In this Part 3 of the 10-step guide to stock investments, we’ll wrap up the discussion on the principles and methods used by great investors past and present. If you haven’t already you are encouraged to read Part 1 here, and Part 2 here.
A 10-Step Guide to Stock Investments
- When you buy a stock, you become the owner of the business
- Business owners should think differently
- Focus on the value of the company, not the price
- Set a long term investment horizon
- Understand the business you buy
- Identify a good business to buy
- Return on Equity
- Find companies with exceptional management
- Require a Margin of Safety
- Know the difference between investing and speculation
Let’s pick up where we left off in Part 2 of the series.
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Find companies with excellent management
It’s essential to find companies with exceptional management because you are entrusting your money to their care for potentially many years.
A good track record, industry experience, and integrity are apparent job requirements. But, there are other essential characteristics as well.
Management that is open and honest with shareholders
Good management knows they are working for the shareholders and behave accordingly.
Do they come across as transparent, open, and honest communication? When you’re done, did you understand what was read? Did you learn anything? Or, was the message filled with a bunch of cliches and industry jargon?
Is the message consistent over time, or does it change quarter to quarter to discuss what went well?
Read the CEO’s annual or quarterly letters to shareholders.
Two examples of outstanding CEO’s that I’ve entrusted my money to are Bruce Flatt of Brookfield Asset Management (BAM). BAM’s letters are posted in their investor section here. And, Warren Buffett of Berkshire Hathaway (BRK.B) letters are posted here.
Both are exceptional CEO’s, and their companies show the results.
Listen to the quarterly conference calls
These calls typically start off with the CEO and CFO reporting on the last three months followed by a question and answer session. The conference calls usually highlights the content of the earnings report published before the call.
I find the Q&A the most interesting. It is where management responds to analysts and sometimes shareholder questions. You learn a lot about the company and management through both the questions and answers in this typically 30 to 60-minute call
Is management transparent, open, and honest in their responses? Do they respectfully answer even though they may be difficult questions?
You can find the schedule for the conference call typically in the investor sections of the company’s web site. You usually have to register as a shareholder or prospective shareholder to listen in. The calls are often recorded and available online for some time after the actual call.
Management that resists the institutional imperative
A virus called “the institutional imperative” can infect seemingly good management if not adequately immunized by the board of directors.
The institutional imperative is a term coined by Warren Buffett in the Berkshire Hathaway 1989 Shareholder Letter. He describes it as an unseen force that exists in the business world to the detriment of shareholder wealth.
Buffett explains he did not learn about the institutional imperative until after business school when he naively thought: “that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.”
He goes on to explain the imperative: “For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction. (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds. (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops. And (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.”
This is one of the more challenging points to identify in the 10-step guide to stock investments because it is usually not the obvious motive.
This interview below with Howard Marks of Oaktree Capital Management and Bruce Flatt of Brookfield Asset Management is an example of management resisting the institutional imperative. Their two companies merged, and the interviewer asks Bruce Flatt, the CEO of Brookfield if the company’s target is to grow as large as their competitor Blackstone (BX). Growing faster or larger than a competitor is frequently an institutional imperative.
The question and response at 8:50 in this video are telling.
Find management that invests their money alongside yours
Does the management invest a significant portion of their wealth in the company’s shares? Management and shareholders interests are aligned to maximizing share value if they own shares.
Still not Sure?
Not sure if you’ve identified a good management team? The antidote for poor management, according to Peter Lynch and Warren Buffet is to pick a good business.
“Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.”
– Peter Lynch
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Require a Margin of Safety,
Benjamin Graham devotes a chapter to Margin of Safety in his book “The Intelligent Investor” entitled “Margin of Safety as the Central Concept of Investment.”
He goes on to write: “Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY. This is the thread that runs through all the preceding discussion of investment policy—often explicitly, sometimes in a less direct fashion.”
So what is the Margin of Safety? In a nutshell Margin of Safety is an allowance or margin for error to help manage risk.
Risk is defined differently by investors. However, in the 10-step guide to stock investments, we use the Merriam-Webster definition. It is the chance that an investment will lose value.
Investopedia defines the Margin of Safety as: “A principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. In other words, when the market price is significantly below your estimation of the intrinsic value, the difference is the margin of safety. This difference allows an investment to be made with minimal downside risk..” – Investopedia
The Margin of Safety is the difference in the underlying value of the company and the share quoted price. The share price is a given, however, the estimate of value is based on assumptions about the future. And, estimates are subject to error.
Valuation; the law of gravity in investing
“Valuation is the closest thing to the law of gravity in finance. It is the primary determinant of long-term returns. The objective of investment (in general) is not to buy at fair value, but to purchase with a margin of safety. This reflects that any estimate of fair value is just that: an estimate, not a precise figure, so the margin of safety provides a much-needed cushion against errors and misfortunes. When investors violate this law by investing with no margin of safety, they risk the prospect of the permanent impairment of capital.” – James Montier
The Margin of Safety is often associated with value investing. However, it is a universal concept applicable to all methods of investing.
As an example, if an analyst estimates a growth company is valued at say $100 per share, the analyst makes assumptions to determine that value. The assumptions include the growth rate of sales and expenses.
If you decide to build in a 30% Margin of Safety, you will buy the company only if the price goes to $70 per share. That purchase provides a $30 per share margin for error. If the company only achieves a $90 per share price because the estimate was overly optimistic, you will still realize a 28% gain compared to a 10% loss if purchased it at $100.
The Margin of Safety helps both novice and experienced investors from making big mistakes.
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Know the difference between investing and speculation
Many fail to recognize the difference between investing and speculating and pay for it dearly.
Speculation is the purchase of stock with hopes of profiting on price rise in the future due to price fluctuations in the stock.
There is no attempt to understand the underlying value of the business. Speculators seek profit over an often arbitrary and relatively short period. “I think it will be worth $100/share next quarter or next year.”
Investors, on the other hand, seek to profit from increases in the underlying value of the business through long term ownership.
They attempt to understand the fundamentals of the business and how that will lead to capital gains or dividend payments. And, then make an estimate of intrinsic value based on the anticipated business’ performance.
Assets that generate earnings like stocks or pay interest in the case of bonds are investments. Assets that require a supply and demand imbalance to move prices like gold, commodities, and stocks without earnings are speculations.
The greater fool
Speculators buy and sell stock trying to anticipate the emotions or expectations of others, supply and demand imbalances, or the direction of the market. All very hard if not impossible to do.
They often rely on “the greater fool theory.” It is a belief that any price can be justified because there is another person (a greater fool) that will pay an even higher price in the future.
It is easy to form opinions about how others may behave in the future. But, it is not a good investment strategy since there is no reliable way to predict these things.
On the other hand, investors use price movement to their advantage because they have a reference point; the underlying value of the company. The estimate of value helps determine if the price is, in fact, advantageous.
“Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.” – Benjamin Graham
What have we learned?
Invest in companies run by capable, honest, and shareholder-friendly management.
Require a Margin of Safety in every investment to manage risk and help offset the errors in estimates and judgments that will inevitably occur.
Use value estimates made within a reasonable margin of error as the reference points to determine if a share price is attractive.
Speculators try to predict emotions, supply and demand imbalances, and market movements. There is no reliable way to do that.
Good prospective investments show many if not all the elements of the 10-step guide to stock investments.
The 10-step guide to stock investments summarizes the critical considerations used by the best investors in the world. Use it for sustainable investment success over the long term.
A 10-step Guide to Stock Investments: Part 2