Investing is Tough Stuff???

Posted on September 29, 2012 by Don Shaughnessy

What should form the basis for an investment decision?

People who buy investment funds learn about risk and volatility and return and so on. Alpha (value added by management), beta (match to the underlying index) and others are used as persuasive tools by advisers. As I discussed yesterday, the market stats may be misleading because they are dominated by trades that are not investment trades.

To invest wisely, we will need other methods.

Profit is a poor proxy for success and investors should not rely on the number without considering other facts. Traders need not care. They are driven by market anomalies not underlying business values.

Strangely, a business can become bankrupt while it is profitable. This profit ambiguity causes problems for business owners, managers, policy makers and investors. The problem is that profit doesn’t mean much by itself. Even earnings per share or the Price/earnings ratio may not tell you what you need.

The market value of a security may be more in the realm of a psychiatrist than an investment analyst. But over a long time, the strangeness of price will be replaced by the reality of fundamentals. You still need to pay attention though.

Profit is an opinion not a fact. Unlike people, IBM does not get a T4 for their annual income.

Suppose an incorporated business earns $1,000,000 using the tax rules and generally accepted accounting principles (GAAP.) In Ontario, the tax bill would be $220,000 leaving $780,000 to invest. Clearly profitable! BUT, only within the system of GAAP and taxation. In the real world, the result might well be very different.

Suppose the business must invest $1,500,000 to remain competitive in its industry, (same market share and same technology as the leaders in the industry.)

Did it really make a profit or did it really lose $720,000?

The “economic answer” is it lost $720,000, but even that is not simple.

By investing the profits and borrowing, the business continues to exist and possibly a weak entrant in the industry will become weaker still and succumb. So, the true long-term economic loss is actually somewhat smaller. Maybe a lot smaller and possibly not a loss at all. Some of the cash loss is an investment in future market share. How do you value that now?

Management faces the task of deciding if they will survive long enough to benefit from the investment. They might be wrong. Especially problematic if the government bails out the weak entrants.

For those looking at profit alone, other expenses matter too. Marketing, advertising, R&D, and employee training, pay off over long periods but have immediate cost. Good for tax expense but hard for the analysts Some other expenses, like pensions, have a visible price today but an unknowable future cost.

In both accounting and taxation, profit is not the result of facts but rather is the result of rules and opinions. Things like depreciation rate, inventory and product obsolescence, bad debts, investment rate to be earned on the pension fund, future technology effects and more.

As an investor, can you glean much from the financial statements?

Maybe.

In most cases, it makes sense to pay attention to the management letter. I know a high performance fund manager who looks for the words challenge or challenging in that letter. If he sees either, he throws the statement away. In his words, “I have only limited resources, so why would I invest with people who have challenges?”

When looking for an investment, use commons sense.

I like and use the product, I like management, I like the industry.

Then look at the numbers.

  • Cash is real, profit is opinion. Or at least, cash is more likely to be real because you go to jail if you fool with it. Not so much with profit.
  • Look for dividends.       They impose a discipline on management and the cash paid out reduces the homeless dollar problem. When management finds that problem, some pretty dodgy projects get funded.
  • Not much debt. You cannot go bankrupt if you don’t owe any money.
  • When things go wrong, quit quick. Holding losers and waiting for recovery is a losing tactic. The price of tulip bulbs peaked in Holland in February 1637 and has not returned to that high.
  • Apply the buy/keep symmetry rule. A decision to keep a stock at a given price is fundamentally the same as the decision to buy it at that price. Either way you are making a choice between having a given amount of money or having a given amount of stock. If you would not buy the stock at that price, you should not keep it at that price either. Your history with it is not relevant. You will live in a future that does not care how you get to it.

Sometimes investing is as easy as finding a good business and participating in it. That is especially true if you cannot understand the “other” market.

This entry was posted in Personal Finance. Bookmark the permalink.

2 Responses to Investing is Tough Stuff???

  1. John Page says:

    Don…have you written about Gamma?

    • No I have not. I have dismissed it as being beyond the scope of what I want to think about. Derivatives in a technical sense are in that group. Maybe I should look. I get chills as soon as the little Greek symbols lying on their side appear.

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