Intelligent investing has two components: the numbers and the story. They are interconnected, and understanding the latter gives insight into the former and vice versa. Buffett and other value investors have said that they look for situations where they “know” what is likely to happen, but not when.
Once Upon a Time…
When evaluating an investment, you should do your research like a history scholar. I recommend starting your “story reading” from a company’s annual reports and shareholder letters 10 years into the past. As you progress into the present, you’ll get a picture of the firm’s “story”. Where they were, and how they got to where they are now. A good story should reflect in the numbers. Even if the letters to shareholders seem authoritative and confident, it doesn’t matter if it’s not reflected in business performance over time. But since you are an enlightened investor, it’s the numbers that grabbed your attention in the first place, right?
Improvement in business performance comes in different forms. Generally you do want to see growth in things such as revenues, shareholders equity, operating cash flows and net income over time. I recommend the 10 year starting point as mentioned earlier for a reason: Business operations are not linear, and they can be subject to different market cycles, competitive forces and conditions. Therefore, It’s smart to have a mindset that all businesses are somewhat “cyclical”, not just those that are classified as such in the traditional sense.
Interpreting the Story
Understanding the business’ story helps you understand the numbers. Perhaps they’re having a weaker year because they invested in something that should generate strong cash flows in the future. But you don’t know for sure if this will happen. The story will expose the quality of their decision making. The track-record will show if they’re using resources with prudence, or squander on worthless endeavors that ultimately leave the firm in a more putrid existence. The biggest red flag is having fluctuating numbers combined with rising debt; a clear indicator that management doesn’t know what to do and/or are incentivized to behave in value destroying practices. Perhaps the underlying economics are fundamentally handicapped, but it doesn’t matter, since we don’t want to give our hard-earned money to these companies anyway.
I always look forward to quarterly earnings calls from the companies I own. Unfortunately the sad aspect of these calls are the analysts questions. Granted, sometimes there are good questions, but most of the time it’s crystal clear that they are analysts, not owners. They are focused on the short-term, and their questions reflect this. They’re not looking where the business was a few years ago and how it has developed, but what’s to be expected in the next few months. They may ask about interest rates or politics, something you are wise to ignore most of the time, since there is no way of knowing what will happen on those fronts. Their modus operandi is not their fault, it’s what they’re paid to do. And this short-sightedness is one of your greatest advantages.
The Best Stories
After looking at relevant numbers on a company via Barron’s, I go to the firm’s annual reports. The starting point is in the letter to shareholders. Here’s what I like to read, which gives indication to a good story.
The letters have a personal touch to them. You can hear the author’s own voice. You’ll find personal remarks, or even humor in them. This gives the CEO a less distant feel, and that it’s written by themselves instead of a hired pen. I also appreciate honest self-criticism; it’s always easier to deliver good news over bad. I don’t necessarily mind bad news, but I’ll take management integrity over self-congratulation any day.
Mistakes of Omission, Not Commission
To give an example of a company with a great story: Texas Roadhouse; an investment mistake of omission that I’ve made. The letters were a delight to read, but I just sat there in the bleachers, with an increasing heap of dust gathering on top of my undecisive head. Mr. Market rewarded the firm a price premium, and there’s no margin of safety left for me. Here we have many years of personal, folksy language written in a way anyone can understand and their 2020 letter even begins with praise for Rittenhouse’s awesome book. Mistakes of omission are just a fact of life in investing, and there will be more to come.
The Numbers in the Story
Good business stories are also about the numbers. What you want to read from the company’s documents is an emphasis on the realities of free cash flow and return on invested capital. I also believe it’s management’s duty to treat their balance sheet with care. This means having ample working capital and low debt levels, preferably coverable within a few years from normal operating cash flows. These are just some of the key variables. Obviously different situations may require different approaches.
It really boils down to some primordial truths for success. Spending less than you earn. Paying yourself first (aka. reinvesting in the business). Invest in projects that give great returns in the long-run. Incentivize value creation and good behavior. Create win-win scenarios where stakeholders, employees and investors all gain. Good business does not need to be a zero-sum game.
In simple terms, I want management to act like owners.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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