Step 1: Observe, Read, Think. Repeat.
Warren Buffett spends most of his time reading and thinking. At one point he described his investing style as “laziness bordering on sloth”. That is probably not how your fund manager or financial advisor operates. They probably spend more time reading and repeating other peoples’ opinions, because that requires minimal amount of thinking. Then they spend more time calculating and being busy.
I spend a lot of reading and thinking. At the end of the day, as investors we’re trying to make sense of the world. And that involves not only reading about what’s going on but also observing the way the world is changing. Industries are being disrupted. Consumption patterns are changing. Hundreds of millions of people in Asia are about to enter the labor force; while the developed world is ageing. These may be labelled as “macro” trends, outside the purview of an investor who invests in companies. That’s how Wall Street and Academics think. But that’s the wrong way to look at it. Charlie Munger is fond of saying:
“Be a business analyst, not a market, macroeconomic, or security analyst.”
The Investment Management industry loves to silo people into each of these groups. But the best investors do a bit of everything. They must, because a business doesn’t exist in isolation. Today, more than ever, businesses are part of giant, global ecosystems. To have a view on a business requires a view on the sport it’s playing, globally. The financial results of the company may tell us what has happened in the past. But it’s value today depends largely on how it survives the competitive onslaught in the future. And that prognosis requires multi-disciplinary thinking.
“You must know the big ideas in the big disciplines and use them routinely – all of them, not just a few. Most people are trained in one model – economics, for example – and try to solve all problems in one way. You know the old saying: To the man with a hammer, the world looks like a nail. This is a dumb way of handling problems.” – Charlie Munger
Investing is a liberal art, which is why I gravitated towards it. My daily life as an investor requires reading trusted newspapers, magazines, books, watching documentaries, and the good ole’ talking to people who know stuff. I spend at least 2 hours a day reading newspapers and magazines, about 2 hours reading books, and many more hours thinking about what I read. When I get a sudden burst of energy, I write. And once I begin writing, the intention is to form a definitive worldview on that subject.
Step 2: Form a Worldview
At some point, all that reading-and-thinking must be put to good use. That starts with a well-thought-out Worldview. Worldviews in the The Buylyst cover two major strings of topics: 1) The art of investing and 2) Where to find investment opportunities. We’ll talk about the art of investing Worldviews later. In finding investment opportunities, the process is simple, and rooted in common-sense. Basically, we observe the world, read about it, think on it, talk to some people, and connect a few dots to come up with a hypothesis. These hypotheses are usually about a phenomenon or an industry, and normally involve more than one subtopics. In The Buylyst, these connections – between Worldviews – are shown in “Related Worldviews” in each article. But the articles are also peppered with links to related Mental Models, Worldviews, and Guest List articles; what we end up with is a growing latticework of worldviews on a phenomenon or an industry. Out of this latticework, a few investable ideas shake out. For example, if we have a latticework of Worldviews on the Energy sector, it shakes out certain sub-industries or niche markets that appear to have a nice asymmetric payoff – limited downside, great potential upside. Wind Energy, for example, is one such industry with a nice asymmetric payoff.
Here’s an important point: The latticework of Worldviews is meant to result in hypotheses, not in indisputable conclusions. We must bear in mind that these hypotheses could be wrong. A successful outcome from this latticework of Worldviews is this: it directs us away from sports we shouldn’t play. Those are the sports with a bad type of asymmetric payoff: limited upside, great potential downside.
“All I want to know is where I’m going to die, so I’ll never go there” – Charlie Munger.
Step 2b: The Bottom-Up Alternative
Sometimes, ideas pop-up as I go through my day. I may like a product or a service, and wonder whether it’s a worthwhile investment candidate. In most cases, however, companies with great products or services tend to be overvalued. And if they’re in an initial growth phase, they tend to burn through a lot of cash, which makes it hard to value the company. Tesla is a good example.
This type of a process is commonly known as a “bottom-up” process. Normally, in a reputed investment management firm, such a bottom-up process begins with a “quantitative screen”. The screen shakes out some companies that pass certain quantitative tests (like P/E ratio, earnings growth, ROE etc.). Research Analysts then get that short-list, and they go to work on companies listed on the screen.
The Buylyst process doesn’t employ quantitative screens, yet. If we ever start doing so, it will only serve as a time-saving tool that complements the latticework of Worldviews. The reasons are simple: 1) quantitative screens are based on dirty accounting numbers 2) they require access to expensive databases and 3) they tend to make analysts myopic by focusing more on the micro, company-level details and less on the ecosystem within which the company operates.
The last point there is an important one: The main difference between The Buylyst process (so far) and that of professional investment managers is the latticework of Worldviews. It means that:
- The Buylyst spends a lot of time thinking about the ecosystem within which a company operates.
- The Buylyst is totally transparent about it. Our thoughts are published, and can be used as tangible “institutional knowledge” in the future.
Step 3: Are any of these ideas worth my time?
We all have limited time, so we must use it wisely. Once our latticework of Worldviews gives us a list of potential investable ideas, it’s best to narrow down our options or prioritize our efforts towards the most likely investment candidates. The Buylyst employs a short, simple “First Date Screener” for these investment ideas. The screener, while discussed here, involves 3 basic quantitative “tests”, that simply answer the question: “Is this idea worth my time?”. Nothing more. Here are the basic tests:
- Has this company been generating cash for shareholders consistently?
- Has this been a financially productive company? In other words, have the underlying returns of the company been healthy? This is usually measured by a version of Return-on-Equity (as calculated by The Buylyst). It’s meant to give us a rough idea of Management Quality.
- Does the company borrow too much money?
This is an important point: These questions are merely a starting point. All this simply informs us whether the company has been (note past tense) showing signs (numerically) of a worthwhile investment candidate – whether it has been a good company. This is leads us to another important point: At this stage, I’m less concerned about price at this stage than I am about the quality of the company.
“If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter.” – Warren Buffett
Step 4: Is this a good company?
Now that an investment idea has passed through the “is this worth my time test”, we’re ready to spend some time on it. In determining whether this is a good company, there are 3 basic questions that need to be answered. The questions are basic, but it takes a lot of time and effort to answer them because there is no numerical short-cut. Many of the answers are borrowed from the latticework of Worldviews. These are the questions:
- Does the company have a Competitive Advantage? In Buffett-speak, is there a strong Castle?
- Is the Competitive Advantage durable? Can the company protect it? In Buffett-speak, is there a wide Moat.
- Is the company’s management high quality? Do they allocate capital to strengthen the Castle and widen the Moat?
Much of this analysis is subjective. And much of it boils down to one number above all: What is a reasonable estimate of the company’s Sustainable Free Cash Flow to shareholders. Historical data is merely a rough indicator. The likelihood of a company generating a healthy amount of free cash flow in the future depends on it’s ability to hold on to its competitive advantage. That depends on how management’s ability and willingness to invest in it competitive advantage, and on the ecosystem in which the company operates.
This particular data point – Sustainable Free Cash Flow to Shareholders – is the key to estimating the Intrinsic Value of the firm. And our educated guess about the Intrinsic Value of the firm is the key to answering the final question: Is this a good buy?
Step 5: Is this a good price?
This is the final step in the Research Process. Once we’ve done our best to guess whether it’s a “good” company, it’s time figure out if it’s cheap. The main concept here is Margin of Safety. It’s the central pillar of Intelligent Investing. The concept is simple: buy something for much cheaper than it’s worth. But to do that, you must know how much it’s worth.
A company (or its shares) have an intrinsic value because it’s an entity that produces an income for the foreseeable future. If we’re betting that a company is a “good” company, we’re betting that the company produces a sizeable amount of cash flows for a long time. This intrinsic value of the company today would be the present value of all those cash flows.
The cash flows themselves are rough estimates. We touched upon the concept of “Sustainable Free Cash Flow to Shareholders”. This calculation is a result of much subjectivity. The point here is this: Intrinsic Value is, at best, a rough estimate of how much a company is worth. It’s not a fact; it’s a rough marker.
This is when Margin of Safety enters the picture. If we have enough common-sense and humility to understand that our estimate of intrinsic value is flawed, it makes sense to buy something much cheaper than our estimate. That gives us substantial room for error. A good rule of thumb is to buy something at a 25% discount. So, even if we’re wrong by that much, we won’t lose any money.
Every investment idea explored in The Buylyst comes with a detailed Intrinsic Value calculation. The calculation may appear tedious at first. But it is rooted in common sense and in lessons learned from my experience and that of the giants of investing.
At this point we’re left with either of two situations:
- A good company at a bad price.
- A good company at a good price.
And this is an important step: Ideas that fall into the first case get a "Watch" rating. Ideas that fall into the second case get a "Buy" rating.
All Roads Lead to the Thesis Pop-Up
All the analysis listed above – the Worldviews, assessing the quality of a company and its management, assessing a fair valuation for the company – converge to a Thesis Pop-Up. As far as The Buylyst Research Process is concerned, the Thesis pop-up is the final, distilled amalgamation of all the steps listed above. For the user of The Buylyst, however, the Thesis pop-up could serve as a starting point.
Each Thesis pop-up has clearly laid out sections that point to the steps taken to arrive at this distilled one-pager – Related Worldviews, assessment of a company’s quality, and the assessment of a company’s numerical value including details about valuation are all clearly marked. A user can easily navigate The Buylyst thought process through this one-pager. The Thesis pop-up is a doorway to much more detailed and nuanced analysis of a company’s prospects. You may or may not want to dig in from the one-pager. It’s entirely up to you.
Approximately Right over Precisely Wrong
At the end of the day all that analysis that finally distills down to the Thesis Page is an educated guess. It’s dangerous to think that any of it is deterministic. We start by avoiding playing a losing sport. Then we rule out the duds with a screener. We then make a subjective call about the quality of a company. And finally, we make a rough numerical assessment of a company’s value. While the Thesis Page looks very precise, it’s not meant to be. At best, we hope it’s approximately right.
Much of Wall Street and Academia like to turn Economics and Finance into a precise science. It’s not. We’re dealing with uncertainties that are not normally distributed and are not linear. The giants of investing – who provide most of the fodder for The Buylyst Mental Models – understand this. A few golden nuggets from some of these giants capture the idea of humility and self-awareness upon which any investment research process should be based. They say it better than I do:
“In my investing career I operated on the assumption that all investment theses are flawed…The fact that a thesis is flawed does not mean that we should not invest in it as long as other people believe in it and there is a large group of people left to be convinced. The point was made by John Maynard Keynes when he compared the stock market to a beauty contest where the winner is not the most beautiful contestant but the one whom the greatest number of people consider beautiful.” – George Soros
“The most successful investors get things ‘about right’ most of the time, and that’s much better than the rest.” – Howard Marks
“[The] function of margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” – Benjamin Graham
Mental Models: The Backbone of The Buylyst
Much of the process described above is firmly rooted in the The Buylyst Latticework of Mental Models. The experience of the giants of investing is neatly laid out in the Mental Models section. These are the building blocks of everything we do at The Buylyst.
The Mental Models section is laid out like a periodic table of elements. Maybe it’s a cheesy symbolic nod, but it works visually because it also looks like a lattice-type structure. All the wisdom that I could collect from the giants of investing is housed in this latticework. Each box leads to a Mental Model. And each Model has a list of statements made by the giants. Each Statement has tags to other applicable Mental Models. There is also a very cool database functionality. You can explore what a particular giant of investing has said about a particular topic on investing.
In the Worldview section, many of the discussion are about finding investment opportunities. But many others are discussions on topics related to the Art of Investing. These discussions borrow heavily from the Mental Models section. This is where we combine their wit, wisdom and experience with our own. Some users may prefer the magazine style format of the Worldview in their quest to learn about a particular topic.
Every step in The Buylyst Research Process listed here is rooted in The Buylyst Latticework of Mental Models. The section is free. And it’s ever-growing. It won’t be long before it turns into a powerful encyclopedia of Intelligent Investing.
“What is elementary worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try to bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form. You've got to have models in your head. And you've got to array your experience - both vicarious and direct - on this latticework of models.” – Charlie Munger
Many Happy Returns.