IDS series links:
Step #1: Find out who you are as an investor
Step #2: Where to find ideas
Step #3: Establishing your primary fundamental factors
Step #4: Checklist and elimination process
Hello from DaNang, Vietnam! My better half and I decided to take a short weekend break from Hong Kong’s hustle and bustle to enjoy a quieter place. Although it’s the rainy season in Vietnam right now (meaning pretty crappy weather), it’s always good to take it easy and refresh for a couple of days. If you live in a city as busy as Hong Kong, you understand what I mean.
Back to our IDS, congrats if you’re still hanging in there and going through each step of the Investment Decision System! This week we’re wrapping up and so it’s the last part of the series. After reading this post, you should be in a pretty good shape to develop your IDS and practice on your own. Let me repeat this again – as it is important – an IDS should be a personally developed system. Two people can have very similar approaches, but don’t try to replicate an approach which doesn’t fit you just because someone else applied it successfully. Alright, this last part includes a few steps, so let’s get started with the first one.
- Valuation
So far, we have done very little in terms of valuation besides considering common valuation ratios (such as EV/EBIT) and probably comparing them with industry peers, historical levels and considering what you, as an investor, are ready to accept. At this point, if the target you’re considering is still of interest, you might want to dig a bit deeper into the value of the company. When valuing a firm, you’re trying to look into the future and to be able to do that, you need to have some knowledge about the company you’re reviewing. After you’ve been through step 1 to 4 of your IDS, you should be in a much stronger position to be able to judge and value a firm. The more you know about a firm, the easier it gets to value it and to focus on the core factors which will really move the needle. It’s important to have a very clear understanding of how valuation works and the different forces affecting it. Once you are crystal clear about how it works, go for it, but keep it simple! I mean it. Building a 72-page DCF model won’t help. Unfortunately, your valuation won’t get more accurate based on the amount of data you input. Why? Because it will all be forward looking and that it’s basically impossible to accurately predict the future. So, you better spend more time understanding the business than inputting precisely wrong forecasts in a model which will give you a false impression of being right. (Why do you think equity analysts review their target price every three weeks!?) Besides some specific situations and strategies (eg: net-net investing, “hidden” assets, etc.), what you’re basically trying to find out is if the company you’re looking at will do badly in the future, if it will stay more or less stable, if it will do good or if it will do great. And if you can correctly predict this based on your knowledge of the company, you’re already a long way ahead.
Instead of repeating myself on how to approach valuation in more detail, I suggest you have a look at the following three posts which should be fairly helpful.
What can you really earn?
Be vaguely right, not precisely wrong!
Big spenders, Big value
The way to decrease risk is by knowing as much as you can about a business and however you value a firm you should also require a significant margin of safety to protect your downside.
- The primary fundamental factors loop
Once you get into the nitty gritty of a potential investment target, it can get difficult to keep the big picture in mind and that’s why it’s important to build a loop in your IDS which goes straight back to your primary fundamental factors. After having done all of your research and digging, go back to Step #3 and see if you still agree with the notes you took while going through these factors. These are “fundamental” factors so if at the end you realize that the target doesn’t fit the bill, have the courage to let it go. The target doesn’t care that you went through your whole analysis and spent time and energy on it. If you’ve done the work, considered the big picture and at the end it’s not right, just pass and go to the next one.
- Decision
It’s decision time. There should be very few potential targets making it this far, but that doesn’t mean it’s necessarily the right time to invest in these selected few. So you basically have two choices here: 1) Give it a pass, but keep the target on your watchlist, or 2) Invest. If you’ve studied the target and have a fair understanding of its business and valuation, there’s no good reason to totally discard it and forget about it forever. By following a company you know something about, you can always learn, especially over a long period of time. So, if you decide to pass, use the target as a learning tool. The second obvious advantage of keeping an eye on an interesting target is that its valuation might become attractive at some point and you might decide to act on it. If you decide that it’s the right target and the right price, go big! Diversification can easily become “diworsification” if you take tiny stakes in several targets because of the fact that you want to decrease your risk. You decrease your risk by knowing what the hell you’re doing, not by doing a lot of what you’re not certain about. So, if you’re not sure about a target, keep working on it or just keep it on your watchlist and learn from it.
- Record
What I mean by “record” here is not just keeping track of your investment returns – that goes without saying. What I really mean is that you should keep a log and take notes of your investment decisions. What works? What doesn’t? What are the factors which influenced your decision and on which you were wrong (or right)? How can you do better next time? The objective is to improve your IDS and make your “money machine” as good as possible. This takes time, but it’s worth it. To do this, you can use a simple Excel log or a well-organized note taking app or software. By only relying on “experience”, your progress will be much slower. Human beings tend to make similar mistakes over and over again and as opposed to what you might think, we don’t learn that quickly, especially for decisions which might seem counterintuitive. By recording as much as possible, you’ll be in a much better position to learn from your past experience and decisions.
Conclusion
In summary, once you think you’ve developed a strong IDS, the real question is: can you apply your system repeatedly and successfully over time? If you can, then you’ve found your IDS – a system which works well for you. It will act as a little (or big) money machine! As for most machines and systems, you’ll have to keep improving on it and come up with version 2.0, 3.0, etc. Keep growing your snowball!
Featured image: Yep, a crossroad… Source: documill.com
Embedded image: Two monkeys in the wild – Danang, Vietnam – November 2017
Next post, next week!
