Monday, December 18, 2006

No B.S., Common Sense Investing!!!

Not to discredit my accounting and finance training, but I don’t believe one needs much of either to succeed in finding good investments! I strongly believe one can do reasonably well with just a calculator, good common sense, and some basic knowledge of stock valuation. I seldom look at the accounting policies section of annual reports and discounted cash flow (“DCF”) analysis to me is purely academic.

There are very few instances (M&A a notable exception) where one needs to study in details how accounting is done for a business, and my experience is those companies which do require such level of analysis are often too difficult to understand and their performance too unpredictable to qualify as good investments anyway.

DCF analysis is good in theory but like centralized planning in communism, it fails miserably in real world. Save for those securities of fixed income nature, it is never possible to have reliable enough information to complete an analysis. And it doesn’t take a lot of assumptions to render such analysis less than useful, e.g. just 5 assumptions which are 90% correct will lead to the result only 60% correct, slightly better than guesswork.

Before the numbers, more time should be spent understanding the business itself. This critical first step is often done with haste or neglected altogether in many analyses I have come across (note 1). One needs to think through why and how a business makes money. This process helps one spot good businesses from ordinary ones, and saves time too because those don’t qualify can be dropped right off without looking at the numbers. Some common trails of good businesses are those which are easy to understand, with stable operating environment, and manned by competent and honest people. Next step is simpler, never overpay and buy as cheaply as you can (note 2).

These are all common sense right? Just like what I wrote in the beginning. It’s of course easier said than done. So I’m not going to go any further because first many excellent books have been written on it already (you’re welcome to look at my favorite book list when it comes out) and second I’m definitely not an expert let alone a good writer. What I’ll do instead is to share with you from time to time my work done on some companies which I find interesting. Your feedback is welcome.

Footnotes
1. Maybe many believe the market is so efficient that they only need to analyze everything marginally, i.e. the price is always right and only new information is relevant and worth spending time on. But these people will likely miss the big jackpot because the market is as often wrong as it is right.
2. Of course you’ll need to know some valuation framework to determine what is ‘cheap’. But without it you’ll still fare much better when you buy the right company at the wrong price than vice versa.

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