For many years, people have asked me questions about how I analyze individual securities and my overall investment strategy. Saying I am a value investor doesn’t really make a difference for most people asking the question. As Charlie Munger would say, “all investment is value investing.”
This post will not be about how to read a balance sheet, how to analyze a cash flow statement or the ways in which I assess management. This post is about general frameworks for thinking which I believe is just as important.
Circle Of Competence
The first question I ask myself when analyzing a stock is whether the company is in my circle of competence. In essence, do I understand the business? If the answer is no, then I immediately skip it no matter how compelling the investment looks.
Intrinsic Value
The second question I ask myself when analyzing a stock is can I reasonably value the company? There are plenty of businesses that I may understand, however, I have a hard time grasping what the business is worth. Most small biotech companies would fit into this category as one example. If I can’t reasonably value the business, I skip it.
Avoid Losing Money
The third question I ask myself is will I avoid losing money? All too often, investors talk about the upside of an investment but will not consider the downside. Warren Buffett has a saying, “Rule #1, don’t lose money; Rule #2, don’t forget Rule #1.” The avoidance of losing money is one of the most important things in a long-term investment track record.
Consider this math:
Let’s say you’re just out of college, you’re 22 years old, have a decent job, and decide you want to start putting money away to invest until you’re 65. At the age of 65, without adding any additional capital to your savings, you would end up with $602,401.
Say you can earn 15% on your money for the next 43 years. If you start with $10,000 you will end up with $4,073,870.
Now say you became one of the world’s greatest investors and could do what Warren Buffett has done, and a few others, and earn 20% a year, you would end up with $24,397,653.
However, let’s say you decided to take a lot of risks while investing and didn’t care as much about your downside. Every 12 years, you lost half your money because you were investing in something very speculative. By the age of 65, compounding at 20% a year except for the years you lost 50%, instead of ending up with over $24 million, you’d end up with slightly over $1.8 million.
If I can’t determine whether I will lose money or not or I believe the chance of losing money is quite high, I will skip the investment idea.
Business Quality
From there, the next question I ask myself is whether the business is of high quality:
Does the business have a competitive moat?
Is the business in good financial condition?
Does management allocate capital efficiently?
Is the management team good operators of the business and are they ethical?
Diworseification
If I can’t answer yes to all of these questions, I will skip the business. If I can answer yes to all of these questions, then I will ask myself whether I believe I can make at least a 10% IRR on the investment or make at least double the current risk-free rate in a conservative scenario. If not, then I skip the investment idea. If I can answer yes then I ask myself if I have any better ideas.I would rather not dilute my best idea with my 40th best idea. As Peter Lynch says, “Distrust diversifications, which usually turn out to be diworseifications.” If I don’t have a better idea then I will invest.
The Art Of Value Investing
How do I determine if I will make 10% or double the risk free rate?
This is a tricky question as there is no cookie-cutter answer. Value investing is more of an art than a science. How do I know that? Because if it was purely a science, every mathematician and account would be a billionaire and that is simply not the case. However, there are a few ways I look at businesses depending on each situation.
One example could be the business is very stable and the cash flows are very predictable. If a company is not growing but trading at 10x free cash flow, that means shareholders will make make a 10% return on their money (1/10), with 0 future growth. However, there are other examples where a company is growing at double digits and you can pay 12-15x free cash flow for the business and you believe the business will grow at double digits for the next decade, now all of a sudden that multiple allows for quite high returns. The most extreme example in my lifetime was paying 3x revenue for a SaaS company growing revenues at 100% a year. I didn’t have to be a rocket scientist to figure out that the return would most likely be quite satisfactory.
There are other ways to look at a business besides earnings/cash flows. For example, the company could be selling at a clear discount to the companies net current asset value. In this case, a basket of these securities should yield a high return on investment.
Special Situations
There are also special situations which are the exception to the above rules. A special situation could include: tracking stocks, holding companies with large stock portfolios, litigations, liquidations, mergers, miscategorized businesses, rights offerings, spin-offs, tax shells, illiquid securities traded over the counter, non-reporting dark companies, and community banks.
Resources
For those interested in diving deeper, I would recommend the following resources:
Books for Frameworks
Making of an American Capitalist by Roger Lowenstein
The Education of a Value Investor by Guy Spier
The Intelligent Investor by Benjamin Graham
The Essays of Warren Buffett by Lawrence Cunningham
Poor Charlie's Almanac by Peter Kaufman
Simple (yet powerful) Investing Books:
The Dhandho Investor by Mohnish Pabrai
You Can Be a Stock Market Genius by Joel Greenblatt
Margin of Safety by Seth Klarman
Corporate Financials
The Interpretation of Financial Statements by Benjamin Graham
Community Resources
Corner of Berkshire & Fairfax
Value Investors Club
