Ben Graham, the father of analytical investing, said that an investor
should only "do those things as an analyst that you know you
can do well, and only those things". Through continuous testing
of performance and self-examination, I have striven to improve my
investment technique while developing principles to shape my investment
philosophy. These principles are as follows (in no particular order):
- Analyze the business, not the stock.
- Apply the circle of competence concept by focusing
on specific industry groups.
- Rotate through a fixed population of companies.
- Place the highest emphasis on developing and
following the story.
- Look for specific data to track.
- Use checklists extensively.
- Specifically identify factors behind future earnings growth
- Prefer businesses with free cash flow.
- Look for solid balance sheets.
- Avoid complexity.
- Remain specific.
- View stock volatility appropriately.
- Evaluate and scale according to the risk/reward
scenario of a business and value.
- Continually study an investment style
that already works.
- Be flexible.
These principles are described below.
1. Analyze the business, not the stock.
I focus on the business first, not the stock price, in the belief
that over time the stock price will mirror the underlying progress
of the business.
2. Apply the circle of competence concept by focusing on specific industry groups.
In the 1992 Berkshire Hathaway report, Warren Buffett said that
"What counts for most people in investing is not how much they
know, but rather how realistically they define what they don't know".
Peter Lynch called it investing with an edge. The key is knowledgeable
buying and selling. I have attempted to enhance this approach by
focusing on industries where my knowledge is the highest as evidenced
by our own returns. I am also continually working
to expand my circle of competence.
3. Rotate through a fixed population of companies.
I concentrate my efforts on particular industry groups because
more opportunities can be reviewed that way with the same level
of knowledge. For example, if one is following a single asset manager,
it makes sense to follow several, because the same skills that master
the first company can be applied to many others. This increases
the odds that a profitable investment can be found, because the
overall population of stocks can be expanded with less additional
effort. After all, individual sectors are not homogeneous and stock
prices fluctuate continually, offering opportunities to those who
are watching - but you have to pay attention. Also, I believe the
most attractive business is one that does what you expect. The actual
results may or may not be favorable but what ends up hurting the
company is generally not a surprise. And when an undervalued situation
develops, I expect to be there to see it - the value will be obvious.
I believe it is easier to identify an undervalued stock when you
already know the company versus trying to identify an undervalued
opportunity in a company you don't already follow.
Place the highest emphasis on developing and following the story.
I believe that even the most stable businesses experience peaks
and valleys in performance. Therefore, I spend the majority of my
time not in trying for absolute precision in estimating future earnings
but in checking to see exactly how a company plans to increase its
earnings and use its existing assets most effectively. Periodically
I will check the situation anew to assess the company's progress.
5. Look for specific
data to track.
I look for companies that have business models which lend themselves
to simple mathematical analysis, that have some tangible, measurable
visibility to future results. I like restaurant and retailers because
their growth rates and results can be quantified; for example, if
you compare how many units a retail company expects to open in the
next 12 months versus the year before you can get an expected sales
growth rate. You do not have to "guess" at the growth rate. I like
asset managers because an investor can look at previous asset levels
and current performance. Compare this with a business like wholesale
apparel, which is more difficult to predict because growth rates
do not lend themselves to easy measurement.
6. Use checklists
I use a systematic approach to analyze each possible investment
and use checklists extensively to assure continuity and thoroughness
in the investment process. Check the following link to see the latest
version of this checklist; you will need the free Adobe Acrobat
reader to view this document. TIS
7. Specifically identify factors behind future earnings growth.
I believe that most explosive stock price rises come from a combination of strong revenue growth with solid margin growth, leading to significant earnings increases. As Peter Lynch noted, what makes a company valuable and why it might be more valuable tomorrow than today revolves around earnings and assets, but especially earnings. He noted there were five basic ways a company can increase earnings: reduce costs; raise prices; expand into new markets; sell more of its product in the old markets; or revitalize, close or otherwise dispose of a losing operation. I attempt to identify the sources of earnings growth in all selections, with a particular emphasis on finding a reason why the next year will be better than the last.
businesses with free cash flow.
I prefer companies that generate significant free cash flow, which
is the amount of money available after all normal capital expenditures
have been subtracted from net income. These companies have significant
flexibility to buy back shares, pay dividends, or make acquisitions.
They can also fund their operations internally, without need for
outside capital sources.
Look for solid balance sheets.
I prefer to avoid trouble. Investing is almost like tennis: you
can win by simply not losing. One way to avoid losing is to stick
with companies with conservative financing, those with strong balance
sheets. Manageable debt can be useful in growing a business but
excessive debt can lead to problems. This can be easily seen on
a personal level; mortgage debt is certainly appropriate in correct
amounts, but when credit card debt is added to the mix a temporary
loss of income can have a catastrophic impact on finances. I have
simply chosen to avoid this problem entirely by focusing attention
almost exclusively on companies with strong balance sheets.
I try to keep things simple, relatively speaking. I like companies
that can be found through the power of common knowledge, which can
be easily evaluated, monitored, and identified when undervalued.
I want to identify the easiest opportunity possible. Investing is
not college football -- there is no strength of schedule involved
in determining how much money you make. With some exceptions, our
companies are as boring and pedestrian as they come. They have good
balance sheets with lots of cash. They make money in ways that are
easily understood. They have relatively simple annual reports.
I do not make stock market or economic forecasts, unless they relate
specifically to the business in question. I believe the health of
the economy, the growth of GNP, and other large and general questions
will not help you evaluate whether company ABC is a purchase candidate
or not. In fact, such large deep-thinking issues can often obscure
what is really important in a company.
12. View stock
I try to focus much more on the fundamentals of a company verses
a stock price for that company. I believe that frequent price checks
make an investor more liable to forget there is a real, live business
behind a gyrating stock price. Stocks are invariably more volatile
than the businesses they represent, and following a fluctuating
price can introduce emotional elements into a decision. You base
decisions on the stomach, not the head. Risk should not be defined
by how much a stock price fluctuates, but rather by how inexpensively
the stock can be purchased in relation to its intrinsic value.
and scale according to the risk/reward scenario of a business and
TIS tries to be optimistic about our holdings, subject to verification,
but also with the view that it is only what we own that can hurt
us. This has often led to rapid portfolio turnover, especially when
our positions are undergoing substantial volatility. In part this
is a function of the type of stocks we follow. Retailers in particular
undergo wide price swings, as their progress is usually updated
monthly. You might think that having more information available
would increase the patience and intelligence that investors possess
but the opposite is often true. In essence, it appears that more
information on a short-term basis results in a short-term viewpoint.
Since this leads to substantial changes in valuation, we will buy
and sell as circumstances dictate.
Continually study an investment style that already works.
From the beginning, I have carefully studied the philosophies and
practices of very successful investors. My two biggest influences
are Peter Lynch, former manager of the Fidelity Magellan fund, and
Warren Buffett, the most successful investor of the 20th century.
Both have written extensively about their investment approach. I
have found Lynch, who wrote the books One Up on Wall Street
and Beating the Street along with numerous magazine articles,
to be particularly helpful, especially his stock category system and extensive
industry analysis. Buffett is obviously
the standard for long-term investment success and I have carefully
studied his discussions of superior business models.
15. Be flexible.
I am continually attempting to refine and improve my investment
technique. I have explored alternative investment techniques (e.g.,
merger arbitrage securities), industries (e.g., semiconductors),
investment styles (e.g., very small speculative purchases in
1999 and 2000), and countries (e.g., Canadian securities starting in 2011). In the end, I am only interested in what works over
the long-term and will remain open to anything which results in
a fundamental improvement in my technique.