Do You Have an Intellectual Framework for Investing?Quick! Before you have time to think about it, grab a piece of paper and write down the investment principles by which you operate your portfolio and the characteristics you look for in the stocks you buy.
Whats the point of this exercise? If you had to think about your answer, you may be making a mistake by managing your own investments. It may indicate that you lack a structural framework that allows you to remain emotionally detached from your investments a detachment that is vital if you are to make intelligent decisions based upon rational analysis of a business rather than emotional reactions to market changes in market prices. On the other hand, if you are truly an investor this exercise should take no effort or time. Thats because you think from a business perspective. As someone of the Graham and Dodd school of value investing, for example, Im aware that stocks with certain characteristics such as low price to earnings ratios, low price to book values, high returns on tangible capital, low debt to equity ratios, and stable dividend policies have tended to outperform the market over long periods. These things, among others, are what I search for when I seek out potential new investments. The list may vary by your specialty and area of interest turnarounds, startups, oil companies, etc.
Can You Value the Cash Flows?A business is only worth the cash flows that it will generate from now until doomsday discounted back to the present value at an appropriate rate (typically the long-term U.S. Government bond plus an inflation kicker). If you dont understand that sentence nor do not have the skill set to discount annuity streams, it is probably a very bad idea for you to be selecting individual investments for your portfolio. Without the ability to arrive at an independent, reasonable valuation you can find yourself vulnerable to unethical promoters that simply push seemingly attractive (often high-priced) initial public offerings or the like.
Can You Spot Aggressive Accounting?Many new investors dont realize that the reported net income and earnings per share in a companys annual report are, at best, a rough estimate. Thats because even the simplest business with the cleanest balance sheet has numerous estimations and assumptions that management must make the percentage of customers that arent likely to pay their bill, the appropriate rate of depreciation on buildings and machinery, the estimated level of product returns, future returns on pension assets and thats just a few of the most obvious examples!
The downside of this is that unscrupulous management can game the numbers to look better than they are by utilizing aggressive accounting techniques. Knowing how to spot these is vital to protecting yourself. Again, if you cant do it, you shouldnt be investing your own capital without the assistance of a qualified professional.
Do You Understand the Fundamental Business?You might be surprised how few people actually know how their company makes money. Coca-Cola, for example, does not generate most of its profit from selling the drink you pick up in the grocery store. Instead, it sells concentrated syrups to bottlers throughout the world who then create the finished beverages and sell them to retailers. Its likely that many Enron investors didnt understand how the company made money.
Do You Understand Correlation Risk?How many stocks does it take to be diversified? Philip Fisher talked about this very concept in his famous treatise Common Stocks and Uncommon Profits so many decades ago. Which portfolio, for example, do you consider more diversified? Portfolio A which has ten total stocks consisting of three banks, two insurance companies, and five real estate investment trusts or Portfolio B with five assets consisting of one real estate investment trust, one industrial giant, one oil company, one bank, and one international mutual fund?
In this case, the surprising answer is that you are probably more diversified owning five non-correlated stocks than twice as many equities in similar industries. Thats because when troubles come, they often effect entire sectors of the market; witness the banking crisis of the late 1980s or the real estate collapse around the same time.