When making investment decisions, most people I know consumes investment advice from financial advisers, brokers or the online forum ‘gurus’. They purchase stocks based on rumours, gut feel, reacting to corporate announcements, buying ‘flavour of the week’ stocks or blindly following over optimistic analyst recommendations. Don’t get me wrong, it is okay to keep track of analyst reports, you might be able to get some great ideas when reading them. However, its not wise to rely too much on such reports as there might be a conflict of interest especially for sell side analyst. Some of you may ask, is there a need for an investment framework? and why is it important? The framework ensures that you do not engage in speculation or making emotionally driven investment decisions. It ensures that you keep a clear objective and composure went things go wrong. Having a framework is also key to achieving consistent returns in the long run.
To start, you need to lay down the core principles of the framework. This includes quantitative and qualitative criteria of the strategy, have these criteria back tested over a long time frame and lastly, understand its limitations while keeping a realistic expectation on investment returns.
I begin my thought process by identifying quantitative factors, the Net Current Asset Value (NCAV) is my primary criteria for identifying undervalued stocks. It is a stringent test to weed out companies with high levels of debt and to ensure that they have a strong balance sheet to survive operational challenges. I would prefer to purchase my stocks at a discount to its NCAV, this is to provide a margin of safety should there be any errors in my calculation. Ideally, I aim to acquire them at 33% discount to NCAV (similar to Ben Graham’s criteria). Next I will look into the operational cash flows of the business, as you probably know, NCAV stocks are usually companies going through tough times, changing business cycles, structural or management changes. Hence keeping an eye on operational cash flows will help prevent you from holding onto stocks that are eroding its NCAV value.
Debt to equity ratio is next on my list, in general, I like to buy stocks with debt to equity ratio of less than 50%, lesser the better. I will avoid companies with more than 100% debt to equity even if they passed the initial NCAV criteria. As you can see, my focus is not on earnings of the business, but rather on its financial health. If the business can survive tough times without burning into too much cash reserves, probability of a turn around will be much greater.
Assessing management of the company is often a challenging task for most of us, unlike institutional investors, we do not have the luxury to speak with management. However, we can evaluate their track records and insider buying activities, as the saying goes, action speaks louder than words. I would start by understanding the capabilities of the existing management as well as their experience in business and I’d like to know if the CEO or other senior managers possess relevant experience in managing the current situation of the company. I will assess previous decision made by the committee in acquisitions or capital investments.
Skin in the game: is Mr. CEO walking the talk? Does he owns enough shares in the company? Is he showing faith in his company by buying more stock at these depressed levels? What’s his remuneration like? Are his interests aligned with shareholders? Has he considered a pay cut if the company is losing money? These are the questions that I asked myself when assessing management of the company.
Once you have finalised both quantitative and qualitative criteria, it’s time to construct a portfolio of NCAVs. So how much capital should you allocate to each stock? and what weightage should each position be? Obviously, these factors depends on your investable capital. Ideally, I’d like to keep my positions at equal weightage and to maintain a diversified portfolio of at least 20 stocks. Buying NCAV stocks is a game of probabilities, if you invest too much capital on a single position, the performance of your entire portfolio is highly correlated with that position. Remember to hold spare cash on hand as you might need it to average into certain positions as long as the investment remains valid.
So you’re done! Just 3 easy steps to build a framework with 3 fundamental factors. An investment framework doesn’t have to be a long and complicated list of formulas, rather its better to have fewer factors and define each in greater detail. To sum it off, here are some wise words from the Oracle of Omaha “What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”