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   [ + ]

Weekly Kaizen – Jan 8th – What is your Edge?

What I learned in 2016

Setting resolutions is easy, keeping them is another story…Tim Ferriss held a podcast episode on setting resolutions and planning:

Stream Podcast
Blog Post: What I Learned in 2016

CHARLIE MUNGER ON THE PARADOX IN HOLD VS. BUY DECISIONS IN LONG TERM INVESTING

Sanjay Bakshi, professor and value investor most recent blog post (Fundoo Professor blog):

Charlie Munger on the Paradox in Hold vs. Buy Decisions in Long Term Investing

Daniel Goleman: “Focus: the Hidden Driver of Excellence”

From talks at Google: “In Focus, Psychologist and journalist Daniel Goleman, author of the #1 international bestseller Emotional Intelligence, offers a groundbreaking look at today’s scarcest resource and the secret to high performance and fulfillment: attention.” A must watch to understand the importance of being able to focus good on your work.

Gene genius Siddhartha Mukherjee on why ‘doctors shouldn’t be gods’

Brilliantly written interview from Jo Ellison, interviewing Siddhartha Mukherjee who won the Pulitzer Prize in 2011 for his book, The Emperor of All Maladies: A Biography of Cancer, discussing his recent and one of the best books of 2016 The Gene: An Intimate History:

Gene genius Siddhartha Mukherjee on why ‘doctors shouldn’t be gods’   The philosophical physician and Pulitzer Prize-winning author talks about life, death, and lamb chops.

The article is behind a paywall, if you register for a free account at FT you could read up to 3 articles free a month.

What is your Edge?

John Hurber portfolio manager at Saber Capital Management LCC frequently posts on his blog, BasehitInvesting, his post on looking for your edge goes into making use of your biggest edge as an individual investor; is it Information, your analytical skills or time (patience)?

What is your Edge?
Presentation supporting the article.
Video of the talk John gave on Three paths to finding value:

Hope you enjoyed the content shared.

Have a wonderful week!

English is not my native language nor am I a skilled writer; if you have suggestions on the writing style,grammar, content or anything else please feel free to leave your feedback.