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A Framework for Practical Investing

November 22, 2013 | About:
Everyone has a different approach to investing, but I base my approach in being statistical and logical in nature. I will provide a macro view of how I approach it currently. Since my approach has changed dramatically from when I first started my investing journey six years back, there will be probably some slight changes to my approach 10/20 years down the road. But nevertheless this is a great start.

1) Read investing articles by great investors (try those with at least a CAGR of 15% return for at least 10 years) and underline important things. Once I finish reading, I will rate with a rank of 1 to 5 (e.g. 4/5 or 4.5/5) and file those with 5/5 right at the top. Somehow I notice that the articles written by deceased investing legends are the best. I have only one 5/5 ranking in my archive which is a 1976 interview with the father of Value Investing, Benjamin Graham. Most of those with 4.5/5 are by Joel Greenblatt.

2) Be patient. I can't stress it more than what the world's greatest investor Warren Buffett said about it being the most important characteristics of a great value investor. I do agree with him, and you do not need to have awesome knowledge or skills to do well. Once you have a decent amount of knowledge, being patient will be the greatest asset one could have.

3) Read lots of investing books. It is only recently that I started to underline the important parts and write the pages I underlined on the first page. For a start, you could go to the library and browse some books. Once you do that, go Amazon.com and read their reviews to own a copy. If you see more than 100 reviews and the average rating is at least 4.5/5, that should be probably be good enough, but be careful of dubious reviews skewing the rating. In fact on the hindsight, only one of my top five favorite books on investing has a rating of around 4/5 in Amazon.com. The rest are at least 4.5/5. My favorite book is still "One Up on Wall Street," despite it being among the first few investing books I read.

Lastly, I have found that the most effective way to learn investing is to find books with many case studies which is also the approach Harvard Business School uses to educate their students. It allows one to reverse engineer the mindset of some of the greatest investors and the rationale behind each individual stock they bought or sold.

4) Make an investment checklist and constantly update it. Even two years after creating my own checklist, I am still working on it, and I think it's going to be the foundation of any investing I do before I buy or sell a stock in future. Do include qualitative (competitive advantage/economic moat, possible questions to ask management, etc.) and quantitative factors (earning yields, ROC, NCAV, P/E ratios, etc.).

5) Classify your investments and investment styles so you will know the reasons why you buy and will sell in the future. For example, in the Singapore stock exchange: Hengxin Technologies belongs to the kind of deep value play of Walter Schloss and Benjamin Graham, and even the kind of stock Warren Buffett would probably own when he first started out. If you read "One Up on Wall Street" by Peter Lynch, Usana Health Sciences (USNA) is the kind of growth stock I think Lynch would like to own.

Then you may have those kind of large-cap stocks with a strong competitive advantage (free cash flow cow) like Coca-Cola (KO) that Warren Buffett started to own when Berkshire Hathaway (BRK.A)(BRK.B) morphed into a gigantic holdings company. But I prefer small and mid-cap stocks with a strong competitive advantage, and USNA fills those characteristics.

Or one could use the simple investing style that Ben Graham advocated before he passed away. It is to buy a large number of cheap stocks using a metric like low NCAV or price/tangible book, which is also quite close to Joel Greenlatt's approach of combining return on capital and earning yields. This approach requires a minimal amount of time as compared to other styles, since in-depth stock research is completely abandoned in favor of the "law of large numbers" working to your advantage. I have unquestionable confidence in using this approach in the U.S. stock market, but definitely not in China's stock due to the lax accounting standards and prevalence of accounting fraud.

The beauty of this is the simplicity of being logical and statistical in approach while achieving a great return at the same time!

Note: A non-technical way of defining the law of large numbers (as above) is, "Own a bunch of companies with Apple computer-like characteristics and even though you wouldn't know for sure which one will do well, you can be pretty sure that on average they will do quite well."

About the author:

Matthew Tan
Analyzing companies & investing are my intellectual passion. Hopefully, I would love to engage in it till a ripe old age like the centenarian value investor Irving Kahn. Particular investors/fund managers that I follow are Peter Lynch, Warren Buffett, Benjamin Graham, Walter Schloss, Joel Greenblatt, Michael Burry, Jamie Mai, David Einhorn, Seth Klarman, Li Lu, Charlie479, Mohnish Pabrai, David Tepper, Stanley Druckenmiller, & George Soros.

Visit Matthew Tan's Website


Rating: 3.8/5 (28 votes)

Comments

chentao1006
Chentao1006 premium member - 10 months ago
Good article!
matthewtan91
Matthewtan91 - 10 months ago
Currently, I have received 2 comments on Facebook so I thought I will post my reply here (& my blog) instead. First comment: great piece. perhaps you can do one to distinguish the aggressive vs defensive investor; focus on growth vs dividend stocks since not every investor's objectives would be aligned given they have different priorities depending on their stage of life. (Note: For some opinions, I am using the perspective from my country Singapore instead)

My reply: I will answer your qs from another point of view: Ceteris Paribus, I would prefer a US stock with no/low dividends over a high dividends stock since capital gains are not taxed for a Singaporean while US dividends is taxable (30% for me) but US citizens got both capital gains & dividend tax. Despite this, Warren Buffett really hates dividends. When he took a huge stake in Coca Cola in the 80's he used his voting power to make sure they do stock buyback instead of dividends since he is a long term investor, that really make sense in creating more value for its long-term shareholders. So both of us have an even much greater reason to buy low/no dividend stocks though its not practical (as we would then have to give up lots of great companies with high dividends) or unless we can own a huge stake to effect changes to the dividend policy or through shareholder activism etc.

Or imagine a US corporation that pays $100 million in dividends to its shareholders and the average dividend tax for for all shareholders is around 30% or $30 million. Wouldn't it be better if the company management decides to use the $100 million to do a share buyback which is not taxable instead of handing over the $30 million to Uncle Sam to fund more wars. Besides that, even if you are a US citizen facing a capital gains tax, won't the $30 million in potential dividend tax saved be put into good use by compounding it first (by share buyback or/and expanding the company) and face a one off capital gains tax in the future with regards to the long term investor. But of course the company stock price must be undervalued in the first place for the share buyback to make sense. And Warren Buffett is still holding on to the Coca Cola stocks that he had purchased in the 1980's in which he use the billions of dollars of potential capital gains tax owe to the government (in other words if he sold his entire stake) to work for him through the magic of compounding.

In my opinion I think one should not try to the follow the conventional finance textbook too much. Just my 2 cents view. I used to think that I could find all the answers to the real world in a conventional finance TB till I was prove wrong by reading about many great investors I come across and most importantly a book called: More Money Than God. Don't let the distasteful title fool you. It is the most interesting finance book I have ever read and probably the only book that convinces me to think in an independent and unconventional manner. Sometimes its really alright to disagree with even with the greatest financial mind especially if a situation requires a sightly modify version of the prevailing financial paradigm.

The book basically talks about the history of hedge funds and you will understand that during their time, most great investors throw conventional financial wisdom out of the window in favour of more practical and logical solutions through independent and unconventional thinking which is quite radical to most even till this day. Not many people really listen to Grahamian wisdom when he was still alive due to its unconventional thought till his most famous and successful student Buffett change that. And even till today, Buffett deviate quite a lot from what his mentor taught him initially through applying the unconventional/unique thinking process. Even arguably the most famous scientist in the 20th century, Albert Einstein thought in a very unconventional manner which was quite radical for his day and no one really listen to him when he was a still a patent clerk in Switzerland till the 1905 publishing of the Special Theory of Relativity change all that. The interesting thing is there are quite a number of famous scientist that rejected his work before 1905 just because they concluded that it is too radical and unconventional for their time. This could potentially bury one of the most important works in mankind history if not for an eminent physicist to chance upon his work and accepted its unconventional thought. To conclude, I think there is some truth in the adage: To succeed spectacularly one must think unconventionally. Hope that helps!

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Second comment: i think using the ncav 65% rule is great but is very limited in terms of portfolio diversification as many industries/stocks have negative ncav.

My reply: You could always diversify with growth, deep value, special situations stocks and you could always tweak with the NCAV formula to fit your needs. A few of china stocks in SGX qualifies but you would need someone with a strong forensics accounting to sniff out the good from the bad deals. What I meant by tweaking of formula is some of the companies, you will just need to use the cash less all liabilities and account for stock dilution to see value and you wouldnt mind to buyout the whole company at prices at even 2x of market quotation because basically you are getting the rest of the assets for "free". This comes to the question of the "realization of value" problem in a NCAV kind of company since it may take a long time to realize value, and I think 2 possible solutions is to acquire a huge stake in the company and get onto the board of directors and effect changes to realize value for all the shareholders or offer a buyout to all shareholders at an attractive price to them so even if the deal fall aparts, the market will more likely reflect the correct price and you could then proceed to sell your stake. The catalyst of those 2 solutions will make the realization of value much quicker and thus improving the compounded per annum returns of the investor so he/she could redeploy the capital efficiently at a higher turnover.

And conversely one of the risk of the NCAV type of company (provided if the company doesn't make a loss in earnings) is when the price collapse (as compare to the price one paid, for example intrinsic value vs market price widen) maybe due to a recession and an acquirer (usually a management buyout) steps in to acquire the whole company at the expense of the rest of the shareholders. You could then potentially make a loss there. Some of the deep value/NCAV stocks Buffett bought in the 1960's face this problem by an acquirer not paying adequately to the rest of the shareholders. But I do agree that NCAV is very rare in the US stock market currently but maybe in the OTC market there is some deals. But if currency risk is not an issue or with good international diversification, there is always the emerging/overseas market. A great example I think is Samsung electronics (fuel by its smartphone/smart tv) is a great growth stock at deep value kind of quotations.

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