“A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” – Burton Malkiel, “A Random Walk Down Wall Street”
Have you ever trounced a blindfolded monkey with a clipboard? It is harder than you think.
I have though.
More on this in a moment. Let’s move from the macro (i.e. how invested to be) to the micro (i.e. what to be invested in). As suggested, I am a big advocate of core portfolio construction and diversification using low cost index Exchange Traded Funds (ETFs) and select special purpose, actively managed ETFs and mutual funds. But some direct individual company investment is often necessary if your aim is to do better than above average. Besides, an all passive world is grey. It has no entrepreneurs. So let’s talk about how to be a little more savvy when getting specific.
What about the monkey and the checklist? As it would happen, there have been a number of tests professing random security selection (such as a monkey throwing darts at a stock page) have beaten average fund manager (and even passive index) absolute return performance over the same sample period. Perhaps, not so much on a risk adjusted basis in many cases, but the point is there. For example, Research Affiliates’ 2013 journal article, “The Surprising Alpha From Malkiel’s Monkey and Upside-Down Strategies“, discusses their 1964 to 2012 sampling of the 100 randomly selected portfolios of 30 equally-weighted stocks – where the random portfolios outpaced their cap-weighted benchmark return by 1.80% over the period. The study also reviewed strategy factor models with normal and inverted weightings, which is highlighted in more detail in our Processes Not Outcomes dialogue.
To even have a shot at consistently besting a totally random outcome we need a reliable list of characteristics to look out for – those unique factors attracting us, early, to that Gretzky rookie card, vintage Chanel, or Spiderman #1 that can be tucked away in an old drawer, and not pull it out again for a long, long time. This is where the clipboard comes in. The clipboard holds the checklist. The checklist includes the attributes and actions that have traditionally improved your odds of success when investing in individual equities.
Technically Speaking
Although not an exhaustive list, we generally want to look for companies with as many of these qualities as possible.
High Profit Margins and Return on Equity (ROE) – Businesses with a stable record of generating superior returns on investor capital have a habit of outperforming over time. Companies with high profit margins and returns on risk capital are also much more predictable investments; particularly when the high margins stem from a low cost base. So what do we mean by “high profit margins”? If you stick with companies with multiple long term historical ‘Return on” (RO) metrics in the double digits, such as Return on Equity (ROE) or Return on Invested Capital (ROIC), you are on the right track. More on this in The Power Three post.
Low Relative Capital Expenditure Requirements – Companies with lower relative capital expenditure requirements are usually lower risk investments and worth paying higher valuations for, all else equal. These businesses can be lower risk because they don’t need access to capital in the same way, and capital can be most scarce at times when capital is most needed. They also yield higher free cash flow and return capital to investors sooner. More on this in The Power Three post.
Sustainable Strategic Competitive Advantages – This is the magic created by the company’s assets, market positioning and culture that allow it to deliver a product or service that is better, cheaper and/or faster. Competitive advantages can be short-lived and difficult to identify, so it pays to do thoughtful research here. More on this in The Power Three post.
Predictable, Recurring Revenue Businesses with Increasing Cash Flow – My friend. I apologize. I am about to invoke my right to cliché and reference Warren Buffett yet again. It will happen again so just accept it. But, you know, he is pretty amazing, repeatedly proven right if you give him the time, and communicates in a way people understand. An article Mr. Buffett wrote in Fortune magazine in 2014, “Buffett’s annual letter: What you can learn from my real estate investments“ provides earnest advice about how to evaluate a new investment. He states, “focus on the future productivity of the asset you are considering” when doing your evaluation, and that, “if you instead focus on the prospective price change of a contemplated purchase, you are speculating”. Here Mr. Buffett is encouraging us to lay out our 5 or 10 year expectations for the business’ free cash flow or “owner earnings” (as Buffett would call them). This cash flow spotlight keeps us focused on what will reward us most consistently over time and support our of cost of living. My father actually also created significant wealth in commercial real estate with largely a simple, similar doctrine, “I bought real estate to ‘buy’ cash flow for my retirement”.
Granted, forecasting the “productivity of an asset” can be really hard, particularly if you are doing research your spare time. It is lot easier for some businesses over others however. For example, a local utility has a much for predictable 5 year cash flow stream than a smaller capitalization software company. If you are vetting an opportunity and finding it too difficult, as is often the case for me, it is time to move along and perhaps refocus on diversified strategies. Recurring revenue businesses are the best though. Wall Street and private equity firms love them. Unsurprisingly these predictable cash flow businesses, like real estate security companies, are commonly rewarded with higher valuations, less volatility and lower turnover. Companies with consistently increasing free cash flows also tend to particularly play out well in the end.
A Reasonable Valuation – Once we have generated our expectations for owner earnings over the next 5 to 10 years, we need to make a call on whether the selling price is reasonable against these productivity projections. We are effectively calculating an “owner earnings yield” by dividing annual owner earnings by the market capitalization of the company. This is the amount that could be paid out to you each year for your proportionate share in the company related against your original investment amount. Ergo, one important step in grading valuation is to relate this owner earnings yield to our own internal cost of capital. The valuation could be identified as attractive if there is a notable positive spread between the two and negative if not.
Full disclosure, this approach at valuation is probably overly simplified but appropriate for our discussion purposes. The fuller valuation methods practiced by industry professionals often involve completing discounted free cash flow (DFCF) models and a precedents & current comparable valuation analyses. A DFCF will project cash flow farther into the future, incorporate detailed assumptions on things like tax and capital expenditures, and assign a terminal value multiple at the end of the forecast period to also be discounted back with the cash flows. If you are interested in going this route I would recommend McKinsey & Co’s, “Valuation: Measuring and Managing the Value of Companies“. I had a well-used copy on my desk for many years.
As highlighted in another section, an investor’s sense of margin of safety is also hugely relevant to the valuation discussion. In other words, what do we realistically see the notional future potential realizable value being here and how different is this from the current market value? We want to invest where this perceived spread is highest – where there is a lot of room to be wrong and conceivably still do well.
Management – Emphasize companies led by proven and honest management teams. Management teams with an established history of strong returns and honest communication with shareholders are commonly much lower risk investments. They also tend to have a substantial cost of capital advantage, access better deal flow, and hold their value disproportionately well through tougher markets.
Strong Future Prospects – Have a clear understanding of why other investors or a potential acquirer are going to pay more for a company later. Strong future prospects can include further market penetration in a company’s core market, new growth markets, new product & service offerings, and / or acquisition targets.
Clean Balance Sheets – Balance sheet risk is generally to be avoided; particularly in cyclical industries. Many of the bottom 10% to 20% public company performers unfailingly seem to have either too much leverage relative to total capitalization or relative to their ability to service debt. How you evaluate leverage can differ between industries however. For example, an unhedged natural resources producer’s leverage profile is likely better assessed by running sensitivity analyses under various commodity price scenarios and incorporating both the capital structure relative to reserves and relative to cash flow under the various scenarios.
Skin in the Game – Concentrate on “owner-oriented” managers with a history of delivering returns. The level of insider ownership and insider buying should ‘mean business’.
Qualitative Actions
Soft skills matter as much as the more quantitive influencers. Mawer, a unique gem of a investment manager in Canada, so properly professes that before you take any action you need to (Lilly, “Decision making in an uncertain world”, Mawer.com, Nov. 2, 2016):
- “Bet” only when you have an edge.
- Diversify otherwise.
- Realize that most of the time you won’t have an edge.
This is worth restating. We invest only when we have an edge. We should diversify if we don’t have an edge. We recognize we will rarely have an edge.
Next question. Why are you buying this? Warren Buffett once suggested to an MBA class that if you want to become wealthy you should make a punch card with 20 slots on it. That card is only good for your lifetime and every time you make an investment you have to take out one punch. Doing this will compel you to research and think carefully about each investment decision you make. It will also inspire you to act with conviction when you do make an investment.
Keep an investment journal and write out your logic before taking any positions. Also write out a few reasons why you may be wrong or if there is evidence of bias in your decision process. The journal will encourage you to properly criticize your own logic. Even better, force yourself to post this publicly on a blog or other online forum if you really want to develop conviction. We dig deeper in the face of scrutiny.
Next question. Do you have a disaster relief plan? Individual equities are volatile and your conviction can be tested to its core before giving you anything back. Before investing, have a deep, sincere think about how you will respond to seeing your beloved investment idea trading down 15%, 25%, or 35% – even without any material adverse change in the fundamental story. That’s real money and this happens. Preparing for the worst may help you to hang onto the best through rough waters and push you to do the right amount of planning before setting off on your voyage.
Now, check out Thinklings for more valuable insights. And if you have the time…
- Find three qualified people who disagree with you and find out why.
- Talk to suppliers and customers.
- Use the company’s products and services yourself.
- Check job boards and online reviews.
- Read trade journals.
You will almost never find an opportunity that checks all or even the vast majority of the boxes, and you will learn that some of the factors above are a lot more relevant than others. A more probablistic than deterministic mindset is required for successful investing. Timing will also never be perfect and the stars rarely align. However, if you buy the right kind of businesses at the right prices you will do well over time.
Making It Happen 
3 thoughts on “Besting Dart Throwing Monkeys with a Clipboard”