Tuesday, 26 December 2017

Purchasing Common Stock: A 7 Step Code of Conduct

This is the 7-step code-of-conduct I follow whenever I attempt to purchase a Common Stock. The code is derived from the ideas of some of the investing greats, like Warren Buffet, Charlie Munger, Philip Fisher, Peter Lynch, Monish Pabrai and Prof. Aswath Damodaran.

  1. Do I understand this business? If the answer is yes, I ask myself again, ‘Do I understand every transaction in this specific company?’ While it’s okay to for me understand a company’s business model alone, it helps to have a broad idea of all their business transactions. I expand my 'circle of competence' by reading books. A lot of books. The more your 'circle of competence' expands, the wider your investment universe. But don't be quick to declare yourself as 'competent' in a specific industry. If you think you will never be competent enough to understand a specific industry, you don't have to ever invest in it. And that's okay.
  2. Does the company have a good Moat/Long Term Economics? This part is a little dangerous and I may be deluded into imagining a wonderful future for the business. The trick is to stay very objective and physically list out the positives. While a strong moat (Ex: Low-cost leader, Brand) is preferred, good long term economics (Ex: Government subsidies, natural rise in Demand) is a consolation. In technical terms, a moat is a ‘Sustainable Competitive Advantage’. A weaker, not-so-lasting Competitive Advantage can be called an ‘Economic Advantage’. At least one of them is necessary. I am not an expert in this and probably why this is the most important part of my investment thesis that I keep revisiting every now and then.
  3. How well does the company operate? When I say ‘operate’, I mean its core business, as well as its important subsidiaries. This is done in two parts: Financial Statement Analysis and Scuttlebutt. There are no shortcuts around this. I will have to crunch a lot of numbers and ask a lot of questions in relation to those numbers. It gets easier with practice, however.
  4. Does the company have an appreciable work culture? You can find these on job review websites for many companies. However, a great deal can also be found in interviews by the top brass of the company. While a great leader at the helm is essential, I also look for a great corporate culture, management ethics and a powerful vision for the future of the company. If the employees genuinely feel like the company is a great place to work, that will seal the deal. A company is nothing but its people.
  5. Do I already own a related business? Diversification is powerful. Diversification is a protection against unexpected outcomes. What if the government banned the products of a company you own? Or what if your company gets caught in a severe accounting malpractice? It might be highly unlikely, but you can’t control such things. So unless you have an exceptional understanding of a specific type of businesses, it’s advised that you diversify your investments across different sectors and different types of companies.
  6. Am I paying a fair price for the company’s Assets? The trick up the sleeve of every great investor’s playbook. Even if all the above conditions are met, it may turn out to be a wrong bet. A great company can be a bad stock, simply because the market over-estimates the growth prospects of the company. Classic Indian growth-story-related companies like Eicher Motors and MRF might be bad stocks because they are almost always overpriced. Any decline in their price is immediately filled up by new buyers. I have built some valuation models to value different types of businesses. I continue to learn better ways to value businesses objectively. The models will also help me to understand if a company is ripe for a sale. If a company I hold is trading at 1.5x or 2x its current intrinsic value, I may book partial profits or sell it off completely. If I hold an extremely good business, in an extremely important industry and with excellent long-term economics, I may never sell it.
  7. Does the potential investment pass my checklist? All great investors have a Checklist. In a simpler sense, you can consider it as a 'Not-to-do' list. It's a list of mistakes made by you or any other investor (Especially the investing greats) in their investing decisions. Life is too short to become successful by learning from only your mistakes. Learn from the mistakes of others as well and avoid making them. Of course, no single investment can score a 10/10 on your checklist. So, set a baseline score (Say, 70%) and stick with it.

You don't necessarily have to follow my Code-of-conduct for your investments. But do try to build some kind of code to be followed rigorously every time you pursue an investment opportunity. The idea is to keep your emotional mind at bay. Every time you think about investing 'with your gut', pinch yourself really hard and start looking at your Investment Code. That should do it.