Allan Mecham’s 4 tips to achieve market-beating returns regularly

According to him, it is vitally important for investors to take emotions out of the equation, or at least minimize them as much as possible.

He says the secret to his success has been following a culture that is conducive to rational thinking.

Mecham, who founded the hedge fund Arlington Value Capital, goes on to say that the most critical job of any investment firm is to cultivate and maintain a culture that minimizes emotional noise and short-term performance pressures.

Mecham has been compared to Warren Buffett on several occasions. He has earned an astounding cumulative return of more than 400 per cent by investing in the stock of US companies over a 12-year stretch.

He even managed to turn a profit during the crash of 2008, when Standard & Poor’s 500-stock index fell nearly 40 per cent.

“You need investors to think and act like owners, rather than short-term renters, and to judge performance over longer time frames,” he once said in an interview to a financial website.

Mecham says in order to be successful in the stock market, investors must look for a rare combination of business safety, attractive price, and a clear understanding of a business that leads to low-risk and market-beating returns.

According to him, the main objective of investors should be not to make money but to not lose money.

“This doesn’t mean the stock price never goes down from where you bought it, but rather, the value of the business never decreases from where you bought it,” he says.

Mecham says determining whether or not a business’ value will decrease comes down to finding a safe company at a great price and making sure investors understand them fully.

He says investors should make rational decisions in investing that can lead to wonderful returns which include staying within their circle of competence and thinking objectively.

“The most important thing I can tell you about becoming a great investor is to focus on your circle of competence. Try to buy businesses that really mean something to you. What are you passionate about? What do you actually know something about? Those are the questions that will make you connect to your investments, and the more you connect with your investments, the more you will own it as if you own the whole business. The more you understand the meaning of the business, the better investor you are going to be,” he says.

Key criteria to employ when making an investment decision

Mecham says investors need to understand the business like an owner.

“The firm needs to have staying power; I want to be confident about the general nature of the business and industry landscape on a longer-term basis. I’m big on track records and generally stay away from unproven companies with short operating histories. I also believe a heavy dose of humility and intellectual honesty is important when looking at potential ideas,” he says.

According to Mecham, investors always have a strong urge constantly to invest which makes it quite easy for them to fall into the trap of thinking they understand something well enough when they don’t, especially if they are in the constant need of producing quarterly and yearly returns.

He says ultimately, what tends to cover all the bases is the mentality of buying the business outright and retaining management.

“Over the years I’ve come to realize the importance of management, so we look hard at the people running the business as well. And, obviously, the price needs to make sense. The criteria bar is set high; we really try to avoid mediocre situations where restlessness causes you to relax investment standards in one area or another. We also stress test the business under various economic scenarios and look to a normalized earnings power,” he says.

Mecham says if investors can be patient, there’s a good chance the volatility of the marketplace will give them the chance to own companies on their watch list.

“The average stock price fluctuates by roughly 80% annually (when comparing 52-week high to 52-week low). Certainly, the underlying value of a business doesn’t fluctuate that much on an annual basis, so the public markets are a fantastic arena to buy businesses if you can sit still without growing tired of sitting still,” he says.

Biggest mistakes that keep investors from reaching their goals
Mecham says most investors are their own worst enemies as they are buying and selling too often, ignoring the boundaries of their mental power.

According to him, patience, discipline and intellectual honesty are the main qualities that investors need to possess to amass superior returns.

“I think if investors adopted an ethos of not fooling themselves, and focussed on reducing unforced errors as opposed to hitting the next home run, returns would improve dramatically. This is where the individual investor has a huge advantage over the professional; most fund managers don’t have the leeway to patiently wait for the exceptional opportunity,” he says.

Mecham shared his insights in his investor letters which, if followed, can help investors in their careers to achieve success:

1. Avoid Noise
According to Mecham, investors should avoid trading gossip and noise and focus on their own well-researched portfolio.

He says avoiding sensational financial news media found on TV and the internet can be beneficial for investors.

“I disagree with the notion that more information is always better. The edge is found in clear thinking and an uncluttered mind. Our brains only have so much decision making power capacity each day. Disposing that energy into numerous outlets — reading too many blogs, following too many investors, watching Mad Money — reduces our brain’s capacity to make full-powered decisions on important questions. The less information you consume the more time you have to ponder the few critical bits that really matter,” he says.

Mecham says the steady surge of information coupled with short-term performance pressures can push rational long-term investing to the brink of extinction.

2. Never sell great businesses
Mecham says there is never a perfect world in the financial market where investors find businesses they love having.

“My view on selling is akin to the old sports adage, ‘the best defence is a good offence’; the best sell discipline is a stingy buy discipline — which couples proper analysis with a bargain price,” he says.

3. Learn to do nothing
Mecham says investors should favour infrequent action and patiently wait for exceptional opportunities.

He says not only does frequent activity result in reduced performance, but it also translates into higher costs of doing business.

“If you don’t have the ability to be patient, do nothing and wait for opportunities, you’ll never be able to hold on to great businesses. In order to achieve the powerful effects of compounding, inactivity isn’t a preferred skill, it’s a must-have,” he says.

4. Focus on long term success
According to Mecham, investors should try to cultivate a culture that encourages rational decision making that ultimately leads to solid risk-adjusted returns

Mecham says investors should try to develop an owner-like mindset that can have an impact on long-term investing success.

“Not only does an owner-like mindset change the time frame as an investor, but it also forces you to change what you care about when looking at businesses. Focusing on long-term investing (i.e., holding businesses for decades, not decimal seconds) leads to a natural decline in the level of importance you place on quarterly results (earnings “beats”), short-term headwinds and temporary compressions in earnings and margins. When you think long-term, all of that doesn’t really matter. More than that, if you keep thinking like this, you’ll start to question why others even ask for quarterly guidance,” he says.

Mecham’s stunning success is evidence that an intelligent, thoughtful and sensible investor who does his homework and keeps out distractions can indeed produce superior long-term investment returns.

(Disclaimer: This article is based on Allan Mecham’s investor letters and interviews)