good investor

The long-term goal

Everyone's pursuit is to be a good investor; this is true whether that person's training or day's job is in the field of business and finance, or not. If earnings are not invested properly, financial security for the family will be at stake. That brings us to think about investing. 

There are certain things that I consider fundamental to investing and to becoming a good investor. It is imperative to be clear about those things before we start our efforts in building a secured financial future, i.e. by taking the right investing decisions.

Investment and speculation

The first thing is to understand the difference between investment and speculation. I see a lot of confusion, mostly subconscious, out there about this.  Investment looks at the downside first; speculation does not. Investment gives a reasonable comfort that the capital invested is protected, i.e. it will not be eroded, and the returns over the period will be more than the inflation rate. Thus, investment gives the consolation that purchasing power of capital is retained at a minimum. If analysis is done properly, investment can give higher returns, but that is only incidental. 

Speculation fails to do any of this. There are many activities which have the characteristics of speculation; one example is trading of stocks without business analysis. 

If one starts with a wrong footing, i.e. thinks investing when actually is speculating, or even vice versa, the results are not going to be pleasant. 

Price and value

As a corollary to the first one, this is another important aspect.  Price is what we pay and value is what we get, is a widely known phrase. This has to be taken literally when it comes to investing. Value is based on the fundamentals of a cash flow generating asset, such as a business. Value is mostly driven by changes in cash flows, growth and associated risk; any decision that does not impact these, does not change value of that asset. On the contrary, price is influenced by almost anything including the value drivers. Speculators get this concept wrong invariably; investors understand it well.

In the short term, the most common factor that changes prices, is the behavior of the market; fear and greed are the traits of the behavior that drives prices. Bad weather, headline news, political changes, stock splits, stock dividends, less-or-more--than-expected earnings, management's views, analysts' views, and you-name-it are examples that influence prices.

Most corporate acquisitions take place without understanding the difference; overpaying has become a habit the cost of which eventually is paid for by the providers of capital.

In the long term, however, prices usually catch up with the fundamentals, i.e. the value drivers. That is the presumption the investors hold on to in order to expect adequate returns on their investment; history is on their side to support this presumption.

If one is not able to understand the difference between price and value, the advise is to first grasp it before taking any investing decisions. 

Risk

The meaning of risk in business and finance is quite clear; risk is a downward movement in prices when long on securities, and upward movement in prices when short on securities. This is fine, we are all worried about downside risks, not upside risks. So far so good.

The problem starts when it comes to measuring risk. The common understanding of measuring risk is in terms of the volatility in the price of an asset. It is perceived that if the price swings too much, the asset is considered risky; if prices stay within range, it is considered stable, i.e. safer. Practically, this assumes that market prices are good enough to measure the value of the asset all the time. For someone who understands the difference between price and value, this is bull. 

For instance: The prices of the stock of a lousy business which has no takers could remain at stable, albeit lower, levels for quite some time, giving low volatility. A great business, having short-term problems, although nothing related to its long-term cash flows, growth and risk has changed, could trade at swings if markets do not factor its fundamentals, giving high volatility. A private business or a real property or a farm land may not have quoted prices, and hence have low volatility; yet, if analyzed based on their fundamentals, these may be independently viewed as risky or safer assets.

We can correct this mistake in measuring risk in an asset by knowing more about it. Like someone said, risk lies in not knowing what one is doing. This is apt; to measure risk, what one needs to do is to understand the asset more, i.e. to understand the factors driving its cash flows and growth. An asset is viewed safer, if its cash flows are more certain and growth is more reasonably visible. In other words, we need to look at the downside risk that is more likely to be permanent; short-term downside risks are temporary in nature, usually speculative, and therefore are not actually a risk in the investment.

The riskiness of a business depends upon - nature of the business, the products it sells and the regulation under which it prices it products, the managers running it, the corporate governance surrounding it, its operating and financial leverage, its capitalization, i.e. equity and debt proportion, and its competitive advantages - its long term prospects. The more we know about these aspects of the business, the less we feel uncertain about it, the less we speculate about it, and therefore, the less risky it appears to us if acquired at the right price.

Contrary to the common belief, risk cannot be measured in precise terms; it can only be perceived as a guide for the investor's analysis. It is possible that something that appears to be risky to one, may not be risky to another because of her knowledge on the value drivers.

Understanding the concept of risk is crucial for the long-term investment results.

Analyzing and valuing an asset

Analyzing value comes first; any asset is a buy or a sell only at the right price. Let's be clear that there is a business behind a stock or a bond. Consequently, when investing in stocks analyzing the business itself is important. Watching ticker prices is of no use; that is for the speculators. 

Accordingly, developing the skills for business analysis and valuation is vital to investing. Without this we will not know the real worth (intrinsic value) of the business. That said, it is not easy. The good news, though, is that it can be developed gradually. As the knowledge grows, so do the skills. Over the long period we should be better at understanding and valuing businesses than before.

However, it is important to understand that there is no such thing as a complete knowledge; it is a life-long learning process. 

The first step in this learning is to read about the business from the annual reports, quarterly reports, and manager press conferences. Annual reports of past years should supply enough information about the business, the managers, where investments were made, how these investments were financed, the quality of these investments in terms of return on capital, and what was done with excess cash, if any. As we read more about the business we should be able to understand more about it, and thus, feel less uncertain about its prospects, good or bad, to be able to value it. The numbers, i.e. financial statements, tell us the most part of the story we seek. Gradually, we will be able to gather which part of the annual report and other information is relevant to our analysis.

Then there is information related to the business, the industry, the economy, and other aspects of business and finance that should be read. Since accounting is the language of finance, it is advisable to have some knowledge related to accounting and financial reporting as well. Moreover, it is always good to read about the investment philosophy and methodology of investors we admire. It is amazing how interesting this process can be; accumulation of knowledge is a good stuff.

It is also important to know what not to read. Any views expressed by the analysts or even managers about the future prospects should be shunned. These are the personal opinions more often based on bias. So ignoring them is the correct thing to do.

Finally, it should be realized that value is only an estimate based on some analysis. For valuing a business, we need to estimate both cash flows until perpetuity and the right discount rate, which is never going to be precisely right. Therefore, it is prudent to keep the price paid for the asset fairly lower than the value estimated. This is to make up for the human error of judgment. Only hubris can come in its way; so it is better beware.

Behavior

In the meantime, we need to build the right behavior, not to be swayed by the whims of the markets. For that sticking to the basics is what is required. If the analysis is done right and an investment decision is taken, the short-term price movements, which are the doings of the speculators, should not change our decision. On the contrary, we can thrive on these price swings by taking advantage. It is clear that investors make money at the cost of speculators. 

Maintaining some discipline in investing is important. Fear, greed, and envy are to be avoided at all times; it pays to control that urge. 

Business of investing

There are no shortcuts to this process. If, let's say, we start a business today, we cannot reap rewards immediately. Any business, private or listed, has to operate for a fairly long period of time to give results. There are short-term investment strategies too where the price catches up with value sooner than usual. Usually, investing is a long-term process. We read, we analyze, we value and we buy; then we need to wait until our efforts fructify, which usually takes longer than we would like. It is best to view active investing as a business we operate.

There is no scope for part-time active investing. If we have no time or interest in this process, it is better to invest regularly in an index fund; over the long term, the return on investments should be fair. In the meantime, our time and efforts can be directed towards things we like, rather than being halfhearted or forceful on the business of investing. 

Limits to expectations

With all the time and efforts that we put in learning about business and investing, it is crucial to understand the limits to the expectations from our investments. There are no super-normal returns to be expected. Some exceptions could be there in the short term, however, over a long period of time, it is wise to have a limit to our expected returns.

Usually, the price paid becomes a key factor in determining the returns. Stating the obvious, the lesser the price paid the higher the returns. Nevertheless, super-normal returns over a long period of time are not only unsustainable, but also unreasonable. Both the long term macro economic conditions and the fundamentals of the business itself will ensure dilution of the competitive advantages attached to the business; at some stage, the competition, technology, or regulation will kick in such that the business will experience stable growth or even decline, rather than high growth.

Therefore, it is sensible to set the expectations to be normal; ideally, the rate higher than long term inflation rate plus a few points should be adequate to beat the broader index. Rest assured the amazing power of compounding should take care to create wealth. 

Humility
Finally, it will be good to have some humility in this whole affairs. If we attribute success only to our skills, it would be imprudent. For investment success, the market price should eventually catch up with our estimated value; if this does not happen, however good our analysis be, we will not be able to seek expected returns. For all the silliness, irrationality and inefficiency in the short term, we want the markets to become efficient at some point; and this requires both our efforts and a bit of luck. So let's shun that hubris, if there is any.

Plan for the coming years
Let us be the owner of the business of investing; let us put in our time and efforts to seek long-term financial security; And let us have loads of fun in the process, because it is actually a lot of fun.

Let's defy the markets.