was potential competition from the likes of Peet's (NASDAQ:PEET), Sara Lee's (NYSE:SLE) Chock Full o' Nuts, Seattle's Best, and Caribou (NASDAQ:CBOU). In 2000, investors headed for the hills and the Nasdaq lost 80% of its value, taking Starbucks down 50% in the process. During any of the sell-offs, it would have been easy to be spooked, or to worry that the company built on coffee would fail, or to take some profits off the table.
Yet investors who blocked out the noise and persistently focused on the business saw that competition was not impacting revenue, cash flow continued to grow at a healthy clip, and Starbucks was becoming a dominant global brand. Even if you'd purchased Starbucks at its high in 2000, you still would have 130% gains today.
So every time there's a media-induced frenzy about inflation, rising interest rates, inverted yield curves, high oil prices, falling consumer confidence, and worldwide financial collapse, I think about windless days on Lake Michigan. And I remain stoic.
Back on the lake
Every year we raced from Michigan City, Ind., to Chicago, and every year it seemed as though there was no wind. The sun would beat down; the boat would roll slowly in the water. We would look at the horizon, wondering which direction the "weather" would come from -- the lake or the beach. We always took the beach -- a longer route that was slower at the start. Only three or four boats would head toward the beach, believing they would find something away from the crowd.
One year, we were one of only two boats on the beach. The boats on the lake looked like they had more wind, and they were miles ahead of us. The Old Man went below to get out of the sun and gave the helm to Randy, the most experienced sailor on the crew. His instructions: "Whatever you do, just stay on the beach." But Randy couldn't handle being on the beach. He couldn't be patient. He couldn't be stoic. He had to follow the crowd. He said, "Look at all the boats on the lake, they are killing us. We have to go out there and race them." By the time the Old Man was back on deck, we were several miles directly behind all of the boats on the lake. The only boat left on the beach found the shore breeze the Old Man had anticipated all along and finished an hour ahead of everyone else. We were dead last.
Back in the market
So what should do you do if you own a volatile small cap like Hidden Gems recommendation FARO Technologies (NASDAQ:FARO)? Shares have fallen 30% over the past six months. Management has fumbled the past two quarters, and the company's recent earnings miss and downward revision to full-year earnings pummeled the stock another 20% on Friday. The future is clouded by competitors Hexagon (OTC BB: HXGOF) and Immersion (NASDAQ:IMMR). It sure looks like there are better places for your money.
First, be stoic. Don't sell because of the wild price swings. Don't react to interest rates, the price of oil, or other macroeconomic factors. Don't simply follow the crowd, trying to chase returns of the latest hot sector. Chasing returns is a sure way to lose.
Second, be persistent. Keep learning about the company and evaluate how far you think management and the company have strayed from the course. Hidden Gems offers discussion boards where investors can swap ideas and analysis. As long as you believe the story remains intact and the company maintains your trust, stick with it. With its recent fumbles, FARO management has tarnished their previously good report card, and loss of trust is a legitimate reason to sell.
Third, if you decide that FARO is off track but not a total train wreck, be patient. The FARO investment thesis is that the company's computerized measurement devices will fundamentally change the manufacturing environment. This change, if successful, will take place over several years -- maybe a decade or more. If you hang tough and never sell, being right just once could bring you a small fortune.
Of course, FARO management must get back on course in order for shareholders to benefit from not selling. So what am I going to do? Over the next two weeks, I am going to evaluate the information from the conference call and the quarterly report. If I decide that I no longer trust FARO management, I'll sell. If I decide to hang on, management will be on double-secret probation, and I will expect significant improvements in their candor and performance in future quarters. Right now, they have two strikes, and we aren't playing baseball.
Finally, you are not going to win every race, so don't overweight your portfolio with one big bet in a volatile small cap. Build a diversified portfolio of small companies that are currently undervalued based on their future cash flow growth. That's what Tom Gardner and his team are doing at Motley Fool Hidden Gems, and their recommendations are besting the market by 20 percentage points. To view their buy reports and most recent updates, click here to take a 30-day free trial.
But most importantly, Tom has the patience to wait for the picks currently under water to come around. Smart analysis and courage of conviction is the surest way to beat the market over long periods of time, as master investors like Buffett, Munger, and Ruane proved time and time again. Long-term winners take the sting out of short-term bumps in the road, so make sure you heed the Old Man and stay stoic, persistent, and patient.
Robert Aronen owns shares of FARO, but no other company mentioned in this article. He does believe there are still some nuggets in the oil patch. Sara Lee is a Motley Fool Income Investor recommendation. The Motley Fool has a disclosure policy.
