The markets are “interesting” just now so perhaps a rethink of the fundamentals is in order. This article appeared with minor differences 29 September 2012. Most of the ideas still apply.
What should form the basis of 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), Sharpe Ratio and others are used as persuasive tools by advisers.
Many of those “facts” rely on trades that are not investment trades. They are trades based on pricing anomalies and last fractions of a second. Investors need other ideas.
Here are some possibilities
- 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. Profit doesn’t mean much by itself. Even earnings per share or the price/earnings ratio may not tell you what you need.
- The reasons that the market price is as observed, may be more in the realm of a psychiatrist than an investment analyst. Fear and greed rule here. But over a long time, the strangeness of price will be replaced by the reality of fundamentals.
- 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. That is 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 security 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 reality, 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 limited resources, so why would I invest with people who have challenges?”
- When looking for an investment, use common sense. I like and use the product, I like management, I like the industry. Then look at the numbers.
- While profit is opinion, cash tends to be real. 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 some managers find homeless dollars, 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 yet returned to that high.
Twelfth is when to sell. An often overlooked part of investing.
Apply the buy/keep symmetry rule. A decision to keep a stock, or anything else for that matter, 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 choose to buy the stock at that price, you should not keep it at that price.
Whether a profit or a loss, your history with it is not relevant. You will live in a future that does not care how you get to it.
Sound investing evolves to a position that is boring. That may be the best measure of success.
Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.