"The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in that market... I have seen no trend toward value investing in the (65) years I've practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing over the last 60 years. It's likely to stay that way. Ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper."

Warren Buffett

I make no claim to be as knowledgeable as Warren Buffett, however, that doesn't mean I don't try to use his advice the best I can. 

For me, investing is primarily about risk management - as Buffett repeatedly comes back to - and secondarily, about trying to find asymmetric upside on enough of my investments that the risk I do take is worth it. 

I have found that the best way to manage risk is to stick to investing in good to great companies. I know this might jump out at you as common sense, but it is amazing to me that clearly more than three-quarters of investors do not really even try to only invest in good to great companies. 

Most investors try to invest in one of two ways.

The first way most folks invest is that they index. They might not know that they index, but that is what the vast majority of mutual fund investors are doing. Indexing of course is the surest way to take 100% of the risk in a market. Why is that? Simple, you own an entire market. By definition, that is 100% of the risk. I don't like taking 100% of the risk of a market, so I don't do this. 

In addition to taking 100% of the risk of the markets they are in, most mutual fund investors don't come close to getting 100% of the gains, due to expenses. Only a few actual index fund companies can come close to about 99% of the gains due to lower management fees and fewer trading costs. Most mutual fund investors are using much higher expense managed funds that aren't actually index funds. But by owning six or seven managed funds, those investors are essentially indexing without even knowing it, just at more expense.

The second way that some people invest is to trade. The vast majority of traders are under-trained, under-experienced and over-emotional. They generally rely on some sort of system they don't quite understand and are reduced to gambling. What we know about most gamblers is that ultimately they lose. 

While I know some day traders (their trades last days) and a handful of swing traders (their trades last weeks or months) beat the markets, IRS statistics tell us that about 80% of traders do not beat the markets. Those who do beat the markets, are either savants, lucky for awhile or better professionals. If you aren't in one of those groups, you probably shouldn't trade much.

Here at Fundamental Trends, the first step to investing is to find the good to great companies. Only about 5% of the stocks on the U.S. markets make my cut. That's not a big percentage, but it is still 200-300 companies at any given time.

I use a five step process for finding companies for my universe of companies to possibly invest in: 

  1. I use several screens to find companies with attractive growth metrics, strong financials, undervalued assets, improving free cash flow and a strong return on equity. These are companies that might make the Fundamental Leaders list. This is a lower risk list from a corporate perspective, but often the stocks are not priced at a value price and can't be invested in.
  2. I search for companies that have a higher than normal probability of achieving the above characteristics in the near future if they are not there yet. These are companies that might make the Emerging Leaders list. This is a higher risk list from a corporate perspective, but if we can find the companies that will execute, then we can make outsize gains.
  3. Study the management. If the management isn't good and honest, there is no sense in moving onto number 4.
  4. Study the long-term outlook for the business. I try to specifically find companies with some monopoly pricing pressure and barriers to entry for competitors (durable competitive advantage - yeah, more Buffett). 
  5. Decide if the company can be added to one of the lists. The inclination of folks is to include most companies they study to their list. For me, I make sure I only include half or less of the companies I study. Why? Because I have found that there is a bias that develops when you study companies. You want to include them because you put the work in. For that reason, there is always at least one that doesn't make my lists for every one that does.

Once I have culled my universe, I develop a range of value for the company. From time to time, I can buy a stock right away. My simple criteria is this. I have to believe I will double my money in under five years with a chance to triple my money. That yields an expected rate of return of 15% to 24%. In general, I've been able to average that much in rolling 5 year periods (the exception being 2007-2011 which was single digit return period).

Over time, you can imagine it is hard to keep up with 200-300 companies. If it weren't for computers, I'd be able to keep up with about one-tenth that many. What I try to do is maintain enough background knowledge on each company, to be able to bring myself up to date if there is some pricing action that might allow me to invest. Our quantitative analysis comes into play for finding entries and exits. 

So, that's a the short of it. If you are a subscriber, you are finding more and more in the Forum and in the Research section. Regardless, the rules I have laid out above are a good set of premises to start with for any investor. 

Kirk