What questions to ask before buying a stock.

“Good thinkers are good questionnaires.” — Alison King

Mistakes will be made when investing, that’s how you learn and become a better investor. One mistake I have made, one of the many, was that of following other investors stock picks, cloning respected value investors and losing the vast majority of the investment.
Why did it happen? I didn’t do my homework, I didn’t ask the right questions, all I did was looking for confirmation bias on why it would make a great investment.
Do not blindly clone other investors. If they promote a particular stock, put it on your ‘radar’, and do the thorough analysis you would have done otherwise.
The part you can clone and learn from is their methodology. Try to understand what system/process they have and how they arrive to the conclusion to make or not make an investment.

Two well known investors I like to learn most from are Charlie Munger and Warren Buffett, their investment methodology is simple and effective:

Understanding the business

Warren Buffett uses the following questions as filters before committing time and money1) Seeking WIsdom – From Darwin to Munger – Peter Bevelin Page 220:

  •  Can I understand it? If it passes this filter.
  • Does it look like it had some kind of competitiveness advantage? If it passes this filter.
  • Is the management composed of able and honest people? If it passes this filter.I
  • Is the price right? If it passes this filter we write a check.

What does Warren Buffett mean by “understanding” a business? Predictability: “Our definition of understanding is thinking that we have a reasonable probability of being able to assess where the business will be in 10 years.

Asking the right questions

Warren Buffett learned a great deal from his mentor Benjamin Graham, the ‘father’ of value investing. In the book that Benjamin Graham wrote with David Dodd, Security Analysis, they outlined their analysis process into two parts, Quantitative and Qualitative analysis:

Quantitative:

  1.       Capitalization
  2.       Earnings and dividends
  3.       Assets and liabilities
  4.       Operating statistics

Qualitative:

  1.       Nature of the business
  2.       The relative position of the individual company in the industry
  3.       It’s physical, geographical, and operating characteristics
  4.       The character of the management
  5.       The outlook for the unit, industry and business in general

Each point of the analysis has questions that need to be answered, for instance the second point of Quantitative analysis, Earnings and dividends:

  • What are the true earnings for the period studied? 2)Accounting, Business and Investing leading questions
  • What indication does the earnings record carry as to the future earnings power of the company?
  • What elements in the earnings exhibit must be taken into account, and what standards followed, in endeavoring to arrive at a reasonable valuation of the shares?

Not any company is the same, therefore the questions shouldn’t be the same for every situation and company, alter each set of questions to the company and industry.

Create a narrative

Warren Buffett combines questions and answers on a multitude of topics with a capability most of us can only dream of, he does this to create a narrative in his head that will help him make a decision. Most importantly, he has a partner, Charlie Munger, for discussing ideas and thought processes. From a 1988 Carol Loomis article in Forbes3)https://www.fool.com/investing/general/2015/01/31/charlie-munger-5-quotes-show-why-warren-buffetts-2.aspx:

So in conversations with Buffett over the years he preached the virtues of good businesses, and in time Buffett totally accepted the logic of the case … ”I have been shaped tremendously by Charlie,” says Buffett. ”Boy, if I had listened only to Ben (Benjamin Graham), would I ever be a lot poorer.’

Other famous partnerships are those between Mohnish Pabrai (Pabrai Funds/ Dhando Funds) and Guy Spier (Aquamarine Capital). If you have no immediate person to discuss your analysis with, you can use websites like cornerofberkshireandfairfax.ca , The Motley Fool, Seeking Alpha, etc.

Keep it simple

When doing an analysis try to keep it simple. There is no point in getting lost in the process, you will only be more likely to miss something and make a mistake. In Seeking Wisdom From Darwin to Munger, Peter Bevelin quotes Warren Buffett and Charlie Munger on the importance of keeping things simple:

Warren Buffett: “We try to stick to business we believe we understand. That means they must be relatively simple and stable in character.”

Charlie Munger: “We never sit down, run the numbers out and discount them back to net present value. The decision should be obvious.

Charlie Munger: Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they’ve got to do something.

Making good predictions in general is something that you should try to stay away from as it almost impossible to do it correctly. Just look back at the predictions that professional analysts and Economists have made..they are almost always all wrong.4)https://www.oaktreecapital.com/docs/default-source/memos/go-figure.pdf?sfvrsn=7

Margin of Safety

What is the risk of losing 100%? Maintaining a margin of safety will protect you against miscalculations/ mistakes made in your analysis and unforeseen events. Be patient and wait until the stock reaches your target price that includes a margin of safety.

Seth Klarman – founder of Baupost and investing legend, wrote a book: Margin of Safety (out of print), in there he states the importance of maintaining a Margin of Safety:

“It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Not only may questions remain unanswered; all the right questions may not even have been asked. Even if the present could somehow be perfectly understood, most investments are dependent on outcomes that cannot be accurately foreseen. Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. Investing would be much simpler if business values did remain constant while stock prices revolved predictably around them like the planets around the sun. If you cannot be certain of value, after all, then how can you be certain that are you buying at a discount? The truth is you cannot.”5)https://www.fool.com/investing/general/2010/05/18/10-quotes-from-one-of-the-greatest-investment-book.aspx

The more things that can go wrong, i.e. with the business you analyse, the higher the margin of safety, thus, the higher the risk of something going wrong the more margin of safety you should apply.

Keep learning

Analysing companies is an evolving, never ending process. Adapt and improve when you learn new things. Keep reading/ learning, applying new techniques and learn from your mistakes. Stay curious and have a desire to learn.

…Munger later wrote, “If Warren Buffett had never learned anything new after graduating from the Columbia Business School, Berkshire would be a pale shadow of its present self. Warren would have gotten rich — because what he learned from Ben Graham at Columbia was enough to make anybody rich. But he wouldn’t have the kind of enterprise Berkshire Hathaway is if he hadn’t kept learning.”6)http://www.omaha.com/money/buffett/warren-buffett-and-charlie-munger-billion-dollar-partnership/article_2819b16e-1933-51a7-b14b-002d9bb918de.html

Reading is key to gaining knowledge,besides books there are other sources to expand your knowledge, such as Podcasts, Youtube Channels, Magazines like the Economist, articles, hedge fund letters, and of course other Blogs.

Alice Schroeder on Buffett and Munger:

…The lessons that they had which is learning yourself, making yourself as smart as you can, is extremely valid, and not just relying on a library where you can look something up all the time. Because a lot of the times when you need to make a decision and need 50 pieces of information, you need to know it then and that’s been Warren Buffett greatest secret of success.”

In summary:

  • Ask the right questions (use a checklist)
  • Create a Narrative (bull and bear case)
  • Keep it Simple
  • Maintain a Margin of Safety
  • Be patient and never stop learning

Links:

Seeking Wisdom From Darwin to Munger

Security Analysis

The Snowball: Warren Buffett and the Business of Life

Alice Schroeder on How Buffett Values a Business and Invests

Keynote: Alice Schroeder, author of “The Snowball: Warren Buffett and the Business of Life”

http://buffettfaq.com/

 

 

 

References   [ + ]

What kind of investor are you?

In the book, Hedge Fund Market Wizards: How winning traders win, Jack D. Schwager interviews successful hedge fund managers and traders who have outperformed the market for a considerable amount of time. What I found fascinating from the book was the variety of trade strategies they used. Every trader had a different approach. Jack D. Schwager summaries this at the end of the book:

Find a Trading Method That Fits Your Personality

Traders must find a methodology that fits their own beliefs and talents. A sound methodology that is successful for one trader can be a poor fit and a losing strategy for another trader. O’Shea lucidly expressed this concept in answer to the question of whether trading skill could be taught: If I try to teach you what I do, you will fail because you are not me. If you hang around me, you will observe what I do, and you may pick up some good habits. But there are a lot of things you will want to do differently. A good friend of mine, who sat next to me for several years, is now managing lots of money at another hedge fund and doing very well. But he is not the same as me. What he learned was not to become me. He became something else. He became him.
Schwager, Jack D.. Hedge Fund Market Wizards: How Winning Traders Win (p. 490). Wiley. Kindle Edition.

Jack’s son, Zachary Schwager,  explained the same principle in the book’s epilogue:

There is no single right way to make money. Those who succeed do so because they find what works for them. Trying to replicate someone else’s method almost always results in failure. All successful traders have their own methodology, an approach that makes sense to them and that they are comfortable with.
Schwager, Jack D.. Hedge Fund Market Wizards: How Winning Traders Win (p. 511). Wiley. Kindle Edition.

The same principle applies to the process of analysing an investment. It should fit your personality.
Someone working as an engineer in the aerospace industry has a different circle of competence than an IT consultant working in India.
The engineer is probably more comfortable with numbers and uses various types of excel sheets for his analysis. For the IT consultant it comes much easier to read annual reports, proxy statements and other filings.

In The Big Short: Inside the Doomsday Machine – Michael Lewis explains how Michael Burry was probably the only person, beside the lawyers who set up the prospectus, who would be able to go through all the CDO1) “Collateralized Debt Obligation (CDO) – Investopedia.” http://www.investopedia.com/terms/c/cdo.asp. Accessed 20 Apr. 2017. and subprime mortgages2)“Subprime Mortgage – Investopedia.” http://www.investopedia.com/terms/s/subprime_mortgage.asp. Accessed 20 Apr. 2017. This was due to Burry’s exceptional ability to focus intensely on topics of interest to him for very long periods of time. It was just his luck that his interest was in investing, specifically in this case, shorting the Subprime mortgages with CDS (Credit Default Swaps)3)“Credit Default Swap (CDS) – Investopedia.” http://www.investopedia.com/terms/c/creditdefaultswap.asp. Accessed 20 Apr. 2017..
This ability to focus on volumes of detailed information on a relatively narrow topic is often a feature of Asperger’s Syndrome, a condition which Burry is believed to have.  While this intense focus came naturally to him, other skills such as socialising and interacting with people were things he had to learn:

On the other hand, it explained an awful lot about what he did for a living, and how he did it: his obsessive acquisition of hard facts, his insistence on logic, his ability to plow quickly through reams of tedious financial statements. People with Asperger’s couldn’t control what they were interested in. It was a stroke of luck that his special interest was financial markets and not, say, collecting lawn mower catalogues. When he thought of it that way, he realized that complex modern financial markets were as good as designed to reward a person with Asperger’s who took an interest in them. “Only someone who has Asperger’s would read a subprime mortgage bond prospectus,” he said.
Lewis, Michael. The Big Short: Inside the Doomsday Machine (pp. 183-184). Penguin Books Ltd. Kindle Edition.

Getting to know your own personality, traits and skills is only part of the equation when it comes to determining what kind of investor you are. Before starting to invest the most important question that you should ask yourself is:

How much time am I willing to spend analysing?

Benjamin Graham explains in The Intelligent Investor that there are three types of investors:

It has been an old and sound principle that those who cannot afford to take risks should be content with a relatively low return on their invested funds. From this there has developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task. The minimum return goes to our passive investor, who wants both safety and freedom from concern. The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill.

Jason Zweig continues explaining this principle in the commentary:

How aggressive should your portfolio be?

That, says Graham, depends less on what kinds of investments you own than on what kind of investor you are. There are two ways to be an intelligent investor:

  • by continually researching, selecting, and monitoring a dynamic mix of stocks, bonds, or mutual funds; 
  • Or by creating a permanent portfolio that runs on autopilot and requires no further effort (but generates very little excitement).

Graham calls the first approach “active” or “enterprising”; it takes lots of time and loads of energy. The “passive” or “defensive” strategy takes little time or effort but requires an almost ascetic detachment from the alluring hullabaloo of the market.

As the investment thinker Charles Ellis has explained, the enterprising approach is physically and intellectually taxing, while the defensive approach is emotionally demanding 4)For more about the distinction between physically and intellectually difficult investing on the one hand, and emotionally difficult investing on the other, see Chapter 8 and also Charles D. Ellis, “Three Ways to Succeed as an Investor,” in Charles D. Ellis and James R. Vertin, eds., The Investor’s Anthology (John Wiley & Sons, 1997), p. 72.
Graham, Benjamin; Jason Zweig. The Intelligent Investor, Rev. Ed (Collins Business Essentials) (Kindle Locations 10093-10095). HarperCollins. Kindle Edition.
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If you have time to spare, are highly competitive, think like a sports fan, and relish a complicated intellectual challenge, then the active approach is up your alley. If you always feel rushed, crave simplicity, and don’t relish thinking about money, then the passive approach is for you. (Some people will feel most comfortable combining both methods— creating a portfolio that is mainly active and partly passive, or vice versa.)

Both approaches are equally intelligent, and you can be successful with either— but only if you know yourself well enough to pick the right one, stick with it over the course of your investing lifetime, and keep your costs and emotions under control. Graham’s distinction between active and passive investors is another of his reminders that financial risk lies not only where most of us look for it— in the economy or in our investments— but also within ourselves.
Graham, Benjamin; Jason Zweig. The Intelligent Investor, Rev. Ed (Collins Business Essentials) (Kindle Locations 1625-1630). HarperCollins. Kindle Edition.

Before you start investing, think about what type of investor you are based on your strengths, and how much time you are willing to commit. It could for instance be trading in derivatives or index investing with ETF’s, both are ok, as long as you’re honest with yourself and stick to your process.

References   [ + ]

Handy Investing Websites

Looking for a website where you can easily filter 13F forms or for a new stock screener? These are some websites that can come in handy:

Name Topic
13F Filings News – MoneyBeat – WSJ 13F
AppAnnie Market Analysis
Contexxia Sec Fillings Screener
Holdingschannel 13F
IAPD – Investment Adviser Public Disclosure Regulator
Insider Buying Stock Screen (old school value) Stock Screener
Morningstar – Bonds Bonds
Portfolio holdings of Super Investors – DATAROMA
13F
Portfolio Slicer – Investment Tracking In Excel Excel Addon
Stock Screener – Overview Stock Screener
The Benjamin Graham Stock Screener Stock Screener
Whalewisdom 13F

 

Warren Buffett & Bill Gates: On Success

Warren Buffett & Bill Gates: On Success
University of Washington’s Husky Union on July 20, 1998.

Warren Buffettand Bill Gates, treated business students at the University of Washington to a rare public dialogue. The funny, philosophical and personal conversation between these two business leaders and unlikely friends focused on the things most important to them. Buffett and Gates share an extraordinary appreciation of the qualities that matter most, in work and in life.

 

Source: Buffettology