What really matters in investing? Regular visitors to The Value Perspective will be unsurprised by our first-choice answer – a company’s valuation. After all, as we argued in All in the price and Lost and pounds, the price you pay for an investment is the biggest driver of future returns. Valuation, however, is not our only consideration – so what else matters to us when we are analysing a business?
With such an exercise, there are many factors an investor could think about. While valuation will dominate in the long run, over the shorter term other important considerations would include, for example, the macroeconomic outlook, the outlook for inflation, the outlook for commodities, the outlook for foreign exchange, the outlook for a business’s competitors, the outlook for …
Are you spotting a pattern here? What all these factors have in common is you need to forecast them and, as we have said before, ‘forecast’ is just a City word for ‘guess’. If investors want to get involved with macroeconomics, inflation and all those other outlooks, then they need to guess and they need to guess right – and that is incredibly tricky to do with any sort of consistency.
At the other end of the spectrum, there are the things where you do not need to make guesses, which might be summed up as ‘every single detail about a company’. The problem here, however, is that the amount of work you can put into analysing every last detail of a business – should you so wish – is almost infinite. Here on The Value Perspective we do not so wish.
You will not hear this from most professional investors but, to our way of thinking, spending hours and hours poring over every single detail about a company is a waste of time. There are a couple of reasons why we believe this – the first of which is that, just because you have done masses of work analysing a business, it is not necessarily going to help you make a better judgement on whether or not to invest.
In fact, as we argued in Prediction addiction, there is a serious risk that you will actually make a worse judgement. The more you know about a business and the more time you spend with its management team, the harder it becomes to be unemotional about it. You become compromised psychologically, with the business becoming closer to ‘friend’ than ‘investment’.
Yes, that is only human nature but it is unhelpful to investing – as is the fact that, as humans, we do not like to do lots of work and then see it go to waste by deciding a business is a bad investment. The more work you do, the more likely you are to conclude an investment is a good idea. Again, it is just human nature not to want to rip everything up and start again – but it can make for poor investment decisions.
Here on The Value Perspective, we choose to focus on a very limited number of factors – but factors we believe to be incredibly important. The first, as we never tire of repeating, is a business’s valuation. Then there is the business’s balance sheet, from which we can gauge the associated risk – the chance that, as investors, we could permanently lose money.
We also look at historical margins. Is history a guide to the future? Probably not in the case of, say, newspaper companies but there is a good chance it will be with most businesses. People keep worrying companies are facing structural challenges in almost every sector but the reality is that mean reversion is the most powerful force in investment. Far more often than not, what goes around, comes around.
Finally, there is company management. We do not spend huge amounts of time with them – as we suggested earlier, we are more interested in making investments than friends. But, then again, we do like to make sure the people running the companies we own are not complete cowboys. As ever, there is a balance to be struck but we aim to do what we perceive to be just enough work.