I was lucky enough to see Howard Schilit, the author of “Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports,” present a few months back at a financial event. After listening to
Schilit speak and reading his book, something became quite clear to me – while it would be far from easy, anybody with a solid understanding of the language of accounting (particularly what is being said by and in financial statements) and willing to put in the hours to carefully read SEC filings is capable of detecting the shenanigans he has highlighted; of the two, I think with near certainty that the second part of the equation is what holds most experienced investors back.
I thought of this when I watched Warren Buffett and Carol Loomis during a recent sit down with Charlie Rose; during the interview, Rose asked why Buffett has the astounding record that he’s accumulated over the past few decades, and noted that Carol had previously told him the following:
“He understands how to look at accounting statements and find the telling point, maybe a footnote, so that he’ll see opportunity and see the future.”
In response (after agreeing with Rose), Loomis said the following:
“He has an ability to do that that is matched by very few other investors."
Now, if I said something like that, you would (and should) take it with a grain of salt – I only know about so many great investors, and have personally met exactly zero of them. Mrs. Loomis, on the other hand, likely has a rolodex that makes this statement noteworthy (she is the editor-at-large for Fortune magazine, where she has been an employee since 1954). Warren’s ability to derive meaning from financial statements is without question directly related to his intellect, as well as decades of business experience. However, I think it’s critical to understand that this expertise was built up over time, and was solidified by a combination of time and hard work (a formula that can be copied); while far from easy, investing is not rocket science – in Warren’s own words, “Investing is not a game where the 160 IQ guy beats the guy with the 130 IQ … Rationality is essential when others are making decisions based on short-term greed or fear.”
This likely isn’t shocking to value investors – thorough analysis will result in more informed decision making, and likely, as a corollary, better long term results; it’s an easy way to avoid mistakes that are likely overlooked by most investors (myself included) due to the time it takes, particularly when considering that you must do it for every company that you follow; without question, this can quickly become a full time job – a problem if you already have another one that you’re expected to be at 40 hours a week.
I don’t think this is the worst problem to have; to be thorough in your analysis, this essentially forces a mixture of patience and selectivity: Despite what the nice folks at CNBC believe, you don’t need to have an opinion on or follow every company in the world.
My solution, which is still a work in progress, is to narrow my focus considerably; I’ve become increasingly fixated on the sustainability of a company’s competitive position, and have started to immediately ditch companies that fail to CLEARLY exceed this high water mark. I’ve learned I’m too uncomfortable with holdings where I’m not happy to see a declining stock price; as such, I need to avoid these companies, which should significantly contract my field of vision over time (a much needed change - I can only follow 10 to 20 companies on a full-time basis as it is).
Without a doubt, this will quickly eliminate the majority of companies that have piqued my interest in the past; so be it. Time and money are both precious, and building up a stockpile of cash while waiting for great businesses to sell at attractive valuations isn’t the worst thing in the world; most importantly, this dedication to a handful of truly extraordinary companies will allow me to develop a level of knowledge about the business generally unmatched by other market participants, and set me up to move in a big way if the stock ever hits my buy target.
Although hardly a secret, there are gold nuggets and red flags alike buried in SEC filings and financial statements. Most investors have taken the default position that thorough analysis is of limited usefulness, and that a P/E ratio plus a few catalysts are all that’s needed to justify an investment. Many good investors fail to keep climbing higher due to complacency, and seriously stunt their long term performance; if you’re like me and have let laziness hold you back from sound equity research in the past, this is a call to tighten your bootstraps and get to work.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.