personal investment blog

Do the work

Rule 3: Do the work

This is perhaps the most difficult investment rule, especially for people who believe that they suffer from some kind of number blindness. I saw some young people from the US interviewed about their credit card debts. They were asked how long they thought it would take to pay off their credit cards if they never used them again but serviced the minimum monthly payment. Their answers averaged around 18 months. The correct answer was 28 years. Suddenly, their ability to understand numbers improved.

The last rule was about never investing in something that you don’t understand. Many people might look at a company whose shares they are thinking of buying and take comfort from the fact that, for example, they frequently go to Tesco or make calls on the Vodafone network. “Those companies aren’t going away” they say to themselves. I do not dismiss the idea that casual observation can be helpful. If a retailer seems very busy or a product very fashionable you might be on to something. And the risks and rewards in the case of small companies are much greater.

Unfortunately, 95% of the work will involve looking at the numbers. In the introduction to the last edition of “The Intelligent Investor” (regarded by Warren Buffett as the ultimate investment manual), Benjamin Graham wrote……

The defensive investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average.

Sadly, my update on this is that the option of being a defensive investor, free from effort and annoyance, has been mostly taken from us by the greed and stupidity of the financial services industry. If you were to go today to a professional financial advisor and tell him that you are a defensive investor who prioritises safety he is likely to direct you to highly credit-rated government bonds, such as those of the US, Germany and the UK (gilts). The problem with this advice is that it is insane. Gilts are more expensive than they have ever been and “ever” in this case means going back hundreds of years when international trade used ships with sails. The popularity of safety has driven prices up (and yields down) to the point at which they can reasonably be said to resemble a bubble, just like technology shares in 2000. I know this because I can see the numbers. If you would like to lend money to the UK government for 8 years because you have a really good feeling about the deficit in 2020, it will pay you 1.25% per annum. That’s not inflation adjusted. In fact, because of the way that gilts work, you will get a higher interest payment but your principal (original investment) will be much reduced. Overall, it will work out at 1.25% per annum.

Given that this is insane, you might ask why anyone buys this stuff. There is no single answer but some of it is speculative (if that 1.25% falls to 1.00% the value of the gilt will rise and they are easily tradable) and some is based on the fact that gilts have been declared to be sound investments for banks and pension funds, regardless of how expensive they are.

With professionals behaving like this, we all need to be “enterprising investors” as defined by Benjamin Graham.

My simple advice is to follow the money, not the people. The money is the cash that a business or any other investment generates. Companies with shareholders should generate cash flow. Some of this they will invest in capital expenditure, some they will hoard against future acquisitions and some they will or should pay out in dividends. These numbers are always available in the reported earnings. Also in the reported earnings are numbers that can and will be manipulated by accounting choices – adjusted operating profit, net profit and earnings per share are best ignored, in my view, though they are the numbers that will make it into the press releases and the newspaper reports.

Accounting choices are made by people. They will often (quite legally if not ethically) be influenced by the desire to promote accounting measures that enhance targets that have been agreed as part of executive incentive schemes. An obvious example is growth in earnings per share. This can be manipulated by reducing the number of shares in issue by buying them back with the company’s (i.e. shareholders’) cash with the result that managers are paid more (of the shareholders’ remaining cash).

CEOs are also, by and large, people. There appears to be a widespread belief that a CEO can make or break a business. There are rare cases where this may be slightly true. Steve Jobs at Apple and Fred Goodwin at RBS spring to mind. But, really, the idea that the fate of Microsoft or Tesco or IBM or BP lies with the choice of CEO is absurd. A good business is a good business and a bad business will not be transformed by the appointment of anyone.

Back to Buffet: “You should invest in a business that even a fool can run, because someday a fool will”.

Rule 4: Probability