Random Thoughts on Investing

Random Thoughts on Investing

The problem with investing in this modern age is the amount of information that an investor has to sift through. The problem is really a matter of choice so I try to focus on the information that will yield the most utility. 

I ignore the macro environment and with it most of the madness that passes for information from the mainstream media. I concentrate on individual companies and even there I try to concentrate only on what really matters. It’s been my experience that randomness will play a huge role in your investment success, so you have to diversify your holdings but only to a point. And I believe in investing more heavily in some of my holdings than others. Extending my investing time frame to 3 years and more has helped me capture some of the inefficiencies that lie in the market. In fact one of the biggest advantages you can gain on the competition is to invest for the long term and filter out the meaningless noise from the media outlets. The longer you hold a portfolio of good solid stocks, the more the risk will go out of them, as the passage of time will erode away the risk of investing in them. By diversifying your stock portfolio and extending your holding periods you essentially are managing your risk (the risk of losing money) and managing your risk is the investor's number one job.

One great shortcut is to concentrate on companies where senior management owns stock in the company they run, better still if it is in the small/mid cap part of the market. When management invest in their own company they put themselves on the same side of the table as their stakeholders. 

And speaking of the small and mid cap stocks, that is where my investing dollars tend to go. I am not a fan of companies that get too big (institution complex) unless I see some resource conversion (spin offs, rights offerings etc) activity going on and I respect the senior management. There are always exceptions of course. In fact large companies that divest themselves of divisions (spinoffs) can be a good sign that management is interested in enhancing long-term shareholder value. Too many large firms only want to get bigger usually to appease the giant egos of their CEO's. 

As always experience will be your greatest teacher. You don't have to be particularly intelligent to be a successful investor but you do have to believe in what you are doing. In time the market itself will provide you with your scorecard.

Life Cycles of Companies...Growth Companies (Small and Mid Caps)

Life Cycles of Companies...Growth Companies (Small and Mid Caps)

Along with the dividend growers, this is my favourite part of the market to invest in. They can be a diverse group, the smaller growth companies while more established than the microcaps are still in the early stages of their growth and can display erratic metrics. Make sure their balance sheets are not too levered and insist upon positive cash flow from operations. One of the very best signs is when the management of these companies decides its stable enough to pay a dividend. This is a major capital allocation decision and management teams don’t make them lightly. The institution of a dividend is an indication that management is confident about the future prospects of their firm.

The midecap growth companies get more of their value from investments they expect to make in the future and less from investments they have already made. The value of their growth assets is both a function of how much growth is anticipated but also the quality of that growth. It is the return they make on the capital they have invested in their business. Remember our definition of return on invested capital (ROIC).

‘Return on invested capital is the return a corporation makes on every dollar of capital invested in the business (both equity and debt). Good companies will have ROICs in the mid teens. It is the ability of a company to create value. Value is created when a company's return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate its growth as an ongoing concern. It ties in closely with management's ability to allocate capital efficiently.’

ROIC is a key metric when measuring the growth potential of these companies as is senior management’s ability to allocate capital effectively in order to fund that growth in the future.

As these companies invest their excess capital in growth assets (intangible assets?) their free cash flow can be erratic. High one year, low the next or even negative. In this case it pays to track their cash flow from operations, which is the cash that flows in and out of the business as it relates to the operations of the company. It should be steady and growing.

Look for firms that can maintain their operating margins in the face of increased competition. Stay away from firms that trade off lower margins for higher growth. 

Scalable growth is best. As firms become larger, growth rates will decline. Look for companies that are able to diversify their product lines and cater to a wider customer base as they grow. Senior management's ability to allocate capital is vital. If you find me repeating this theme its only  because it is fundamental in judging profitable growth companies.  

Since markets incorporate  the value of growth assets and accountants do not  these companies will often trade much higher than their book values and speaking of book value it is a very good sign to see the book value per share of a company increase year after year. This is something that Buffet himself likes to see. It means the shareholder's value in the company is increasing over time.

An increasing dividend is one of the very best of signs.

Finally time is on your side with these companies. If they disappoint in delivering earnings the stock of the company will often be punished by short term orientated traders and sold off. That is the time to move in and buy it while its on sale. Buy right and sit tight.  


Resources

The Little Book of Valuation

Aswath Damodaran