The Right Way to Approach New Investment Ideas

With most situations in life it pays to go into them expecting the best outcome. No one would take a Hawaiian vacation if they thought it would rain every day during their stay, no one would buy a house if their first thought was all the repairs they'd have to make in the coming years, and so on. 

With investing, however, it pays to approach new ideas with a healthy dose of skepticism. 

In a transcript of a 2008 interview with Buffett biographer, Alice Schroeder, she shared the following observation about Buffett's own process for evaluating new investment ideas:

The first step in Warren's investing process is always to say, "What are the odds that this business could be subject to any type of catastrophe risk - that could make it (the business fail)?...It is backwards the way most people think because most people find an interesting idea and figure out the math, they look at the financials, they do a project and then at the end, the (sic) ask, "What could go wrong." (author's emphasis)

Finding new investment ideas can be exciting, but our initial enthusiasm should be tempered until we've first determined the company is highly unlikely to have meaningfully-worse results in the coming years. By doing a "pre-mortem" on our stock ideas, we can save ourselves from making some big mistakes along the way. 

Dividend investors, for example, can ask "What would have to happen to make this company cut its dividend in the next 3-5 years?" More specifically, if the company currently covers its dividend twice over with earnings or free cash flow, you could ask, "What would have to happen for this company's earnings/free cash flow to be halved?" and thus put the dividend at risk. 

However you frame your questions, the key is to approach each idea with a safety-first mindset. Only then can we feel more confident in our subsequent findings. 

Related posts:

• 5 Ways to Avoid Permanent Losses
• Introducing the Dividend Compass
• A Simple Guide to Selling Stocks

What I've been reading/listening to this week:

• A lifetime of saving and investing helped a janitor amass an $8 million fortune - Reuters
• Masters in Business podcast with StockTwits founder Howard Lindzon - Barry Ritholtz
• Don't be a doomster - Monevator
• Imitating genius - Matt Brice
• What do low interest rates mean for stock returns - Ben Carlson
• Michael Mauboussin on contrarian investing - via ValueWalk
• A list of good financial bloggers and writers - Morgan Housel

Stay patient, stay focused.

Best,

Todd

A Fresh Look at the Simple Formula

Earlier this week, a reader* of the blog had a look at the formula I laid out in "A Simple Formula for Investing Success" and cleverly suggested that the formula should be rearranged from:

Investment + Good Company + Right Price + Patience

to...

Good Company + Right Price + Investment + Patience

How did I miss that? 

Clearly, "GRIP" is much more memorable than "IGRP", and more importantly, it's the correct order of operations when investing. I don't know many successful investors who invest first and learn about the company later. 

So while we're on this topic, let's review the formula in the proper order.

Good company: Continuously learning about the business over the life of the investment is an essential component to investing success. Initially, your focus should be on determining whether or not the company possesses durable competitive advantages (i.e. an economic moat), what it's growth runway looks like, the skill with which management allocates shareholder capital, the company's culture, the strength of its financials, and so on.  

Even after you've invested in the company, it's important to stay on top of these items and review the business's progress at least twice a year. After a few years of following a business, you'll be surprised how much of an expert you'll become on its operations relative to the average investor, which itself, in turn, becomes an advantage.

Right price: Even a good company can make for a bad investment if you overpay for it, so it's important to consider valuation before making any investment. That said, investing is about dealing with uncertainty and no valuation model will be perfect. In my experience, the simpler the model, the better. Each investor has his or her own approach to valuation, but the key is to get a feel for the range of potential valuation outcomes and look to invest when you think the market price provides a suitable margin of safety. 

Investment: This may seem to be an obvious point, but I have a feeling that most of us have done a lot of research in a company, liked what we saw, but failed to actually make the investment for one reason or another. 

I know I've done that before, the most painful example being Tractor Supply (TSCO) in March 2009 -- a company I failed to invest in even after doing extensive due diligence and liking what I saw. As the market began to rapidly recover from the depths of the financial crisis, I got cold feet and waited for a pullback that never came. The stock's since gone up over 1,000% and has been the costliest mistake of my investing career. The lesson here is that investing success is impossible unless money is actually put to work.

Patience: If you've followed through with the first three steps -- you have a good company, think it's trading at the right price, and make an investment -- the only thing left to do is be patient. Patience, of course, also happens to be the hardest part of the formula, but it's critical to give the business a chance to compound your capital over time. 

Bottom line

Following this simple formula is far from easy; however, if you can consistently apply it over a long investing career, I truly believe it will produce very satisfactory results indeed. 


*Many thanks to Dev at the Stable Investor blog in India for pointing this out!  

Quote of the week:

What I've been reading/watching this week:

• What Seth Klarman has learned from Warren Buffett - FT
• What to do when your stock plummets - Ed Croft
• What's better -- ETFs or index funds? - Monevator
• Five stock ideas for the future - Richard Beddard
• Ben Graham's greatest gift - Matt Brice 
• 41 things I've learned in the past ten years - Brian Richards
• Investing in foreign dividend payers - Josh Peters
• The future of iron ore - Joe Magyer

Stay patient, stay focused.

Best,

Todd