Our investment approach is not complex. We look for stocks which can give a superior return when our premise is right but limited downside when it is not. We expect a portfolio of such stocks will deliver above average returns over time.
A key part of the investment process is to be able to buy the stock at a ‘good’ price. We set this price at about 40% below where we think a fair valuation for the stock should be. This 40% discount compensates us for the uncertainties of the future including adverse developments that may affect a company or an industry.
We are conservative in our valuations. Generally we prefer using a company’s book value as a starting point rather than earnings projections. The book value reflects the historical cost of the assets that a company owns, a value that does not change as quickly as earnings may.
Besides valuations, our process also steers us towards being contrarian. In a competitive marketplace, it is difficult to achieve superior returns if one follows the market.
Research in behavioural finance highlights the shortcomings of human psychology when it comes to financial markets. One key finding is that our minds are wired to look for patterns or trends, even when one does not exist. In financial markets, this leads to investors extrapolating what has happened in the past into the future. Investors tend to chase past performance. A rising stock will attract more buyers while a falling stock triggers even more selling. In the latter situation, stocks can get to a point where they become significantly undervalued. It is in this zone that we like to look for opportunities.
At this end of the market is where we find stocks that offer the discount that we seek. These stocks will tend to have prices at a 1 to 3 year low and sometimes even a 5 to 10 year low. Stocks that have done well and are popular are unlikely to offer the discount valuations.
Since the stocks we buy do not come with high expectations, they are also less vulnerable to bad news. Even if our premise for buying the stock takes longer to come around or is incorrect, these stocks are unlikely to incur significant permanent losses.
To further protect a stock’s downside risk, we focus on companies with stronger balance sheets and have a dividend policy. Excessive debt is usually the factor that bankrupt companies during crises. So we prefer companies with manageable debt levels (our rule of thumb for a sound credit standing is a $1 of debt for $2 of shareholders equity). We also favour companies that pay dividends. The dividends provide a source of income as we wait for the market to correct a stock’s undervaluation.