Three of the most common questions I get from friends and colleagues are:
How can you learn more about investing?
How do you know what to invest in, since the total investment universe is quite large?
How do you know what to pay for an investment?
These are extremely valid questions, as you don’t have time to study every investment out there!
The first question is relatively easy to answer. I have learnt the most from reading annual reports and articles written by long-term successful investors - yes folks, that means you have to read! Simply watching YouTube or watching social media is not going to help you much in most cases. Hopefully, this blog will also help you become a better investor over time. You will soon realise that keeping your investment process simple and avoiding all sensational news will serve you well in the long run.
The second and third questions may take a bit longer to answer. In my previous article Investing vs. Speculation, I already hinted at the importance of having a process in place that helps you make decisions. In this article, I will take a more detailed and practical look at what that means in practice, by specifically looking at stocks (pieces of ownership in a publicly traded company).
Let’s dive in!
Defining the investment research process
In my experience, most of the confusion these days arises from the lack of clarity. Poorly defined terminology is the root cause of this. You would rightfully ask me: What is an investment research process exactly? When I want to research a particular topic, I always define a clear problem statement or objective first. We already know that the objective of the investment process is to identify high-quality companies that you can own for a long period (typically at least 10-30 years)! So let's start with a definition:
"The investment research process is a number of steps you go through to identify high quality companies worth investing in."
I believe the investment research process consists of 3 steps:
You want to identify high-quality companies
You want these companies to be run by competent management
You want to estimate the value of the company and compare it to the current stock price
Let me share my high-level thought process to bring this to life. Firstly, we want to define a set of simple rules to keep only the best investments –– I bet you love simplicity too! Can you imagine analysing every company's Annual Report and Financial Statements?! I bet you don't. So let me give you an example of a rule I use: I want the free cash flow per share to increase over time (ideally a minimum of 5 years). This is of course just an example –– you can set up your own rules and tweak these over time.
Secondly, you want to ensure that high-quality companies are run by competent management. I define competent management as people with solid integrity and a record of good stewardship of shareholder equity. For example, I want the company to have a consistently high return on invested capital. I also prefer companies that have owners and management with skin in the game (a.k.a. they own a big chunk of shares and they don't rely on stock options and obscene salaries to make a living). Fortunately, we can look at financial and proxy statements to get clues about the management's past behaviour. There is no need to necessarily speak with the management of the company!
Finally, you want the stock price to be below your valuation of the business per share. There are many valuation techniques you can apply to value a business: from simple earnings ratios to complex cash-flow models.
Hopefully, these high-level frameworks will get you started in defining your very own investment process! And remember: keep it simple and keep tweaking –– Rome wasn't built in one day.
Thank you for reading!
The Financial Dutchman
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