Investment Diary #20: Four Basic Principles of Security Selection
What is the basis when you securities selection? Why did you buy this company’s stock?
According to the book Extraordinary Success, investment returns come from: asset allocation, security selection, and timing trades. Today I want to share the basis for making security selection. We know one of the ways (and the main way) that Warren Buffett has made huge gains: concentrated investments. This includes the investment methods of Chinese domestic financial vloggers such as Lao Tang.
Concentrated investment is difficult. According to the book “Buffett valuation logic” mentioned, Buffett once also made mistakes in some areas, such as the textile industry, etc., the first premise of concentrated investment is: this business in your circle of competence. The so-called circle of competence, that is, you can see why this company can continue to create intrinsic value. Why do you need to understand this company? Duan Yongping once said: a company’s business can be explained in a sentence, said not to understand the general is not a good business, that is, the reason to make money should be obvious. Why is this important?
Here first talk about intrinsic value. On the intrinsic value of the old Tang once said:
Don’t look at a fool, look at the ground.
The ground here is intrinsic value. Warren Buffett also said in his “Warren Buffett’s Letter to Shareholders” that a bird in the hand is worth two in the bush. There is an Aesop’s fable told here about a nightingale that was caught by an eagle. Seeing that his life was about to be in danger, the nightingale tried to persuade the eagle to tell him that he was too small to feed the eagle, and suggested that the eagle should go and catch a bigger bird. But the eagle replies that he would be foolish to let the nightingale go in anticipation of catching a bigger bird.
The investment principle Buffett is trying to tell us here is that we must know definitively that the business has large intrinsic value (i.e., that there are bigger birds in the woods as well as how many there will be and when they will appear?) .
When we assess the forest has a bigger bird, Buffett mentioned “perspective surplus”, a business continues to create profits during the life of the company, a simple understanding of the financial statements indicators net profit is a company produced birds (here there are financial traps, involving a premise: the net profit must be real money, not the kind of only increased profits but no cash), here you can see the “Playing with Finance”, here you can see the “Playing with Finance”. (Here you can see “play around with financial reports”, “hand to teach you to read financial reports” and other books). Warren Buffett mentioned that $1 can generate $2 or more in profit, is the value of a business, or free cash flow.
Once we’ve determined that there must be birds in the woods, how do we determine when to show up? That is, how does intrinsic value manifest itself here? In what way does it reveal itself? Here is the problem with concentrated investing, you don’t know when the share price finally reflects the intrinsic value, although capital is profit-seeking but this time is uncertain. That’s why it’s important to understand the business of this company. If the company’s ability to create intrinsic value is getting weaker over time (less and less intrinsic value is being created), it is questionable whether the birds of the forest will still be able to cash in (even companies may need to keep investing retained funds to maintain a competitive advantage, while less and less intrinsic value is being created, and financial metrics characterise the diminishing return on the tangible capital employed). This is why, when investing, we must use a portion of the family funds and not the funds necessary for life, because of the time factor + the uncertainty of the offer of Mr Market.
With intrinsic value, but if the management of the company does not act, or even dilutes the intrinsic value by issuing new shares or even acquisitions, can you get the “bird of the forest”? This is what Warren Buffett referred to: the importance of honest management is a prerequisite for success, and it’s better to have more people on our side, i.e. aligned interests.
Another issue to consider is the risk-free rate, we know that money has a time value, a dollar this year is not worth the same as a dollar in the future. When we calculate the intrinsic value (the bird of the future), we need to discount the money that the business can make in the future to the present by means of the risk-free rate.
If the risk free rate is high enough or Mr Market quotes me a price I can’t refuse, for example, the risk free rate is still 3 points, but Mr Market quotes me $2 million, I have a total investment of $1 million, I can get $1 million by selling immediately, and $1 million * 3 points interest rate, $30,000 income per year (note that it’s the risk free rate here). And if the intrinsic value that this business creates for me is 25k (including perspective surplus and dividends). What I should do is obvious (sell the stock). So when you go deeper to understand something, you naturally know how you should act next.
Old Don mentioned All Cash Is Equal, that’s the idea, always compare the investment opportunities you have at hand and pick whichever one creates more intrinsic value.
When we invest in a good business, dividends are our cash flow and perspective surplus is our profit. Concentrated investment can bring a very high rate of return, calculated by compounding the 72 formula, for example, an annualised return of 20% can be doubled in 3.6 years, which is a huge compounding effect (of course, if inflation in a country is huge and the CPI continues to rise, the amount of loss is calculated using the compounding formula the loss is also huge)
Should we be concerned about stock price fluctuations? When you know for sure the intrinsic value, and if it will definitely be delivered in the future, the volatility of the stock is what Mr. Market quotes you on a daily basis. This is the only good thing about the market, in fact you should value a listed company as if it were unlisted. You can buy something above intrinsic value at a low price. Of course it could be the other way round. Because there is an important variable of time (uncertainty) in the realisation of intrinsic value, plus the possibility that you may have made an error in intrinsic value judgement, a reasonable price is one of the important margins of safety to ensure that you don’t lose your capital and make a profit.
Which is riskier, concentrated investment or diversification? What is the relationship between risk and uncertainty? Risk is calculable probability, while uncertainty is not. In the case of concentrated investments, you can buy at a reasonable price and then calculate important financial indicators, including the return on tangible capital employed (an important prerequisite for determining the growth of the intrinsic value: whether maintaining the growth will require a large capital investment) ROTCE (net profit/total capital employed or marginal capital employed, total capital employed: Fixed Assets + Intangible Assets before Goodwill + Inventories + Accounts Receivable - Accounts Payable). Accounts Payable). This is an important indicator of a company’s ability to demonstrate the quality of its business and whether it is a “compound growth machine”.
Diversification is a “free lunch”, and a well-structured portfolio (with enough types of asset allocation) will yield a high rate of return. So which of these two approaches has a higher probability of winning is impossible to determine, it depends on your understanding of concentrated investing, i.e. the risks of the two are not comparable. Theoretically, if the probability of winning is high for concentrated investments (higher safety ratio), the risk is rather lower than diversification.
Financial and accounting metrics, including a company’s annual report, high-quality information is used to help you judge intrinsic value, business models, and management, among other important bases for decision-making.
To summarise:
- The intrinsic value created is true
- Maintaining the current intrinsic value creation does not require significant ongoing capital investment (or has a marginal effect).
- the creation of intrinsic value is more attractive than other current opportunities
- whether the management is sufficiently honest
are the four basic principles of my security selection.
I hope this sharing is helpful to you.