Analysing Stocks

If investing in great businesses is the key to successful investment, it follows that the ability to select businesses that will outperform their peers is the most important skill that an investor must develop.

Even great investors have found that this skill does not develop overnight. Over the years Buffett has changed his mind considerably about the type of company in which he wishes to invest. In his early years he focussed on companies holding assets with values that were not fairly reflected on the balance sheet – such as railroad companies with large property portfolios. Property is often shown on the accounts at the original cost, but its present day market value may have increased considerably.

As Buffett developed his investing expertise, with the help and influence of his business partner, Charlie Munger, he began to focus on businesses with great revenue-producing potential. He gravitated towards companies with great brands that could continue to generate revenue for years to come, such as See’s Candy or American Express.

In ‘Free Capital’ Thomas notes that all of the investors studied had an initial period of poor performance before they developed their skill and became successful investors. To become a great investor you will need to be patient and persistent in developing the ability to recognize superior businesses.

The main difficulty in seeing success stories before they occur is that there is no single metric that can be used to identify a great business. The uninitiated often believe that great investors are great number crunchers identifying investments through superior analytical skill.

But it is often not just the numbers that tell the full story. Management quality, culture, and the company’s ability to innovate and judge the market can all be just as important. It is this combination of the qualitative combined with the quantitative that makes investing such an interesting and rewarding endeavour.

You don’t need to have a high level of numerical skill to become a great investor. Thomas notes of his dozen investors, ‘None of the investors relies on modern portfolio theory … or indeed on any sophisticated quantitative analysis … despite the fact that several … have strong quantitative or business school backgrounds’. Charlie Munger said of Buffett, ‘Warren often talks about these discounted cash flows, but I’ve never seen him do one’.

A dislike for complication is a common quality of high performers. Between 1973 and 1998 John Malone returned a staggering 30.3 percent annually to his shareholders but he never used spreadsheets preferring to assess projects using simple calculations. William Thorndike writes of Malone in ‘The Outsiders’, ‘he quickly developed a simple rule that became the cornerstone of the company’s acquisition program… This analysis could be done on a single sheet of paper (or if necessary, the back of a napkin)’.

In ‘One Up on Wall Street’ Peter Lynch describes the various parameters he looks for in order to evaluate a business. Shunning sophisticated analysis, he states, ‘I ignore short term debt in my calculations. The purists can fret all they want about this, but why complicate matters unnecessarily?’

But don’t take this as a sign of carelessness in his investigation. Lynch is diligent in studying a number of indicators. But his assessment methods are very straightforward, requiring only basic arithmetic. Is cash growing? What is the ratio of share price to earnings? And how does this compare to earnings growth?

All great investors are able to determine whether a business has strong finances using only basic mathematics combined with a little common sense. In fact, it would seem that skilled investors shy away from complex calculations as they often offer a misleading precision. A common sense ‘feel’ for numbers is the most important aptitude that you need to develop in order to make a realistic assessment of how a business is performing.

It is evident then, that to be a great investor you do not need superior analytical skill. Perhaps more surprisingly, many investors contend that no more than a limited intelligence is required. Buffett said, ‘success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing’.

Stocks may appreciate by 10% a year over the long term. But in a single year they may be up 40% – or more. Or they may be down 40% – or more. The best investors neither break out the champagne nor look for the nearest balcony. They simply keep their cool and focus on the performance of each individual company as a business.

This is good news for most of us. God given gifts of intelligence, or superior mathematical ability are not required in order to invest successfully. Learning to control our emotions holds the key.

In order to beat the market, clearly we have to find stocks that the market has undervalued.

A company’s valuation depends on two things:

Firstly, an arithmetic valuation derived from a company’s earnings, balance sheet and cash flows.

Secondly, a qualitative evaluation of a company’s ability to innovate or differentiate itself from its peers.

There is no shortage of spreadsheets and databases on Wall Street – so it is likely that most companies with strong prima facie figures have already been assigned a healthy valuation by ‘The Street’.

The best hope for the individual investor is to look beyond the raw numbers. You need to find the businesses with hidden attributes that the ‘spreadsheet jockeys’ have missed.

Combine these with strong financial fundamentals and you have a great chance of finding a winning investment.

It’s time to delve into a little more detail on the attributes of a successful business. The factors that most successful investors look for are: