After some years of investing, upon reflection, I thought I would summarise below the criteria for an investment idea.
Must be within my circle of understanding
“Know what you don’t know” – Unknown
I must continuously work to define/refine my circle of understanding.
An investment idea that falls inside the circle should be prioritised than one that falls outside of it.
Quick easy way to know if an idea falls outside of the circle is when I have to ask myself: “do I understand it?”
My circle of understanding currently is:
Consumer product/service that has strong band, is time-tested and demonstrates pricing power.
Technologic platform that has network effect, is backed by teams with strong engineering culture and is user centric.
Investment business that has a long track record, a clearly articulated investment strategy and has a diversified client base.
Must rely predominantly on growth in normalised earning power, rather than multiple expansion
“Everything should be made as simple as possible, but no simpler” – Albert Einstein
The maths of the investment business is simple. Stock price = P/E multiply by E.
Where it can’t be made more simpler is:
The trajectory of the P/E is very hard to predict
The E is not as hard, but it can be meddled with by tactics in accounting
Having said that, I shall focus most of my time predicting the trajectory of the E – the normalised earning power of the business.
That said, if I have a strong case for an appropriate P/E, I shall take that into consideration – it doesn’t make sense for an investor to assume a 15% yoy growth in the earnings of the business, followed by good growth prospect after his explicit forecast period, and still assume a P/E multiple of 10x. The maths doesn’t make sense unless his adopted discount rate is meaninglessly high. Refer to the criteria on valuation below.
It is of paramount important that I must understand whether the E is clean. I should produce my own set of earnings if I think such earnings reflect more appropriately the economic reality of the business, than the accounting earnings or the earnings put forward by management.
Management must be appropriately incentivised
“Show me the incentives and I will show you the outcome” – Charlie Munger.
Management must eat their own cooking.
They must be intrinsically incentivised (e.g., passion) and/or financially incentivised (e.g. usually via substantial stock holdings relative to their net worth) to run their business competitively.
Management should articulate clearly their capital allocation policy. My preferred policy is to invest in growth and any excess cash should be returned to the shareholders.
Management should never compromise on integrity.
Valuation must be attractive
“Price is what you pay, Value is what you get” – Benjamin Graham.
Valuation should be based on
a/ an accurate set of assumptions
Neither being too conservative nor being too optimistic helps.
But being realistic does.
b/ an appropriate discount rate
What is the life of the company?
What would be an appropriate prevailing interest rate throughout its life?
Do I have sufficient margin of safety in my adopted discount rate versus the current interest rate?
Over the past 6 years I have been using a discount rate of around 6.0% to value companies. And it will continue to be at this level for the foreseeable future. (US government bond yield – 1.7% as at Nov 21)