Value Investing

Establishing your primary fundamental factors

By Alex of The Snowball Effect

Key learnings:

–          The primary fundamental factors and how they are linked will (and should) evolve over time

–          You will have more than one set of primary fundamental factors

–          Each factor will bear a different weight depending on the situation

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Hope you guys all had a great week! As you might know by now, I like working out and staying in shape in general, so allow me to draw a parallel here between our Investment Decision System (“IDS”) and physical activity, which are often quite similar in terms of concept. The first step of our Investment Decision System, finding out who we really are as investors (Step #1: Find out who you are as an investor – IDS series), is very similar to discovering what we like to do in terms of physical activities. Do you like cardio? Do you prefer pumping iron? Do you like pushing yourself physically for hours on end? The second step of our IDS was to figure out where to find ideas (Step #2: Where to find ideas – IDS series). Similarly. When you seriously devote yourself to any kind of physical activity, you’ll want to keep improving, finding new ways of doing things and stay inspired by exploring different gyms, fields and running tracks, reading blogs on the subject, surfing specialised websites, etc. For the third step, we will get a bit more specific. What we want to establish are the factors that are so fundamental that they will allow you to fairly quickly decide what you wish to do with an investment idea – keep it or reject it. Comparatively, in terms of physical activities, there is some stuff you just won’t do because it is not in line with who you are and what you like to do. And if you try, you’ll probably fail as you’ll do it half-heartedly.

Again, this third step of your IDS will largely depend on what you found out going through step one and two. Now that you know who you are as an investor and where to look for ideas, it would be humanly impossible to start doing an in-depth analysis of each idea you come across. Just by glancing at the newspaper, you might come up with 4-5 names of potential targets… so you need a system which will allow you to quickly filter these ideas. Like a lot of other stuff, with experience, your brain should get better at this. The way your brain filters potentially complex systems or ideas is by simplifying as much as possible and by taking shortcuts, focusing on what’s important. Your brain does this all the time and it often happens so quickly that you don’t even realize it. For example, when you are in a certain situation and slowly get scared or anxious, it’s because your brain is processing the available information and it encounters enough alarming factors to create that response. As investment is not as instinctive for most people, it will take a bit more work but it will get easier with time – guaranteed. Why do you think Warren Buffett can decide in a few seconds if an investment opportunity is worth exploring further? Well, he’s 87 years old and has been investing non-stop since he’s 11 years old… that’s what I call experience. As some part of the IDS will eventually become fairly instinctive, to make the learning process smooth, it’s important to respect who you are as an investor.

So, what we want to achieve for this third step is to recognize the primary fundamental factors creating that reaction in your brain which, in investment, will translate as let’s put this investment idea into the “keep” basket. At this initial selection stage, don’t focus too much on what you might not like about an investment (I’m sure there’s plenty for each idea), focus instead on what you are looking for in an investment. With experience, you will learn and your brain will instantly aggregate these primary fundamental factors for easier use – and this is in fact the way it should be. You might start with only two to three factors of selection but over time you have to stay flexible and incorporate (or delete) additional factors and allow these factors to interact in a flexible manner with each other. This means that you might not have only one set of factors but rather several sets. In addition, the weight of each factor in a set might vary depending on the investment idea you are considering. For example, I might be considering an idea where the growth of the company is not as good as I’d like but from my initial review, the firm seems extremely undervalued for some reason, then in that situation, the valuation of the stock might bear more weight than usual. This might all seem overly complicated and fuzzy, but it’s simply an exploration of how your brain works and takes quick decisions and how you should try to structure this process to apply it to the initial selection stage of your IDS. If you haven’t read it yet, I would also recommend you to read one of my past posts titled “Investors, illogical by nature?”.

Last week, I discussed the importance of keeping an idea log. Now that we are one step further into our IDS, let me refine this concept a bit. What should you include in your idea log (or at least keep in mind)? When you input an idea into your log, you should find a way to keep track of the most important primary fundamental factors you’ve identified for that specific idea and make sure you can follow their evolution over time based on your primary concerns. To put it simply, if for example, your primary concern is related to the market valuation of a firm, you would want to follow up on its valuation once in a while and see how it’s evolving over time. At the beginning, I would suggest you to take a lot of notes in your log until the process becomes more natural and you can easily follow up on your ideas without the need of extensive notes. Writing down your main concerns and comments will make it more real and much easier to remember and refer to in the future. You’ll then be able to realize if you were right or wrong and learn from it. It’s a simple concept which will allow you to progress tremendously.

Now, you might be wondering what are my own primary fundamental factors (or not, but whatever :P). Just use what follows as an example in order to grasp the concept better. And as we just discussed, my own factors are changing over time (in breadth and depth) and the interaction between these factors is different for each potential target. I kept the list of factors below fairly generic (from my point of view) and short on purpose so not to confuse anyone. Keep in mind that you do also want to keep this list simple as this is a first filter only.

Example of a set of primary fundamental factors:

1-      Strong underlying business: Strong underlying business that I can understand easily in terms of future revenues/earnings and business model.

2-      Strong ROIC: High levels of historical returns on invested capital with good trend and which offers scalability. Avoid firms with size increase but quickly declining ROIC.

3-      Great potential and market: Great potential market for growth. Look for firms which can position themselves strongly within an industry. Avoid dying or highly uncertain industries.

4-      Undervaluation: Inexpensive market valuation, with a focus on temporary undervaluation driven by specific events. Please note that at this stage I’m not looking to do a full valuation analysis. I simply want to get an idea of the target’s valuation and will most likely only rely on standard valuation ratios and metrics (for now at least).

Even though the above list is fairly short, finding a target with high levels of each of these four factors can be challenging and this is why you need to stay flexible and might not give the same weight to each factor in your set.

For your understanding, although it’s not the focus here, there are some other factors which are obviously less important to me. Size is a good example. Even though the size of a firm can become relevant in some circumstances, size is not necessarily part of my primary fundamental factors as I do consider small, medium and large caps. However, I know several investors for example who like to focus mainly on small uncovered firms as they believe this gives them an edge.

Establishing your primary fundamental factors represents only the first step, but clearly, we won’t stop there. Next week, we will go one step further and discuss detailed checklists.

Featured image: What’s your type of apple? (no, it’s not me in the picture). Source: chilesfamilyorchards.com

Embedded image: Make your neurons work for you! Source: fractalfoundation.org 

Next post, next week!

Keep growing your snowball!

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