A problem with investing truisms
“It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. We’ve all come across this quote by Warren Buffett about stock selection. This was part of his letter to shareholders in 1989, and like so many of his statements, is a part of investing lore, simple yet incisive. It’s no surprise that Buffetisms and Mungerisms get referenced on so many financial sites, including this one.
Except, as much as the above and other such truisms resonated with me, I used to struggle to actually apply them in the real world. Here’s why:
Once a company is anointed as “wonderful”, it’s easy to see why in it’s financial statements. From strong and consistent growth to operating cashflows to low debt, wonderful companies invariably check off most if not all the boxes on the investing checklist. Identifying a company as potentially wonderful given no prior knowledge, is the challenge
As the great investors have said, returns are made when you can identify companies that are on the path to becoming wonderful (or are already wonderful, except they’re too small for many to notice). But finding those wonderful companies remains a challenge for the average investor.
The bias of sunk time-cost
A large body of research suggests that passive indexing works better as a strategy than most stock-picking, it follows that an investor looking to build her own portfolio, will need to do a fair bit of spadework to find her winners. At last count there are over 1,300 companies listed on NSE and over 5,000 on the less picky BSE. Even with the generous assumption that one potentially wonderful company exists for every nine ordinary ones, and that a reasonably diversified portfolio only needs to find 10-15 of those, this implies looking through 100 to 150 companies at enough depth to pick your portfolio constituents.
Those who don’t have the time or inclination can of course invest in mutual funds, the easiest way for common retail investors to get access to professional money managers. But they have some pitfalls of their own. So we come back to being willing to put in the effort to read through annual reports spanning several years, looking for industry trends and outlooks to arrive at potentially strong companies to invest in. Fair enough. But here I noticed a problem.
The longer I spent looking through a company, the less willing I would be to discard it as an unsuitable investment
When you start with going through a company, you take in the information piece-meal. Starting with eyeballing the Income statement to see a consistent revenue growth trend, the profitability, then move to the Balance Sheet to see the kind of liabilities, long term debt etc. Sometimes, something obvious jumps out as you like a ridiculously high Debt Ratio that causes you to toss the company aside and move on to the next one. But often, things aren’t as clear cut and you keep looking, going deeper.
Call it an interesting manifestation of the endowment effect. Maybe the sunk investment in time and effort into analyzing the company makes it harder to objectively discard it as a prospective investment. Just like finding a reasonably priced used car with good mileage and an engine in good shape makes us want to overlook the iffy suspension, it’s possible to justify a company you’ve spent a few hours researching as a “decent” if not a “wonderful” investment.
The Calm Investor method to overcome sunk time-cost
It’s all very well to know the fundamental principles to identify good companies and to differentiate them from the mediocre and the plain bad, but I’ve found it a challenge to ignore the sunk cost of time spent in analyzing what turns out to be a mediocre investment.
The investing checklist is meant to help with just that. But I’ve found myself making excuses for companies that don’t check all boxes by rationalizing that declining interest rates will improve profitability by reducing interest costs or that growth rates are likely to be sustained to justify the price appreciation of 150% in 12 months.
So, I introduced a step in the process that precedes getting deep into the annual reports and the financial statements of a company. I like to call it the TCI Rapid X-Ray which gives me, with little incremental effort an overall objective score of the strength of the company’s financial performance over the last five years.
- This is nothing but a quick copy paste of financial statements for the last five years into a spreadsheet, from a standardized source like moneycontrol.com
- A few formulae that read from the financial statements help determine growth rates, cashflows, consistency, interest payments all of which helps score the company on the quantitative aspects defined on the investing checklist; Earnings quality, Leverage (amount of debt), Growth, Consistency and Yield
- The total score then serves as a filter to determine whether it makes sense to open up the financial statements and go deeper into analyzing the company
Note that the intent of the ‘Rapid X-Ray’ is not an overly scientific assessment of the company but a quick look at obvious strengths or weaknesses in the company’s financial performance that suggest further understanding or outright rejection.
In the above illustrative screenshot, doing this for a few companies across industries helps me quickly reject Tata Motors and Exide and helps shortlist Hero Motors, Motherson Sumi and Bajaj Auto for closer analysis. Note though that the scoring mechanism is used as an elimination tool i.e. a company that scores poorly is probably not a good investment, but the reverse isn’t automatically true and a high-scoring company is only a starting point for further investigation.
It can be made more complex and sophisticated by those who’re keen and able, but developing even a standardized scoring tool can serve a basic yet important purpose of cutting down on the effort required to research companies.
How do you deal with this problem of plenty and finding your proverbial needles in the haystack of public companies?
Disclosure: I don’t hold any of the stocks in the above example