Question from a Reader–The Best Way to Improve Your Skill as An Investor

Question from a reader

There seem to be two courses of action in trying to apply the lessons learned via your website to improve your skill as an investor. The first is to do an in-depth study of a single company, its industry and its competitors. The second option is to read as many 10-Ks as possible and do quick and dirty valuation similar to those found in, say, Greenblatt Class #5.

Which option do you see as more valuable? Am I missing a third way?

Great question and I will elaborate more as this blog develops.

Mario Gabelli advises students to pick one industry and study that thoroughly then after 3 to 4 months move on to another industry. Buffett started by pawing his way through Moody’s manuals and Value-Line to find cheap asset stocks like cigar butts. Munger influenced Buffett with Sees Candy to look at high quality businesses.

After you have read the obligatory required materials like Buffett’s shareholder letters, his Buffett Partnership letters, Margin of Safety, The Intelligent Investor, the Greenblatt books and lecture notes, you need to build from there. My interest and suggestion would be to find 6 to 8 compounding machines which can be bought at a discount.  If you can find a few high return on capital companies that are able to redeploy that capital for several years at high rates, you will have outstanding returns. These companies are rare that is why you must be patient to find them and to hold them.  But you must know what to look for.  You should become an expert in how companies develop and maintain competitive advantages. This will help you in searching for great investments and give you confidence to hold them for a while.

For example, if you understand regional (geographic) economies of scale you could focus on service companies like waste hauling and disposal or rock aggregates or health care providers and notice if they dominate their particular regions. Do you see high returns on capital? Study these companies and wait for them to go on sale.  Rather than wait for blow-ups and disasters to study companies, find the best emerging companies you can find, study them regardless of price then wait for your opportunity.

Take a look at the last case study on charlie479.  He epitomizes what I am talking about.  Read broadly and deeply about businesses—10-Ks but books and autobiographies too.  As you learn more about competitive advantages you will see connections in other businesses. You will see companies losing their advantages but look for companies that are successfully entering against incumbents. Look at niche companies that can dominate smaller markets.   Read, read and read.

Next week I will post the best company analysis in the world done by Charlie Munger.  If you can learn how he views business problems then you will grasp what is most important in business analysis.

You can buy cheap assets in special situations where management restructures the debt or assets and you get a nice bump up in price, then you must redeploy your capital like a merchant into another asset play.   This can be profitable and relatively low risk but the big money is made sitting on fantastic businesses that are compounding at high rates.  I would focus there. Few investors study competitive advantages–I mean become an expert at spotting and understanding great companies.

Fire away with more questions.

6 responses to “Question from a Reader–The Best Way to Improve Your Skill as An Investor

  1. I’ve probably missed the point entirely … but one company I’ve held for awhile now is BATS (Brit American Tobacco). I’ve often expressed my own disbelief at the company – it’s up 22% YTD, compared with Footsie down 6%. That’s serious outperformance – well, that will do for me, anyway! Yet it’s a big, well-known company – one that anyone could have picked.

    Also, if you look, you can find companies with amazing track records. One such company is DNO (Domino Printing Sciences). It’s been growing its dividends by about 18% annually for the last decade, and its profits have been increasing every year. It’s average ROE over the last decade has been 18%. This was achieved without saddling the company with debt, either – in fact, the company has net cash of £12m against a market cap of £546m, an interest cover of 201, and a z-score of 5.67. That looks pretty solid to me. It trades on a PER of 13.3. I’ve looked through all the companies on the London Stock Exchange with market caps over £200m, and I’m confident that I’ve never seem a company with such (statistical) quality currently trade on single-digit multiples.

    If you turn over a large number of rocks, you can find companies that, on a simple numerical basis, kind-of “hide in plain sight”. They generally don’t get discussed a lot, because they don’t fit into the category of cigar butts or fast-growth, which is what most people are interested in.

  2. I am trying to understand how deep the analysis should, where do you draw a line? If you go too deep, you might miss the forest for the trees. Do we need to talk to lot of customers, suppliers, competitors or business consultants who have some experience in an industry. I just want to save myself from analysis paralysis which might prevent me from taking a decision. Do we need to know every bloody minor detail to get a full grasp of the business? I read in no of books about Buffett and Munger poring over 10-ks and industry journals but how much leg work did they do for understanding the business like talking to the management, competitiors, suppliers, distributors , i guess this work was done by Henry brandt for buffett. Stting with 10-ks and industry journals one can generate various scenarios for a business but what is the thing which one must do to get a firm grasp of the business and what is actually happening in the businees rather than just assuming and conjuring up various scenarios for a particular business?

  3. Dear Steve:
    Great question that we all struggle with….how deep do we dig and what are the marginal returns on investment compared to effort. Also, no matter how long and deep that we dig, we will never have perfect knowledge.

    I think your answer will be found in your investment approach. Graham’s net/nets or Internet company net/nets after the bust were just a statistical bargain spread out over enough investments to allow the probabilities to work for you. Geiger-counter investing.

    Conversely, you can invest on financial characteristics in stable companies where you can’t get an analytical edge but a behavioral edge.

    http://csinvesting.org/2011/10/07/a-great-investors-2006-lecture-on-investment-philosophy-and-process/

    Or if you invest in a concentrated fashion in small cap technology, you will have to know you are the smartest money in the company. See the link below:
    http://csinvesting.org/2011/09/14/primary-research-the-sleuth-investor-and-scuttlebutt/

    Experience will teach you what is or are the key factor(s) in the investment. Read Greenblatt’s book, You Can Be a Stock Market Genius. He is able to focus on the main factors. He success comes not from his analytical ability but the way he approaches the world.

    Also, you have to accept the unknowable and allow for imperfect knowledge.

  4. Hi there,

    I would first like to thank you for putting together such a wonderful resource to learn and ask questions about investing. In the original question, reader mentions Greenblatt Class # 5 for getting a quick and dirty valuation… I was looking at the notes posted in the Value Vault.. they jump from class 4 to 8, I could not locate the exact point where “instant” valuation is discussed. Could you guide me where that might be?

    I believe you have also mentioned, how WB likes to go through Value Line’s and do something similar.

    Thanks
    DN

    • OK, I will be back to you today on that.

    • Dear DN:

      Over Christmas I must organize the lectures and posts to different categories for easier search. I don’t know about Greenblatt Class #5 but the professor talks about a quick and dirty valuation based on Total Enterprice value divided into EBITDA – MCX to get a pre-tax earnings yield to determine whether to research further. This is similar to the Magic Formula (go to http://www.magicformulainvesting.com). The key is whether you understand the business well enough to normalize earnings. What is the baic earnings power of the business? If the business is growing then what is the sustainable advantage of the company?

      Buffett looks at return on equity unleveraged to get a handle on the quality of the business. I even doubt he looks much at Value-Line since he is limited to what he can invest in and he has a database in his head. He owns a share in almost every major company so he reads their annual report. But for beginners going through the value-line–all 2,500 companies in the small to large cap editions is well worth study. You will see how different industries have different return characteristics. Advertising vs. steel, for example. You will learn alot by observation. Few want to do this work.

      Hope that helps; ask if I am not clear. Thanks for your question.

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