Long-term investment in equities is the best way to create long term wealth for most people.
We will start this note (the third in the series) with a comment on growth and value which, in our view is a distinction, without a difference.
Commentators sometimes talk about Value and Growth Investment strategies as if these are separate processes. Nothing could be further from the truth. Growth is key – an investment in shares of a company which is not growing revenues and profits is not much better than a bond.
Bonds have a role in providing income and preserving wealth but for creating significant wealth one has to invest in growing companies. In that sense every equity investor is a growth investor
However, value is also key. Everybody wants value, nobody knowingly wants to overpay. The equity investor does not want to overpay for growth that they are buying.
So next time you hear somebody talking about growth outperforming value, switch off.
In the previous note, we talked about how the investor can use qualitative and quantitative filters to create a shortlist of stocks for further analysis.
The number of possible stocks that we could invest is very large especially if one looks at markets on a global basis while time available is very limited. Therefore, we need a filter or several different filters to come up with smaller lists of companies which can be analysed in more detail.
What is our approach to the Research of companies?
The short answer is that the Research process is at the heart of what we do and is a very detailed process and we can only discuss a few aspects of this in the short essay format.
We can divide the Research process into three stages.
1. Qualitative Analysis
2. Fundamental Analysis
The qualitative aspects are important. The qualitative work involves lots and lots of reading. There are no short cuts in this process. One needs to understand and analyse the nature of the industry and the company’s position in it. One needs to consider the company’s history and its past performance and try and come up with a view of its likely future performance.
Annual Report and Notes to the Accounts
The Qualitative analysis will help us determine whether the company is worth investing in. Only a very small percentage of companies that one looks at will pass this test.
Fundamental analysis involves looking at the financial numbers of the company. These must be analysed and considered in the light of the qualitative knowledge of the company that one has built up.
The investor needs some knowledge and understanding of Accounting. It is the language of business and needs to be learnt.
In Fundamental analysis, we need to look in detail at the financial performance of the company for the last five years at least and preferably for ten.
The aim is to understand how the company has been making money, how profitable it has been and, most importantly, how profitable it is likely to be in the future.
In the final analysis we want to try and arrive at an idea of how much cash the company is likely to generate over the next five to ten years.
Once the first two stages have been done, one needs to reach an independent valuation of what the security is worth.
This means one needs to use a range of valuation models to arrive at a range of value for securities. One must make conservative assumptions in valuations models – the company may have been very successful in the past, but the future could be more difficult, and our forecasts should reflect this.
At the end of the valuation process, one will have a range of possible values that a stock or other security is worth.
After this one can compare it with the quotation which Mr. Market is giving to decide whether it is overvalued, reasonably valued or at a discount with a reasonable margin of safety. If this is the case, it can be added to the portfolio. On the other hand, if the stock is not trading at a reasonable discount, it can be added to the watch list of stocks which are to be monitored. This must be done with many stocks and a portfolio can be slowly built up.
We will discuss these in more detail in the next few chapters.