Over the past ten years, I’ve participated in both the public and private markets, investing in over 50 late-stage private companies, early-stage startups, and pieces of real estate. This is how I’ve learned to evaluate investments.
Successful investing boils down to buying assets at a discount to intrinsic value. The greater the discount, the more likely the investment will perform. Benjamin Graham, the father of value investing, called this “margin of safety.” The concept is simple in theory and extremely challenging in practice, with the valuation process anything but straightforward.
Two highly-educated, emotionally stable, and reasonable people can view the same information and come to very different conclusions. People weight information differently based on their preferences, values, and experiences. Some are comfortable tolerating certain types of risk. Predictions differ and forecasts can be wildly divergent. Those differences create the market. As just one participant in the market, here’s how I evaluate a company’s intrinsic value.
I always start by understanding what I call owner earnings, which I define as:
Owner Earnings = Net Income + Non-Cash Expenses (Depreciation, Amortization, Depletion) + One-Time Charges – (Maintenance Capital Expenditures + Working Capital Needs)
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“The easy money has been made” is one of my least favourite sayings about investing.
Making money in the markets is never easy. In fact, I would argue that it’s always hard.
Convincing yourself to buy during a bear market is hard. Convincing yourself to hold during a bull market is hard. Figuring out what to do during a sideways market is hard. Watching others make more money in the markets than you is hard. Following a plan when things aren’t going your way is hard. There’s always going to be a reason to do something that goes against your best interests.
Howard Marks wrote about this idea in a memo for Oaktree Capital a couple years ago:
Two of the main reasons people sell stocks is because they go up and because they go down. When they go up, people who hold them become afraid that if they don’t sell, they’ll give back their profit, kick themselves, and be second-guessed by their bosses and clients. And when they go down, they worry that they’ll fall further.
Where we are in each cycle usually determines what the hard part is at that moment. The hardest part for the past few years has been holding on during a rising market. Investors witnessed two epic market crashes in the span of eight years to kick off the start of the century. Those types of losses leave scars on an investor’s psyche.
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Today marks 30 years since a confident young man walked into the back office of Schroder Investment Management in London, to start his first day on the job, the first in his career. Ask me a question back then and I would have answered assuredly and quickly. Today I’d be more likely to say ‘I don’t know’ with just as much confidence.
Now older, wiser, but with just as much hair, I have over the years seen many people come and go. Clients, colleagues, bosses, company mergers, bankruptcies (thankfully not my own), through bull and bear markets, booms, crashes, and have seen my own fortunes fluctuate too before setting out on my own a few years ago.
Thirty years is a long time. The good news is it was all worth it.
The first thing to point out is I don’t have all the answers. That’s not what this post is about. I’m always learning. But I have benefited enormously from people sharing their time and expertise, so if I can help others in the same way, I’m happy to share what I’ve learnt also.
These are 30 observations, guiding principles, or simply things that work for me. Some of you who have followed me for a while will recognise many of them. These aren’t universal truths, they’re my truths, my beliefs, shaped by my experience.
And that’s probably a good place to start.
“The more you believe something to be true, the more you will have accumulated evidence to support it.”
That’s a quote from trading coach Van Tharp, and I’ve applied it to so many areas as a simple way of explaining people’s expression of their beliefs, my own, and the realisation of how powerful confirmation bias is. Van believes we don’t trade the markets, we trade our beliefs in the market. A trading system therefore is simply a set of beliefs, and I think he’s right.
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The heady Indian bull market was fueled by the liquidity rush post demonetization. But that was not the only reason propelling indices in India to new highs. Thanks to lower global interest rates, money was channelized into India in the hunt for better returns. A stable government at the center, lower crude prices and low inflation were other factors that contributed to the overall positive sentiment.
But many of us wanted more than what blue chips had to offer. We wanted to “beat the market”. Or, for that matter even the track records of legendary investors like Warren Buffet or Peter Lynch. Naturally, this led us to scenarios which offered potentially superior returns. And in the perpetual hunt for 10-baggers, we ended up investing in nano-, micro- and small-cap companies with questionable business models, corporate governance and promoter intentions.
We looked at:
- Turn around stories
- Hope stories
- High growth small cap names
- Formalization of informal sector across industries
- Commodity stocks
Many stocks that fell in the above categorizations turned out to be 10-20 baggers over the last 3-4 years. But once the music stopped, we witnessed a vertical decline in stock prices that has stunned even seasoned investors.
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Over the course of 15 years working as a performance coach with traders and investors, from day trading shops to hedge funds and investment banks, I’ve enjoyed an unusual front row on the factors that contribute to success and failure in financial markets. During that time, I’ve conducted numerous interviews, directly observed hundreds of traders and administered countless personality tests. That experience has convinced me that much of what we think we know about trading success is just plain wrong. In this article, I tackle three myths of trading success and offer alternate perspectives.
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In February 2000, a financial advisor named Bob Markman wrote an article that got a huge amount of attention online. Called “A Whole Lot of Bull*#%!” (that’s how the original was spelt) and published by Worth magazine, the article attacked the idea of diversification, arguing that any money put into currently underperforming investments was money wasted. Internet and other technology stocks had been so hot for so long that nothing else was worth owning, Markman argued. He was far from alone in saying that.
Markman and I exchanged long emails and even longer letters (that’s how people communicated in those Neolithic days), but the “debate” boiled down to one point: Can the typical investor predict the future with precision, or not? Markman insisted the answer was yes. I felt then, as I still do, that the answer was no.
In Markman’s defence, there is a case to be made that if you have inside knowledge or superior analytical ability, then you should bet most or all of your money to capitalize on it. Warren Buffett and Charlie Munger have long argued exactly that. If you are as analytically brilliant as Buffett or Munger, diversification will lower your returns. The rest of us, however, should have much less courage about our convictions. And inside knowledge or superior analytical ability are best applied to individual securities, not to broad market views.
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Every day I jot down on yellow legal paper a list of ideas and subjects that I think will be interesting to our subscribers and that I can add value to — topics for future opening missives in my Diary.
Each morning, at around 4:45, I think about what I will write as the subject of my opener for the day.
I typically contemplate the prior day’s market action and the overnight price changes in the major asset classes and regional markets around the world and I try to come up with something relevant, topical and actionable.
Something on my list, for many moons, is the subject of the lessons I have learned from Jim “El Capitan” Cramer.
Over the years I have written about the contributions that Jim has made and I have defended Jim as well against the wrong-footed criticism that he often faces in his role as a high-profile and visible public figure.
My defence of Jim is not done because I essentially have worked for him over the last two decades. Rather, it is heartfelt and done in the recognition of the contributions that Jim has made since he invented and founded TheStreet. I do this in large part because Jim has been my professor, an important contributor to my investment experience.
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In his book Succeeding, John Reed wrote one of the smartest things I’ve ever read:
When you first start to study a field, it seems like you have to memorize a zillion things. You don’t. What you need is to identify the core principles – generally three to twelve of them – that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles.
This extends beyond those learning a new field. I think it’s most relevant for those who consider themselves experts. The root of a lot of professional error is ignoring simple ideas that seem too basic for those with experience to pay attention to.
Having seen the investing world from several different angles, four skills stand out as governing most of outcomes.
1. The ability to distinguish “temporarily out of favor” from “wrong.”
The two strongest forces in investing are “This investment looks broken because that’s how opportunity presents itself” and “This investment looks broken because it’s actually broken.” It’s hard to tell the difference in real time. Distinguishing between the two relies on accurately calculating the odds that something will eventually come along to heal or promote the market or company that looks broken. And since those odds are always less than 100%, it can take a while to tell if you’re any good at it, because even when the odds are in your favor the outcome can go the wrong way. It’s hard to do. But worse, and more common, is forgetting that a distinction needs to be made in the first place.
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Here’s a great article from Morningstar which discusses the importance of patience as a value investor. One of the key takeaways is:
“However, by anchoring investment decisions to value, we can navigate challenging circumstances and look through market noise and emotion to identify and take advantage of opportunities that may present in times of market stress. This often sees our views as contrarian to others in the market.”
Here’s an excerpt from the article:
It is difficult to know how long it will take for an attractively priced asset to appreciate towards its fair value, long-term investors must be prepared to wait.
Value investing has a prominent place in our investment process and is backed up by a vast body of empirical evidence that supports this approach to investing.
Perhaps it can be best described through illustration in the diagram below:
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This is an oldie but goodie – Peter Lynch on how to pick stocks. By chance, we were also doing the Lynch book list and ran into some confusion if anyone knows please let us know
Here are the obvious three
The Davis Dynasty: Fifty Years of Successful Investing on Wall Street says its by John; Peters S. Lynch (foreword) Rothchild, I would assume the foreword for a book about Shelby Davis would be the investor Peter Lynch but we were unlear if he had a middle S initial (or if he did not, is that a typo? – obviously can read the book itself but hard to find some of these out of print books and we only have so much time and rsources) in the end we were not sure so would want to exclude it. We will have our list for better or worse soon. We also transcribed the following video – it is not verbatim and is for information purposes only
Enjoy
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