I have spent a considerable amount of time thinking about how one should approach investing. While merely a memo and not a comprehensive essay, I hope to summarize my views in a quick but concise manor. I believe that an investor needs to get comfortable with what they are truly capable of knowing about the economy, assets within the economy, managements that determine the use of those assets, and securities that entitle holders to legal claims upon assets and cash flows. How much can you know about each of these topics, and how much do you need to know? What is more important, a grandiose top down view of where the world is headed or bottom up understanding of a business? Finally, and most importatly, how does this factor into the price you pay for a security?
Many market participants pontificate about what GDP growth will be, what Ben Bernanke will say in the next FOMC, when China will raise rates, what the forward PE
of the market is, and volumes of other data that investing professionals think is crucial to asset allocation. The truth is, any student of economic history knows that in aggregate people are horrible at forecasting the future of the economy. It has been shown by SocGen's Dylan Grice, Reinhart and Rogoff, and Nassim Taleb that asset price performance is highly nonlinear. There is a very simple reason for this: it is impossible to know the future! Even if you feel reasonably assured of the future, at least a range of possible outcomes, you will not realize a high return on your investment unless you pay a price for a security that ensures a high return. The price that ensures a rate of return whileminimizing downside risk is arrived at only through a bottom up analysis of a number of scenarios. The scenarios can be a number of company specific outcomes (i.e. will the company win a large new contract?) or macro outcomes (will oil be at $80 or $50?).
Purchasing a equity or debt security gives you legal claim on specific assets and cash flows associated with those assets. Although financial accounting is not perfect, audited financial statements and publically disclosed documentation give you
an assessment of asset value under a given set of assumptions. Historical financial statements also give you an idea of what cash flows the assets can generate under a variety of economic scenarios, if the asset base has not changed considerably. The problem is that consistent strong historical performance is easily recognized so the securities on such companies are often well picked over and fully valued on a risk reward basis.
It is critical that valuation is performed on an "a prioi" basis. Some of the best opportunities arise out of corporate events where 1) the asset base is completely different that prior reporting periods, and therefore has limited historical operating data (see my prior piece on Westaim's purchase of Jevco assets), or 2) claims on a companies assets have changed, either through recapitalization or emergence from bankruptcy (see Mega Brand bonds). There are a large number of other corporate actions that provide such opportunity, like spin outs, mergers, etc... Change is what creates opportunity, especially change that other investors feel is out of their expertise. Publically disclosed documents on corporate actions combined with good old fashioned scuttlebutt can give you an idea of what performance can be expected out of a new operating entity. This type of data is not uploaded into database that can be screened for valuation ratios or growth rates, so it is often not picked up by a large class of investors that use screens as a primary idea generation tool. Once the company releases several quarters of results the quants start to pick up on the story.
The best part of investing is that corporate actions don't necessarily have to be the focus of research or idea generation. Any time there is a structural reason for securities being bid up or sold off creates opportunity as well. Index rebalances, analyst initiations, financial duress of a large holder, or changes in foreign ownership laws are only a sample of events that change the dynamics of a market.
I suppose what I am really trying to say is that I usually have a blank look on my face when someone asks where the market is going. I have no idea. I also have no idea what the EPS of Wal Mart will be, or whether the PE multiple of Google will expand. I dont know the future, and I dont have to. As long as I can define the scope of my understanding about a specific situation and pay a price that warrants limited downside versus potential return, the rest will take care of itself.
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