5 Important Share Investment Rules

Important information at bottom of this page

This investment framework was developed from research and experience based on investment methods by the world’s best investors.

We look for:

• Good value. Buy businesses at prices below our estimate of its intrinsic value.
• Easy-to-understand businesses with a consistent operating history.
• Outstanding businesses with a strong market position, competitive advantages and conservative debt levels.
• High insider-ownership, on-market share purchases by insiders and rational, candid management.
• Out-of-favour businesses which are neglected by brokers and institutional investors.

Good value

Good value is the cornerstone of our investment philosophy. We see shares as part-ownership in a business, and as such try to focus on getting our valuation estimates right.

The Discounted Cash Flow (DCF) valuation model is the foundation on which all other valuation models are built ^[1]. It is widely used in investment finance, real estate and corporate financial management ^[2].The DCF model stipulates that the intrinsic value of any asset today is determined by the cash flows, discounted at an appropriate interest rate, which can be expected to occur during the remaining life of the asset.

Easy-to-understand Businesses

We need to estimate future cash-flows with a high degree of certainty, and therefore try to select easy-to-understand businesses which have a high probability of producing consistent and increasing free cash flows year after year. Major change, business reorganisation, repositioning and turnarounds have low success rates. We will avoid investing in such situations unless the expected return is very high.

More on risk

In the academic world of modern portfolio theory, risk is defined by share price volatility. That may be relevant for short-term traders or over-leveraged investors who may be forced to sell at unfavourable times. Our investment approach focuses on buying part-ownership in businesses, and as such we see risk as under-performance or failure of the business, not the volatility of its share price.

Business failure may come from changing market conditions, new competitors, bad management, regulatory changes, disasters etc. We mitigate individual company risk with diversification over multiple businesses. Too much diversification however can make us lose focus. Time also acts as diversification – while luck will always play some part in investing, it tends to even out over time.

Smaller companies

Smaller companies are generally easier to understand. We are not interested in valuing large complicated corporations such as BHP. We try to avoid competing with full-time analysts. The best way to do this is to look at companies which are mostly ignored by others. This article expands on the advantages for investing in smaller companies.

Quality Businesses

We look for businesses who can earn consistent high returns on its equity. A sustainable competitive advantage is rare as competitive forces and constant innovation drive returns towards the cost of capital. We try to identify factors such as good brand names, customer loyalty, patents, customer lock-in, competitor lock-out, buying power, lowest cost producer, supply-chain control and first-mover advantage.

Management

Insider ownership

We like to see directors and managers whose interests are aligned with the minority shareholders’ interests i.e. owning a meaningful amount of shares in the company. If directors are buying more shares on market that is very good indication of confidence in the company. See article: The significance of insider transactions for more information on this topic.

Retaining earnings vs. paying dividends

If retained earnings can be re-invested by the company at superior rates of return then paying dividends will probably forego valuable growth opportunities. On the contrary, if companies can’t reasonably expect to use surplus cash at attractive rates of return, or if they have a track record of making bad investments then hanging on to earnings is bad. It is in practice not that clear cut and each situation is unique. Many shareholders expect profits to be regularly distributed, especially after considering the attractiveness of franking credits in Australia.

Capital allocation

Capital is not free and, if growth is purchased with capital then we’ll keep a close eye on the economic value added (EVA). Since bigger companies tend to pay bigger salaries, there is a natural tendency for managers to go on an acquisition spree in order to expand their empire, often to the detriment of shareholders.

Most studies put the percentage of mergers and acquisitions that fail to create shareholder value at over 60%. We prefer to see share buybacks which have a higher probability of success over mergers and acquisitions.

Out-of-favour and Underfollowed companies

Many companies which are out of favour are that way for a good reason. They may struggle to remain profitable and may not be easy to turn around, especially in a very competitive marketplace. Some never recover.

Herd behaviour, crowd psychology and information cascades have become part of behavioural economics – forces that we believe play a powerful role in financial markets. Most market participants have the same information and proven successful investment methods are well known. It is reasonable to expect that buyers and sellers will reach a good consensus of business value.

We are nevertheless convinced that by looking at the wild fluctuation of share prices that the market consensus is frequently too optimistic or too pessimistic. That is probably one of the reasons why share prices often reach its lowest point (and hence the best time to buy) during recessions when there is no indication of any economic recovery yet. We try to buy into financially strong businesses with conservative levels of debt which have a reasonable chance to recover well. We may however buy into companies with higher levels of debt if we think the market has over-reacted on a particular company’s debt levels and we can buy its shares at exceptional value. As counter-intuitive as it feels, some of the best investments during the 2008 credit crunch were companies with high levels of debt i.e. buying what was widely unpopular at the time.

We don’t have a definite timing strategy for buying out-of-favour companies. Bad situations and profit glitches usually take a long time to turn around. However, overreaction and market expectation of more bad news to come can push share prices to extreme lows.

Conclusion

Benjamin Graham commented in his book, The Intelligent Investor: “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks”. Sustained investment success requires consistent application of sound principles regardless of any market fads and follies that prevail at the time.

References

1. Damodaran, A 2002, Investment Valuation Tools and Techniques for Determining the Value of Any Asset, Wiley, NY, pp.11-12.
2. http://en.wikipedia.org/wiki/Discounted_cash_flow