Ten attributes of Great Fundamental Investors
1) Be numerate & understand accounting
To be a successful investor, you have to be comfortable with numbers. There are rarely complicated calculations; but a feel for figures, percentages and probabilities is essential. One of the main ways numeracy comes up is in financial statement analysis. Great investors are adept at the financial statement analysis, which allows them to understand how a business has done in the past and gives sense of how it will do in the future. The goals of the financial statement analysis are twofold. The first is to translate financial statement into free cash flow, the life blood of the corporate value. You calculate free cash-flow by starting with cash earnings and subtracting the investments a company make to generate future earnings. Investments include increases in the working capital, capital expenditures above and beyond what is needed to maintain plant and equipment and acquisition. Free cash-flow is what is left over after investments have been subtracted from cash earnings. The second goal in the financial statement analysis is to make link between a company’s strategy and how it creates value. You can do a simpler analysis by looking at the path to return on the invested capital (ROIC). You can break ROIC into two components: Profitability (net operating profit after tax/sales) and capital velocity (sales/invested capital). Companies with high operating profit margins and low capital velocity are generally pursuing what Michael Porter, calls a “differentiation” strategy. Companies with low operating profit margins and high capital velocity are following “cost leadership” strategy.
2) Understand value (the present value of free cash-flow)
Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow. Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within the industry, barriers to entry, the economics of the business, and management’s skill at allocating capital. A corollary to this attribute is that great investors understand the limitation of the valuation approaches such as P/E ratio and EV/EBITDA multiples. Indeed multiples are not valuation but shorthand for the valuation process. No thoughtful investor ever forgets that. Short hands are useful because they save you time, but they also come with blind spots.
3) Properly assess strategy (or how business makes money)
Fundamental understanding of how company makes money. The idea is to distill the business to the basic unit analysis. The basic unit analysis varies by industry. Great investors can explain clearly how company makes money, have a grasp on the changes in the drivers of profitability, and never own the stock of the company if they do not understand how it makes the money. One should understand the company’s sustainable competitive advantage. A company has a competitive advantage when it earns a return on the investment above the opportunity cost of capital and earns higher returns than its competitors. Great investors can appreciate what differentiates a company that allows it to build a economic moat around its franchise that protects the business from the competitors. The size and longevity of the moat are the significant inputs into any thoughtful valuations.
4) Compare effectively (expectations versus fundamentals)
The most important comparison an investor must make and one that distinguishes average from great investors is between fundamentals and expectations. Fundamentals capture a sense of a company’s future financial performance. Value drivers including sales growth, operating profit margins, investment needs and return on invested capital shapes fundamentals. Making money in the markets requires having a point of view that is different than what the current price suggests. Most investors fail to distinguish between fundamentals and expectations. When fundamentals are good they want to buy and when they are poor they want to sell. Great investors always distinguish between two. Great investors are able to segregate the stock price into the fundamentals and the expectations which leads it to quote at premium. If the stock price comprises more of expectations than the fundamentals they might like to stay away from the stock. On the other hand if the stock price comprises good fundamentals and down beat expectations than they might buy the stock in the expectation that the sentiments will turnaround in the future.
5) Think probabilistically
Investing is an activity where you must constantly consider the probabilities so the various outcomes. Great investors recognize the uncomfortable reality about probability: the frequency of correctness does not really matter (batting average), what matters is how much money you make when you are right versus how much money you lose when you are wrong. Take the probability of loss times the amount of possible loss from the probability of the gain times the amount of possible gain. Rather than betting on the frequency of right and wrong one should quantify the amount of loss versus amount of the possible gains if the outcomes turns out to be as expected.
6) Update your views effectively.
Most people prefer to maintain consistent belief over time, even when the facts reveal their beliefs are wrong. We all walk around the world that we believe are correct. You are compelled to change your mind only when you confront reality that disconfirms your beliefs. But great investors do the two things that most of us do not. They seek information or views that are different than their own and they update beliefs when evidence suggests they should. Moreover they are actively open-minded. Actively open minded is defined as “the willingness to search actively for evidence against one’s favored beliefs, plans or goals and to weigh such evidence fairly when it is available. The best investors recognize that the world changes constantly and that all of the views that we hold are tenuous.
7) Beware of behavioral biases:
Intelligent quotient (IQ) measures mental skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good decisions. The Overlap between these abilities is much lower than most people think. Warren Buffett “I always look at IQ and talent as representing the horsepower of the motor, but that the output- the efficiency with which that motor works depends on rationality. A lot of people state out with 400- horsepower motors but only get a hundred horse power of output. It is way better to have a 200- horsepower motor and get it all into output. Decisions by individuals depart from normative economic approaches in risky situations amid behavioral biases. RQ is very important.
8) Know the difference between information and influence
Investing is inherently social exercise. Price can go from being a source of information to a source of influence. This has happened many times in the history. Take the dotcom boom as an example. As internet stocks rose, investors who owned the shares got rich on paper. This exerted influence on those who did not own the shares and many of them needed up suspending belief and buying as well. This fed the process. The rapid rise of the dotcom sector was less about grounded expectations about how the internet would change business and more about getting on board. Negative feedback ceded to positive feedback, which pushes the system away from the prior state. Great investors don’t get sucked into the vortex of influence. This requires the trait of not caring what others think of you, which is not natural to humans. Indeed many successful investors have a skill that is very valuable in investing but not so valuable in life: a blatant disregard for the views of others.
9) Position sizing (maximizing pay off from the edge)
Success in investing has two parts finding edge and fully taking advantage of it through proper position sizing. Almost all investment firms focus on edge, while position sizing generally gets much less attention. Proper portfolio construction requires specifying a goal (maximum sum for one period or parlayed bets), identifying an opportunity set (lot of small edge or lumpy but large edge), and considering the constraints (liquidity, drawdowns, leverage). Answer to these questions suggests an appropriate policy regarding position sizing and portfolio construction. Astute investors understand that finding edge and betting on it appropriately are both essential to long-term success.
10) Read (and keep an open mind)
Great investors generally practice few habits with regard to their reading. First they allocate time to it. Warren Buffet has suggested that he dedicates 80 percent of his working day to reading. Good readers tend to take on material across a wide spectrum of disciplines. Don’t just read in business and finance. Expand the scope into new domains or fields. Follow your curiosity. Make a point of reading material you do not necessarily agree with. Find a thoughtful person who holds a view different than yours, and then read his or her case carefully. This contributes to being actively open-minded.