I came across an interesting broker note today on the “Ten Attributes of Great Fundamental Investors”. This is not a typical one you read from brokers (though they occasionally have funny ones on the World Cup and the like), it’s far more a thought piece.
The report starts with the history of the author’s career progression, which is not a boring read if you like financial history. The meat of the document, and what you, of course, are interested in chowing-down on, sets out the ten attributes which make a fundamental investor great. It draws on a lot of academic theory and if you are interested in new ways of thinking, it’s well worth your time.
One chart that I liked is as follows. It’s interesting to see how prices have changed, particularly storage and computing costs.
Ten Attributes of Great Fundamental Investors
- Be numerate (and understand accounting)
- Understanding a business requires understanding the numbers. The task has become more challenging in recent years as companies are investing more in intangible assets and less in tangible assets. For example, in fiscal 2016 Microsoft spent about one-and-a-half times as much on research and development, which it expensed on the income statement, as it did on capital expenditures, which were capitalized on the balance sheet. This shift means that traditional accounting measures are less useful but does not abdicate the responsibility to understand a business’s current economics and prospects.
- Understand value (the present value of free cash flow)
- The landscape of investing has changed a great deal in the past three decades. It is interesting to consider what about investing is mutable and what is immutable. The truth is that much is mutable. The average half-life of a public company is about a decade, which means that the investable universe is in flux.9 Conditions are always shifting because of unknowns including technological change, consumer preferences, and competition. But one concept that is close to immutable for an investor is that the present value of future free cash flow determines the value of a financial asset.
- Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow. Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within its industry, barriers to entry, the economics of the business, and management’s skill at allocating capital.
- “Remember, cash is a fact, profit is an opinion.”
- Properly assess strategy (or how a business makes money)
- The basic unit of analysis varies by industry. What you need to understand to assess a subscription business, customer lifetime value, is different than a business dependent on research and development such as a biotechnology company. Great investors can explain clearly how a company makes money, have a grasp on the changes in the drivers of profitability, and never own the stock of a company if they do not understand how it makes money. You can think of this as the micro dimension of understanding strategy.
- Compare effectively (expectations versus fundamentals).
- Perhaps the most important comparison an investor must make, and one that distinguishes average from great investors, is between fundamentals and expectations. Fundamentals capture a sense of a company’s future financial performance. Value drivers including sales growth, operating profit margins, investment needs, and return on investment shape fundamentals. Expectations reflect the financial performance implied by the stock price.
- Making money in markets requires having a point of view that is different than what the current price suggests. Michael Steinhardt called this a “variant perception.” Most investors fail to distinguish between fundamentals and expectations. When fundamentals are good they want to buy and when they are poor they want to sell. But great investors always distinguish between the two.
- Think probabilistically (there are few sure things)
- Investing is an activity where you must constantly consider the probabilities of various outcomes. This requires a certain mindset. To begin, you must constantly seek an edge, where the price for an asset misrepresents either the probabilities or the outcomes. Successful operators in all probabilistic fields dwell on finding edge, from the general managers of sports franchises to professional bettors.
- When probability plays a large role in outcomes, it makes sense to focus on the process of making decisions rather than the outcome alone. The reason is that a particular outcome may not be indicative of the quality of the decision. Good decisions sometimes result in bad outcomes and bad decisions lead to good outcomes. Over the long haul, however, good decisions portend favorable outcomes even if you will be wrong from time to time. Time horizon and sample size are also vital considerations. Learning to focus on process and accept the periodic and inevitable bad outcomes is crucial.
- Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected).
- Great investors do two things that most of us do not. They seek information or views that are different than their own and they update their beliefs when the evidence suggests they should. Neither task is easy.
- The trait of seeking alternative views is called being “actively open-minded,” a term coined by a professor of psychology at the University of Pennsylvania named Jonathan Baron. Actively open-minded is defined as “the willingness to search actively for evidence against one’s favored beliefs, plans or goals and to weigh such evidence fairly when it is available.” Research shows that actively open-minded people perform well in forecasting tasks that demand collecting information. The trait of being actively-open minded can offset confirmation bias.
- Beware of behavioral biases (minimizing constraints to good thinking).
- Keith Stanovich, a professor of psychology, likes to distinguish between intelligence quotient (IQ), which measures mental skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good decisions. His claim is that the overlap between these abilities is much lower than most people think. Importantly, you can cultivate your RQ.
- Know the difference between information and influence.
- Great investors don’t get sucked into the vortex of influence. This requires the trait of not caring what others think of you, which is not natural for humans. Indeed, many successful investors have a skill that is very valuable in investing but not so valuable in life: a blatant disregard for the views of others. Success entails considering various points of view but ultimately shaping a thesis that is thoughtful and away from the consensus. The crowd is often right, but when it is wrong you need the psychological fortitude to go against the grain. This is much easier said than done, especially if it entails career risk (which is often the case).
- Position sizing (maximizing the payoff from edge)
- Success in investing has two parts: finding edge and fully taking advantage of it through proper position sizing. Almost all investment firms focus on edge, while position sizing generally gets much less attention
- Proper portfolio construction requires specifying a goal (maximize sum for one period or parlayed bets), identifying an opportunity set (lots of small edge or lumpy but large edge), and considering constraints (liquidity, drawdowns, leverage). Answers to these questions suggest an appropriate policy regarding position sizing and portfolio construction.
- Read (and keep an open mind)
- Great investors generally practice a few habits with regard to their reading. First, they allocate time to it. Warren Buffett has suggested that he dedicates 80 percent of his working day to reading. Note that if you are spending time reading, you are not doing something else. There are trade-offs. But many successful people are willing to make reading a high priority.
- Second, good readers tend to take on material across a wide spectrum of disciplines. Don’t just read in business or finance. Expand the scope into new domains or fields. Follow your curiosity. It is hard to know when an idea from an apparently disparate field may come in handy.
- Finally, make a point of reading material you do not necessarily agree with. Find a thoughtful person who holds a view different than yours, and then read his or her case carefully. This contributes to being actively open-minded.
Ten Attributes of Great Fundamental Investors Presentation
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