Sticking to the basics

For the last 5 months, markets have been nuts. The price swings have been awful and painful to watch.

During times like this, it’s hard to focus on the fundamentals because watching your portfolio get diced every day is very distracting.

But, getting distracted, especially when great value are to be had, will lead you to poor returns over time.

How am I avoiding distraction? I’m sticking to the basics: looking at businesses I understand, evaluating underlying business economics, evaluating management, and examining valuation versus price.

First off, I can’t get good returns by looking at businesses I really can’t understand. No amount of research will allow me to understand a biotech firm, so I don’t try to. Sometimes, I can educate myself enough to understand a firm, but it doesn’t make sense to. Why figure out how to pick ripe fruit high on a tree when the same fruit can be picked off the low-hanging branches? If I can understand the firm without having to learn particle physics, I have a good candidate for further evaluation.

Second, I evaluate a business’s underlying economics. What kind of returns will it generate over time? What competitive advantages does it have? Are those advantages stable, or does technological innovation and industry shifts make predicting the future almost impossible. Businesses with good economics are great candidates for potential investment.

Third, I evaluate management. Are they honest? Do they speak plainly and describe their business and its dynamics well? Are they compensated rationally? Do they own a chunk of the business themselves with shares purchased on their own (not options or restricted stock grants)? Do they do what they say over the years? Do they measure the business’s performance rationally? A business I understand with good economics and management is an excellent candidate for potential investment.

Last, I examine price versus value. What is the company worth to a rational, long-term investor? What are the discretionary cash flows relative to the price of the business? What kind of growth rate and return on equity can be generated in a normal environment? Does the business carry too much debt making it susceptible to insolvency during difficult times (boy is this important)? If value is significantly above price, then the business is a very good candidate for purchase.

When the economy is in the tank and stock market prices are gyrating wildly, it’s best to focus on the fundamentals. Right now, I’m focusing on businesses I understand with good economics and good management selling at cheap prices. There are a lot out there right now, so I have a lot of work to do. And, that’s a nice “problem” to have.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.