My top 10 investing lessons from 2020

As the end to an incredibly challenging and tumultuous 2020 is upon us, and the stock market gets ready to close the books on a wild year, I decided to take time to reflect on what I learned about investing this year.

Before getting into my 2020 investing lessons, I thought it was important to call out my most important lesson from this year – the capacity humans have for tapping into a well of resiliency in times of adversity. I have seen it time and time again in my lifetime, when faced with tragedy, natural disasters, injustice, terror attacks, mental illness and now pandemics, human beings have the innate ability to persist and move forward despite the adversity they are facing. Things will get better.

And now, onto my top 10 investing lessons from 2020.

1. Being a contrarian pays off

The stock market in 2020 can be summed up with one word – volatile. We experienced a record setting market crash and an unbridled recovery in the span of 10 months. While the Covid-19 pandemic was changing how we live, work, and learn; the economy was essentially being put on pause. These events set off a market crash that included the three worst point drops in U.S. history.

At the time of the crash, I had been bracing myself for a correction. I would never have been able to tell you when it was going to occur, or how deep it was going to be, nor that a once in a hundred-year pandemic was going to be its cause. But I had some cash stored in a bond fund for the day a correction would inevitably arrive so that I could follow the advice from legendary investor Warren Buffett:

“Be greedy when others are fearful”

The 2020 stock market crash is exactly what Warren had in mind when he offered his sage advice. As I wrote at the time in my playbook for surviving (and thriving after) the Covid-19 bear market (published March 23, 2020) I wanted to “be on the right side of what could end up being one of the largest wealth transfers in history”.

Boy, did it ever pay to be a contrarian at the time, buying good companies that were selling at a deep discount. Some of the companies that I bought at their March lows have rebounded quite nicely, including Square (500%+), Pinterest (500%), Twilio (400%+), Store Capital (100%), and McDonalds (60%).

My only regret is not being greedier.

There will be moments in the future where its pretty clear people are panic selling and good businesses are at “going out of business” prices unjustifiably. Be on the right side of history.

2. Increase your position as your conviction grows

I tend to do a lot of research on the stocks I decide to invest in. I follow a rigorous methodology for evaluating stocks in general, and tech stocks more specifically. So, I go into my investments with my eyes wide open, at least as much as possible based on publicly available information.

The insights I learn from my research and thorough analysis shapes the conviction level I mentally assign to each stock I buy. While I may have a point of view on the likelihood of my investment hypothesis being realized and to what extent, my position sizes traditionally do not reflect the conviction I have for a specific stock. Reflecting on the allocation decisions I have made for specific stocks, I’m embarrassed to admit that it has been pretty standardized, regardless of the stock. Somewhere in my investing journey I decided a consistent fixed amount for each investment would do. This fixed amount may have grown over the years, as my portfolio grew, but I followed a pretty uniform approach to sizing my allocations. It’s strange, I have an overall asset allocation strategy (e.g., how much in stocks vs. real estate vs. fixed income), but when it comes to specific stocks I’m indiscriminate.

That all changed this year. I went particularly deep in my research on one of my highest conviction stock recommendations – Fastly. The company competes in the edge computing market which I previously knew nothing about. To compensate for my lack of knowledge I went super deep on the market, product, competition, optionality, and management. At the end of this extensive analysis, I was left with an extremely high conviction level that Fastly was going to realize its investment thesis and decided to allocate accordingly. This meant investing a larger amount than I typically do. If I were to just go off the recommendation from several sources that I trust, I would never have invested to the level I did, and benefited from Fastly’s gains this year. Personal conviction in an investing idea really matters.

I also learned that it is a good idea to continue buying on the way up. I bought more of Fastly as the price was increasing above my initial cost basis as I become more and more convicted with more insight and signs of their solid execution. Many of my largest holdings today – Pinterest, Twillio, Roku, Sea Limited, all started as small starter positions that grew over time as I learned more and my conviction became stronger. Sure, your average cost for the stock will increase as you add more to your position, but who cares? As your winners continue to win, you will get more certainty and clarity that provides you with a good understanding to confidently add to your position.

3. Look for opportunities where Wall St has not considered the full story

There are certain stocks that Wall St. has a difficult time fully understanding. They might not fully appreciate the market opportunity, the company’s optionality, its moat or, as was the case with one of my most successful investments this year, what business the company is in. As was the case with Roku, most investors did not understand that Roku is in the platform business. For a long time, Wall Street has believed Roku was in the hardware business. Roku built its brand on their digital media players and so this ignorance was understandable. Much of Wall Street was valuing them as a connected TV device manufacturer – a low margin business. Wall Street was missing the fact that Roku is a platform company that is being monetized through Roku’s accelerating advertising business. As more and more people caught onto the “true” Roku story the stock began to pop. There was an extended period of time where the market was mistakenly valuing them as a commodity hardware business where the signals were pretty clear that they had built a successful advertising operation that was ready to explode.

As individual investors, these Wall Street misunderstandings are some of our biggest opportunities.

Some clues I look for to identify misunderstood stocks include companies that are either in the early stages of a new business (that I believe in) or have pivoted or started a new business that has not fully materialized in their income statement. For example, it was not until 2018 that Roku’s advertising business pulled ahead of its hardware business in terms of relative size. There was plenty of time to get ahead of the market. While its not clear if their pivot is going to be ultimately successful, BlackBerry is another good example. If you look at their recent annual reports, it looks like they are rapidly contracting. But if you go beyond the top line you will see that while their legacy mobile handset business has all but disappeared, they have a fast-growing security software business. It just takes some squinting and analysis to uncover these diamond in the rough stocks.

4. Be skeptical

One of the more costly mistakes for me this year is the importance of being skeptical when considering buying a new stock. I made the mistake of getting caught up in the hype surrounding Luckin Coffee early in the year. According to the “experts” Luckin Coffee was the Starbucks of China. Although Luckin had a differentiated take on the coffee experience, one more suited for the Chinese consumer, the company basically imploded on itself as members of the executive team committed fraud. Fraud can be hard to foresee but in the case of Luckin Coffee there were some early warning signs. I remember learning about some potential accounting irregularities and deciding to stay the course. Well, those irregularities foreshadowed outright fraud and I was left holding the bag as the stock lost 93% of its value in a day or two.

I bought into the “story” of the stock sold by a subscription service I have since cancelled. I did not do enough of my due diligence. I should have been skeptical, questioning the assertions made by the analyst recommending the stock, and looking for what could be wrong about the company. In the case of Luckin Coffee, evaluating the leadership team would have uncovered a shady history of one of its executives.

It is easy to get excited about the potential market size or business model of a stock, but we owe it to ourselves to be skeptical and always be looking for the hidden gotchas. Here are some imperfect anti-fraud screeners to look for when evaluating stocks:

• Is there a lot of insider ownership? Does leadership have a lot of equity in the company? If there is a lot of insider ownership, leaderships interests are very aligned with yours as a shareholder.

• What is the quality of leadership? Obviously avoid companies where members of the leadership team have even a whiff of shadiness. Look for leaders that have a long track record of sound governance.

• Are there credible third parties partnering or somehow validating the legitimacy of the company? For example, if Warren Buffet is a major investor in a stock you can count on him or his team doing solid due diligence of the company.

As a side note, the epilogue to the Luckin Coffee story is that they are up 100%+ since their SEC settlement. But the lesson remains, avoid companies like Luckin Coffee where there is history of fraud.

5. Give your thesis time to play out

This year I paid for my lack of patience on a stock by losing out on a significant run up from the time I sold it. The stock was PagerDuty (NYSE: PD) and they are a leader in the DevOps and incident management software market. I loved the product, leadership and amount of developer love out there for the company, but I was concerned whether PagerDuty would be able to cross the chasm from its current niche market to a more mainstream one.

I initiated a starter position and monitored the stock closely for signals it was starting to expand its addressable market. One of those signals I was looking for was growth in the number of customers spending enterprise level dollars with PagerDuty. After two and half quarters without any reporting of an increase in average deal sizes I grew inpatient and sold my entire starter position. Like clockwork, in its next earnings report PagerDuty disclosed a meaningful increase in the number of customers spending more than $500,000 with the company. The stock price grew by 50% in a matter of days and I was left with regret of what could have been.

Our biggest loses in investing often come from selling too early and missing out on our original hypothesis being realized. Sure, it stung I did not realize the full gains I had been waiting for, but I am left with a lesson on the importance of having enough patience to allow your investing thesis to fully materialize. How much is enough patience? For me, unless I see obvious signs that I was off on my thesis or I see signs of risk, I will wait at least four quarters before selling a thoroughly researched and thoughtful investment.

6. Put more emphasis on earnings growth when buying dividend stocks

Last month I reviewed the one-year performance of my annual top 10 dividend stocks made for 2020. Over a one-year period, from when I selected them on October 29th 2019, the portfolio of my 2020 picks delivered 27.4% in stock price appreciation. The Dow Jones US Select Dividend Index and S&P 500 over same time delivered -20% and 11%, respectively. The total dividend yield on cost of the portfolio of my picks finished the year at 2.8%. All 10 stocks raised their dividend year-over-year, with an annual dividend increase of 7.5% as a portfolio. Total return (stock price appreciation + dividend yield) for my top 10 2020 dividend stock portfolio was 30.2%.

Of the picks that either depreciated in value or suffered below index performance, they all had low earnings growth annually for the last five years. All winning picks had earnings growth of 10% or higher. Learning from all of this, I have decided to put more focus on earnings growth as part of my methodology for investing in the right dividend stocks. I want annualized Earnings per Share (EPS) growth over the last 5 years of 10%+. This means that I may lose a little yield, but I feel the trade off is worth it when you factor in the dividend growth stocks that can now be included in my portfolio.

With an average yield of 2.9%, my portfolio of the recently released top 10 dividend stocks for 2021 remain strong dividend investments, with great growth upside. Over time these dividend growers will become high yielding, to go along with their higher growth. It turns out you can have your cake and eat it too.

7. Twitter is a community every serious investor needs to engage with

This year I really engaged with FinTwit (financial Twitter, an online community that uses the social network to discuss investing), both giving and receiving investing insights and stock analysis. There is no question in my mind that my engagement with FinTwit has made me a much better investor. Just a few examples of how FinTwit helped me in 2020:

• Kept me disciplined and calm during a record setting market crash. Surrounding yourself with smart, long-term focused and seasoned investors not only helped me avoid any panic selling but it motivated me to pounce on the opportunity to buy great companies at discount prices.

• I discovered several amazing companies with high returns in 2020 from FinTwit that I would not have discovered on my own. The standout for me in 2020 was Sea Limited, a Southeast Asian ecommerce and gaming company. It is a double bagger for me in less than a year.

• Helped me research companies I was evaluating. From understanding a market, the company’s optionality, valuation, or products, FinTwit was always there for me with insight and a helpful hand. For example, when I was evaluating Fastly, I was concerned about the impact 5G would have on its market opportunity. I wondered if 5G was going to make Fastly irrelevant because both seemed to offer the same outcome – a faster network. Within a couple of hours, I had my answer from a network expert, helping me gain the confidence in a stock that has performed well for me. The answer to my question by the way is that Fastly is focused on server-side speed and 5G is focused on client-side speed. You need both for improved speed and performance.

• Provided me with contrarian views that allowed me to test my investing thesis.

• Gave me inspiration to continue my journey towards financial freedom.

Curation is especially important when it comes to FinTwit. What voices do you want in your head when making consequential financial decisions that will affect your future wealth? Here are my top follows – @OphirGottlieb, @saxena_puru, @BrianFeroldi, @hhhypergrowth, @JonahLupton, @BahamaBen9, @jaminball, @SeifelCapital, @ARKInvest, @7investing.

8. Focus on major trends first to find the best growth stocks

My biggest winners this year, including Square, TradeDesk, Pinterest, Sea Limited, Twilio, Roku, HubSpot, and Elastic, all are the respective leaders in a broader thematic that is disrupting business as usual. Whether it is societies war on cash, digital advertising, social commerce or other disruptive trends, spotting major shifts in the economy, technology or whole industries have brought about my best performing stocks.

“If you're looking for a home run -- a great investment for five years or 10 years or more -- then the only way to beat this enormous fog that covers the future is to identify a long-term trend that will give a particular business some sort of edge”

- legendary investment manager Ralph Wanger

Picking the top one or two companies that compete in the transforming industry or which will benefit the most from the economic/technological shift is key and it is not easy. It is a tricky balance between not entering the thematic too late when all the major gains have been realized and not being too early where you pick the wrong company because its unclear who will win. Before pouncing on the latest technology fad, I tend to be skeptical and make sure all the elements of an investment ready mega trend are present. You do not want to be too early to the party, left holding the loot bag with no loot.

To find the winners within a major technological shift I have honed my approach into a specific methodology for picking tech stocks that deliver wealthy returns.

But remember to first look for those mega trends that will create significant value over an extended period for the elite companies that are best positioned to ride the wave.

9. Digital transformation still has legs to it

One of my favorite investing trends today is digital transformation. You might think I’m a little late to the party. I mean it was back in 2011 that Netscape founder Marc Andreesen, and now successful venture capitalist, published his famous Why Software is Eating the World WSJ article. In the article, Andreesen made the case for a once in a lifetime digital transformation that was changing the economy and offering significant upside for investors. There is no doubt over the last decade or so, investors in this space realized significant and often life changing wealth.

So why do I think there is still investor opportunity in a trend that has been happening over the last decade:

• The coalescence of powerful, emerging technologies such as Artificial Intelligence, Edge Computing, Augmented/Virtual Reality, 5G, quantum computing, autonomous vehicles, robotics and many more, are creating the perfect storm to enable digital transformation that greatly exceed anything that has been achieved over the last ten years.

• History has shown us that it takes times for the benefits derived from investments in new technology to outweigh the costs of learning, integrating, and adopting these new technologies. I believe many of the adoption related costs for the last wave of transformation have been absorbed and companies will begin realizing returns that they will want to reinvest in the next wave of technological advances. Proof of this comes from credible forecasts. Worldwide spending on the technologies enabling digital transformation is forecasted to reach $2.3 trillion in 2023, according to the International Data Corporation (IDC)Worldwide Semi-annual Digital Transformation Spending Guide. Digital transformation spending is expected to steadily expand through 2023, achieving a compound annual growth rate of 17.1%.

• The COVID 19 pandemic has accelerated the digital trend and made it a matter of survival for all customers, regardless of size, rather than a competitive advantage reserved for large enterprises. E-commerce, remote work, connected fitness, food delivery/curbside pick-up have now all been turned into societal habits that are absolutely table stakes for serving customers. Many businesses and institutions began rushing their multi-year digital plans at the onset of the pandemic, and this will continue post pandemic to meet employee, customer, student, and citizen expectations. The impact of COVID-19 on digital transformation is best summarized by Microsoft CEO Satya Nadella:

“We’ve seen two years’ worth of digital transformation in two months."

• Many of the technologies powering digital transformation are being democratized and decomposed into a set of APIs (Application Programming Interface) that developers can easily plug into their app for a low fee so that they can focus on what truly differentiates their app. This commoditization of cloud services is spurring a lot of innovation, investment and acceleration that just would not happen if developers didn’t have these “Lego” blocks to build on top of.

It is this last category of cloud platform providers, like Fastly, Twilio, Elastic and ServiceNow, where I see some of the best digital transformation opportunities. These are the “picks and shovels” needed for today's modern gold rush. This class of platform companies, and their ilk, are providing developers with best in class building blocks so they can build their apps much faster, more scalable and more globally than if they had to build from scratch.

Just like Ford does not build all the components that go into their cars, developers don't need to build all of the infrastructure that goes into their apps. Platform providers like Twilio for communications, or Microsoft Azure and Amazon Web Services (AWS) for compute, storage and artificial intelligence (AI), have become the supply chain for developers building apps.

I went big into this space this year, investing in Fastly, Twilio, Elastic, ServiceNow, Alteryx, and Okta.

Who is the cloud platform company that I think offers the best potential investor gains over the next five to ten years? I did a deep dive analysis of four digital supply chain stocks, culminating in my anointing Fastly as the best opportunity.

10. Use your specialized knowledge

I have always been a firm believer in the importance of proper asset allocation to be able to balance risk and return. I wrote about asset allocation extensively this year, outlining its importance, the primary asset classes and how to determine your investment portfolio asset allocation mix.

This year I decided to make an exception to general asset allocation principles and over index in the technology sector. This adjustment does not mean I have changed my mind about the importance of asset allocation and diversification, I’ve just made an allowance to be overweight in a sector I am quite familiar with. I’ve spent all 20 years of my career in tech, and more than a decade studying tech investing. I decided it was time to put this specialized knowledge to work to realize greater returns on my investment portfolio. Famed mutual fund manager Peter Lynch said it best:

“Use specialized knowledge to hone in on stocks you can analyze, study and then decide if they’re worth owning”

With your specialized knowledge about an industry or set of products you will be in a much better position to make the correct stock purchases as opposed to trying to pick stocks in markets you do not have specialized knowledge in. If you have a better batting average in consumer goods or financial services because of your specialized knowledge, take advantage of it.

How much should we over index in industries or sectors that we have specialized knowledge in? There is no single answer. Part of the decision should include an honest assessment of how deep your knowledge is and how much of an edge it gives you, and a realistic perspective on the future of the industry. For example, if you have deep knowledge in the oil and gas sector you may want to think twice about over allocating to it given the major question marks that surround its long-term viability. Also, make sure that while you may be overweight in a sector, you remain diversified.

It's worth touching on another consideration that went into my decision to over allocate to tech this year. I fundamentally believe that the economy is going through a transition where delineating the other industries from the tech sector is becoming less relevant. For effect, you could argue that all companies need to become software companies to compete in any industry today. For example, Domino’s Pizza has proven digital is not something that can be outsourced, it needs to be a strength. Of their total headquarters-based employees, 50% of them work in software and analytics. Once I realized how significant the current phase of digital transformation is, I felt it was only responsible for me to have my investment portfolio reflect this reality.

This was the year of doubling down on tech in my portfolio and I believe there is still a lot of investor opportunity ahead.

Happy new year and here is too a healthy, peaceful, happy and prosperous 2021!

The Wealthy Owl