There are many schools of thought related to investing in companies. I am delineating what I find most sensible and appealing. At the outset, I would like to say that a lot of the material below is influenced / reproduced from talks, speeches and books of men I admire. Some of the most vocal proponents of the thoughts below are Warren Buffet, Charlie Munger, Ben Graham etc..
Stock investing is a lot like betting on horses – there are 3 key factors to evaluate
- The horse – Business
- The Jockey – People
- Odds of winning – Price
Business
Understanding the horse is fundamental to the game (otherwise it is as good as a lottery ticket). Similarly understanding the business, its business model is also crucial. Some considerations are
- Business Model – how does the company make money?
- What is the Return on Equity Capital invested (ROE)
- What is the return on any reinvested earnings (ROIIE)? Does all the benefit go to other stakeholders? Eg: Capex invested on commodity products usually accrue to consume
- Is the company over-leveraged? D/E < 0.5
- What is the economic moat of the company? Eg: Brand, Scale, Patents, Pricing power
People
Typical signs of good management are regular dividend policy, sensible compensations, measured expansion plans and healthy re-investment in the company/product
Price
Now this is the most complex and subjective part. When betting on a great horse, the odds are usually very low, However when betting on a limping horse your odds might be phenomenal (100:1). This is roughly commensurate to the risk.
There are rare times when the bets are mis-priced – A horse with a strong chance of winning has fairly high odds. This mis-pricing would give the intelligent betting client an advantage called – Margin of Safety.
Margin of safety
- Start by neutralizing the exit price as a source of advantage. Take the lowest historical P/E possible as the exit price
- Now bake in a strong margin of safety in the earnings growth (ROE & ROIIE)
- Calculate IRR (is IRR>10%)
Expectation of outcome
- Assume the above IRR as a base case scenario (Base) with a probability of 33%.
- Recalculate the above IRR, with more optimistic assumptions. Let us call it best case scenario (Best) with a probability of 33%. Typically in a company with a strong economic moat, the best and base case scenarios should have a higher probability than 33%, but it is good to bake in a further measure of safety
- Recalculate above IRR, with worst case assumptions (Worst) with a probability of 33%
- Calculate Expectation [Best, Base, Worst] (is E(IRR)> 5%)
All the above are processed by a fallible machine called the human brain. There are many areas of psychological misjudgments that we need to be aware of – but that is a discussion for another day