Some investors may seek to use complex formulas and complicated financial models to determine how to apportion capital at the present time. For example, they may use forecasts for inflation and interest rate changes to value stocks and determine whether they offer a good opportunity. They may also aim to judge opportune entry points for certain stocks based on models that factor in changing investor sentiment over a short time period.
In my opinion, such formulas and models are likely to be severely limited in their effectiveness. Ultimately, they are likely to rely on a prediction of how future events will evolve. As recent months have shown, the situation involving the economy and geopolitical outlook is highly fluid and very unpredictable. Therefore, it may be more prudent to use a simple approach to investing instead of trying to utilize complex methods that ultimately do not improve capital allocation.
Indeed, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Vice-Chairman Charlie Munger (Trades, Portfolio) has previously shared his preference for a simple investment strategy when he said, “We have a passion for keeping things simple.”
A rules-based approach
A simple approach to investing could mean buying companies with solid balance sheets and wide economic moats when they trade on relatively low valuations. In my view, this could stack the investment odds significantly in an investor’s favor because it would help them avoid low-quality businesses that are less likely to survive an uncertain economic period. It may also mean their holdings are well-placed to capitalize on a long-term economic recovery – especially since they are purchased at low prices that offer significant scope for capital gains.
In addition, it is possible to use simple metrics to judge a company’s investment potential. For example, balance sheet strength can be calculated by assessing a company’s debt-to-equity and interest coverage ratios compared to its peers. Similarly, the size of a company’s economic moat can be determined by focusing on its return on equity compared to peers, as well as its long-term track record of profitability and market share changes.
Meanwhile, ratios such as price-earnings and even dividend yields can provide a good guide to whether a stock offers good value for money – particularly on a relative basis.
An efficient approach
As well as being simple, an approach that requires companies to "pass" various rules such as those described above is likely to represent an efficient use of time. Indeed, it does not take a large amount of effort to check the aforementioned ratios to judge whether a stock offers an appealing risk-reward opportunity. As a result, investors who use a simple approach may be able to scour a wider range of industries for attractive buying opportunities.
Clearly, a simple approach will not be 100% effective. But as Munger’s past returns as part of Berkshire Hathaway show, a simple strategy can produce exceptional returns when followed precisely and with discipline over the long run.
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