The Step by Step Investment Process for Earning Superior Returns – Part I

Updated on

Want to know what the secret to investing is?

The real secret to investing is that there is no secret to investing. Every important aspect of investing has been made available to the public many times over, beginning in 1934 with the First Edition of Security Analysis (1934). That so many people fail to follow this timeless and almost foolproof approach enables those who adopt it to remain successful.Seth Klarman

Get The Full Seth Klarman Series in PDF

Get the entire 10-part series on Seth Klarman in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Seth Klarman, Chief investment officer at Baupost and is considered one of the top five fund managers in the World, measured by investment returns.

There are a number of self-promoters trying to fleece you out of a dollar, by saying to the effect, ‘want to know the secret to getting 800% returns? I know the secret and if you attend my two-day conference for only $7,000 I will tell you the secret! And all you need is a ruler.‘ Or ‘just download this latest trading software to earn 400% returns.’ It’s horse shit!

Warren Buffett, who is currently the World’s third richest man, has consistently spelt out his successful investment strategy for the last 60 years!!! Don’t believe me, here is the link to Buffett’s Partnership letters and Berkshire Hathaway Shareholder letters.

We live in the information age, where we have at our fingertips access to the world’s information. And according to the BBC, in the course of a day, the average person in a Western city is said to be exposed to as much data as someone in the 15th century would encounter in their entire life.

“We’re drowning in information and starving for wisdom.”

– Tony Robbins

95% of information out there about investing is Bull Shit!

Here I will outline an easy step by step investment process to provide you with a timeless and proven investment strategy for beginners. You have worked hard to earn the money you have now, don’t throw it down the drain by taking a punt on the sharemarket.

The investment strategy I will outline for you below has passed the test of time and can be used in a majority of countries. A booklet titled ‘What has worked in investing’, examined 44 studies that assessed the success of historically investment characteristics and approaches. The conclusion of the 44 studies provides empirical evidence that Benjamin Graham’s principles of investing work, as described in his 1934 in his book, Security Analysis, with David Dodd. Benjamin Graham taught Warren Buffett these same investing principles and they are the same investing principles I will teach you.

In a nutshell, successful investing is calculating the intrinsic value of investments including businesses, by discounting future cash flows to be taken out of the business during its remaining life. But before you start discounting the cash flows, you need to assess the quality of those future cash flows. Firstly by understanding the business, looking at the sales, the costs of operations, the value of assets, assessing the strength, if any exist, of the competitive advantages enjoyed by the business and finally assessing the management’s ability to intelligently allocate capital. Then applying a margin of safety to the purchase price, to protect you from any mistakes made during the assessment of the investment.

Let’s start by defining what investing is.

“The definition is simple but often forgotten: Investing is laying out money now to get more money back in the future–more money in real terms, after taking inflation into account.” Warren Buffett

The questions to ask is, what stock to invest in? And how long will it take to get more money back in the future then what I’m putting in now?

The second question requires a brief explanation about the role of inflation and interest rates.

Inflation is the rate at which the general price levels goods and services rise. Central banks try to keep the inflation rate in a band between 1 – 3 percent. Inflation presents to the investor their first hurdle. The hurdle is a rate of return needed to exceed each year in order to increase your purchasing power against the effects of inflation. Inflation is what causes a dollar today to be worth less in one years’ time.

Interest rates are another key consideration an investor must take note of, due to their effects on asset prices and valuations. I cannot explain better than the way Warren Buffett explained it, in this interview with Carol Looms, Fortune. Nov, 1999. [Excerpt below]

Now, to get some historical perspective, let’s look back at the 34 years before this one [1999]–and here we are going to see an almost Biblical kind of symmetry, in the sense of lean years and fat years–to observe what happened in the stock market. Take, to begin with, the first 17 years of the period, from the end of 1964 through 1981. Here’s what took place in that interval:

DOW JONES INDUSTRIAL AVERAGE: Dec. 31, 1964: 874. 12 Dec. 31, 1981: 875.00

Now I’m known as a long-term investor and a patient guy, but that is not my idea of a big move.

And here’s a major and very opposite fact: During that same 17 years, the GDP of the U.S.–that is, the business being done in this country–almost quintupled, rising by 370%. Or, if we look at another measure, the sales of the FORTUNE 500 (a changing mix of companies, of course) more than sextupled. And yet the Dow went exactly nowhere.

To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates.

These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.

Consequently, every time the risk-free rate moves by one basis point–by 0.01%–the value of every investment in the country changes. People can see this easily in the case of bonds, whose value is normally affected only by interest rates. In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the effect of interest rate changes is usually obscured. Nonetheless, the effect–like the invisible pull of gravity–is constantly there.

In the 1964-81 period, there was a tremendous increase in the rates on long-term government bonds, which moved from just over 4% at year-end 1964 to more than 15% by late 1981. That rise in rates had a huge depressing effect on the value of all investments, but the one we noticed, of course, was the price of equities. So there–in that tripling of the gravitational pull of interest rates–lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere.

Then, in the early 1980s, the situation reversed itself. You will remember Paul Volcker coming in as chairman of the Fed and remember also how unpopular he was. But the heroic things he did–his taking a two-by-four to the economy and breaking the back of inflation–caused the interest rate trend to reverse, with some rather spectacular results. Let’s say you put $1 million into the 14% 30-year U.S. bond issued Nov. 16, 1981, and reinvested the coupons. That is, every time you got an interest payment, you used it to buy more of that same bond. At the end of 1998, with long-term governments by then selling at 5%, you would have had $8,181,219 and would have earned an annual return of more than 13%.

That 13% annual return is better than stocks have done in a great many 17-year periods in history–in most 17-year periods, in fact. It was a helluva result, and from none other than a stodgy bond.

The power of interest rates had the effect of pushing up equities as well, though other things that we will get to pushed additionally. And so here’s what equities did in that same 17 years: If you’d invested $1 million in the

Dow on Nov. 16, 1981, and reinvested all dividends, you’d have had $19,720,112 on Dec. 31, 1998. And your annual return would have been 19%.

The increase in equity values since 1981 beats anything you can find in history. This increase even surpasses what you would have realized if you’d bought stocks in 1932, at their Depression bottom–on its lowest day, July 8, 1932, the Dow closed at 41.22–and held them for 17 years. [End] Click here to view original.


I provide members with the appropriate excel spreadsheet tables to calculate the return and length of time it takes to double your money. A shortcut you can use is the rule of 72. Just divide 72 by your return to work out how many years it will take to double your money.

Example: 72/10% = 7.2 years

Back to the first question: What stock to invest in?

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual insights or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

Warren Buffett


We’ll cover the Valuation of the Entity and Assessing the Earnings Power steps before the Search Process, as it will become easier for you to spot investment opportunities if you know what you are looking for, like duck hunting, you want to be shooting ducks, not pigeons.

Before we kick off, throughout this exercise, we will use the 2016 Annual Report of a company called Michael Kors (NYSE:KORS) listed on the New York Stock Exchange (NYSE), as our guinea pig.

Michael Kors is according to their website; ‘Michael Kors is a world-renowned, award-winning designer of luxury accessories and ready-to-wear. These products include accessories, footwear, watches, jewellery, men’s and women’s ready-to-wear, eyewear and a full line of fragrance products.’

Valuation of the Entity

Here we are looking at the balance sheet. Bruce Greenwald, in his book Value Investing: from Graham to Buffett and Beyond; recommends starting at the balance sheet to examine the value of the company’s assets and liabilities at the end of the most recent operating period, as determined by the company’s accountants.

As we work down the balance sheet, we accept or adjust the stated number as analysis dictates. For example, no need to adjust cash but we need to adjust deferred taxes to present values.

Working down the asset list on the balance sheet, from cash at the top, whose value is certain, to various intangible assets like goodwill, whose value is often problematic to determine with accuracy, it reminds us of the decreasing reliability of the stated values. Benjamin Graham would only rely on current asset values, as these are often realised within a year and the values do not vary far from the actual sale of those assets.

And after going down the liabilities side, we finish off by subtracting liabilities from assets to obtain the current net asset value. There is no need to forecast the future as the assets and liabilities exist today.

“Our principal purpose in valuing a firm is based on its assets is to discover if the economic value of the assets is accurately reflected in the price at which the firm’s securities are being brought and sold. Opportunities lie in the gap between price and value.” Bruce Greenwald [emphasis mine]

Warren Buffett noted in his 1993 Berkshire Hathaway annual report, that “one question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.”

Get The Full Warren Buffett Series in PDF

Get the entire 10-part series on Warren Buffett in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues

Let’s see it in practice, so, bring out the guinea pig.


Current Assets

You will notice little has changed on the current assets, as all current assets are expected to be turned into cash within the year, but an adjustment is needed with receivables, as we need to add back bad debt allowance, as a new company will also be faced with non-payment for their own receivables.

As current assets are expected to be converted to cash within the 12 month period, it is referred to as the operating cycle. For a retail business like KORS, the average length of time it takes to acquire inventory, sell the inventory to customers and ultimately collect cash from the sale is within 12 months. But a Jewellery business like Swarovski the operating cycle is quite longer.

Non-Current Assets

Moving down to non-current assets, the longer term fixed assets is where opportunities are more likely to present themselves but also become harder to accurately assess their value. For example consider KORS’s Property (no plant) & equipment valued at $758 million on the balance sheet, property, in particular, is reported by the company accountants at cost less accumulated depreciation and amortisation (carrying value). Property, plant & equipment will be reported on a net accumulated depreciation and will be the largest non-current assets for most companies.

The true value of their property is not reflected on the balance sheet. For example, an office block (not KORS), purchased in 1990 for $1,000 per square metre, could be worth $2,870 per square metre today. And if the office block doesn’t serve the company anymore it should sell it and pocket the difference. The gap between book value and the net gain from the sale should catch our eye.

The retail industry had enjoyed higher barriers to entry before the internet came along, as brick and mortars stores were the main point of sale for retailers, but as Amazon has demonstrated, the barriers to entry have fallen, and customers can now purchase items from home. The cost to set up an online store is now almost free.

KORS has no need for a plant as the ‘Company contracts for the purchase of finished goods principally with independent third-party contractors, whereby the contractor is generally responsible for all manufacturing processes, including the purchase of piece goods and trim.’ KORS AR16

If a company does have Plant, identifying what the plant is, is important. Examples of a plant are; an oil refinery (BP or Shell), fiber-optic or copper cable installed (Telstra or AT&T) or a string of motels across the country (Best Western).

There are two important forces creating large differences between book value and reproduction cost.

The first is depreciation.

Under the rules of the accrual basis of accounting, expenses are recognised in the period in which the consumption of costs can be measured in a faithful verifiable manner. The purchase of a building is considered as a prepaid expense, cash or credit (corporate loan) and is paid before an expense is incurred (consumption of the asset by the business) over 25-30 year period.

The company accountant will estimate the residual value (expected sale price) and deduct the cost of the building to determine the estimated time over which the building is expected to be consumed (referred to by accountants as Useful Life). This portion of the buildings cost is assigned to expense is called depreciation.

Therefore, values will be reported on depreciation basis independently from the economic value of the asset.

And the second is inflation, as the building is being charged depreciation to replace this year’s use economic value of the asset, which is based on historical cost. The historical cost is as relevant as the price paid for a train ticket in 1930.

We may be overstating our income by understating the real expense.” Greenwald

A new competitor today has to pay for plant into today’s dollars and their costs should reflect today’s dollars.

Equipment is much as easier to reproduce, depreciated on a straight-line basis over its useful life. Take note that a new competitor may spend the same amount of money but receive new equipment that is more productive. Sound industry knowledge will give you an advantage.

Intangibles are the most disputed and ambiguous area of the balance sheet. Intangibles divided into two groups’ brand names and goodwill. In brand names, I’m including trademarks under the banner of brand names. Coca Cola’s value is 90% intangible, they sell sugar water and inspiration.

Goodwill arises when a company purchases another company above the market value of the company’s net assets. Broadly representing the excess paid over what is the fair value of its assets acquired.

Goodwill is normally justified on the grounds that the company can achieve synergies and efficiencies (rarely happens) resulting in a suitable return on assets. In the notes Kors has acquired direct control of a previously licensed business in South Korea, $3.7 million was recorded as the excess of the fair value of the assets acquired and the fair value of the assets is 7.3 million. The $3.7 million goodwill includes the trademark and customer goodwill built by the previous license owners. The purchase is satisfactory.

I like honest statements like this: In addition, on June 28, 2015, we obtained a controlling interest in our joint venture in Latin America (MK Panama) causing us to consolidate this joint venture into our operations beginning with the second quarter of Fiscal 2016. As a result of our controlling interest in MK Panama, we will incur additional charges which could negatively affect our operating results or financial condition, and we may not realize a satisfactory return on our investment.

Deferred taxes: Needs to be discounted to present value.

Current Liabilities

Same as current assets, you will notice little has changed, as all current liabilities are expected to be spent within the year, but taxes payable needs to be discounted to present value.

Current liabilities arise intrinsically from normal conduct of the business and are essential for a new entrant.

Non-Current Liabilities

Only two changes, deferred taxes and deferred rent discounted to present value.

There may be non-current liabilities that a new entrant will not need to compete with KORS, such as physical retail space, such as a bricks and mortar shop front, preferring instead to start online. And when assessing other businesses, keep in mind that a law fine or settlement appearing on their current or non-current liabilities side of the balance sheet, will not be needed by a new entrant and should be zeroed on the reproduction value.


Keep in mind that each share you purchase is a piece of the equity, so it is important to understand the moving parts that influence the changes in equity.

No significant change in net value, total assets increased by $239 million thus increasing equity by $239 + $6 million due to the reduction in total liabilities.

I encourage you to practice part I with companies you are familiar with as you wait for Part II, where we will discuss and analyse the earning power value (Intrinsic Value) of Kors.

If this type of analysis is to your liking, join us by clicking here

Leave a Comment