Newsletter 52 – The plan for 2015

​So far I have concentrated on net current asset value investing. This is one of the investment approaches I judged valuable after years spent as a professor of investing examining many alternatives.
 
Ben Graham’s performance record and his compelling logic combined with more recent academic proof confirms the superiority of this approach over many others.
 
Regular readers of my newsletters should by now have a grasp of the process used to identify NCAV shares with potential to rise significantly.
 
While I’ll continue trying to find shares this way in 2015, I feel it is time to move on to other investment approaches.
 
The overall portfolio will benefit from using a variety of routes to find bargains. Technique-diversification can be as useful to the structuring of a portfolio as individual share diversification.
 
Broadening our thinking in this way will reinforce knowledge about key principles of investing (as opposed to speculation).
 
Maintaining friendships with the eminent dead
 
Speaking of reinforcing knowledge: I also intend to introduce a new type of post soon.
 
For my own benefit I need to keep reading the investment classics to light-up in my mind the true narrow investment path. I hope this will be useful for you too.
 
Just as moral compass resetting is necessary for even the most knowledgeable and committed person of faith, through regular exposure to good guidance, so it is with investment (except that our motives are more pecuniary than moral, although I hope we can achieve both).
 
We too need constant reminders of what we should be thinking about, just how narrow the path is, and how to stop us straying off it into speculation (or sin).
 
With this in mind I’ll write short summaries of key points from the great books, many of which are old – it is always a good idea for investors to make friends with the eminent dead.
 
It is remarkable how similar the past is to the present when it comes to investor obstacles and opportunities; and to the speculator's psychological response to pressure.
 
Cognitive limitations, emotional interference and memory failure are always with us, it seems. The same mistakes are made time and again.
 
Thus we can learn a great deal by focusing on the good ideas developed in the past.
 
I’ll start by bring out the timeless principles espoused by father of value investing, Ben Graham using excerpts from the second edition of the Security Analysis published in 1940.  I read it a couple of weeks ago and was amazed at how relevant it still is.
 
The other investment approaches I’ll use in 2015
 
Strong economic franchise investing.
 
This is an approach most skilfully used by Warren Buffett and Charlie Munger as they allocate capital for Berkshire Hathaway (a company with a MCap of under $20m in 1965 now worth $373,000m).
 
This approach puts much less emphasis on the quantitative elements of Graham’s proven ‘facts’ displayed in the balance sheet and in the profit history, and much greater emphasis on the more fuzzy, but crucially important, qualitative factors, which are frequently future-focused.
 
These include the strategic strength of the business.  Does it operate in a business area with sustainably high rates of return on capital employed? What factors create that industry strength? Does the company possesses an extraordinary resource to allow superior ROCE within its industry?
 
It also includes a consideration of the competence and integrity of the managers.
 
Also the financials need to be sound.
 
The price has to be right, leaving a margin of safety by being significantly below the estimated intrinsic value.
 
The share is part of a low diversification portfolio – because such beauties do not come along regularly, and you do not want to move too far down the diminishing marginal attractiveness curve.
 
And, you’ll want to hold a share with such sustainable characteristics for a long time as you follow the story of its dominant place in its industry, with high returns year after year.
 
Low price-earnings ratio (cyclically-adjusted)
 
These shares are priced on a low relative to the earnings per share taken as current share price divided by the average eps for the past seven years.
 
But we do not stop there.  The other hurdles are:
 

• That the company scores highly on the Piotroski tests. These act as indicators of recent improvement in the firm’s operating performance. I’ll explain them as we go along.
• That it has satisfactory qualitative characteristics.  These are not as rigorous as those for the strong economic franchise approach, merely the same as those used in NCAV investing.

 
Return reversal
 
First, take all those shares that have lost over 80% of market value over the past 5 years (an academic paper I wrote with Professor Rose Baker showed these shares, on average, go on to outperform the market in the following 5 years – measured over decades of such investing in UK shares).
 
Second, apply Piotroski factors to filter out those less likely to recover (based on another academic paper).
 
Third, select only those with a net tangible asset value greater than current market capitalisation to build in a safety net of tangible assets.
 
Finally, examine for qualitative characteristics to the same level of rigour as NCAV investing.
 
High growth companies at good prices
 
Philip Fisher developed a very intense investment process that required a detailed knowledge of the firms in an industry. He selected only those with an extraordinary potential for earnings growth.
 
This growth relies on there being an extraordinary team of dedicated individuals both running the company and inspiring innovation, often at the forefront of science.
 
These are the world-beaters of tomorrow and are very difficult to identify.
 
What is more, even if you can identify them, you can only buy if the share price gives good value.  I don’t know that I’ll have the intellectual wherewithal and the time to pick these multi-baggers.  But I’ll try, from time to time.
 
This year is going to be fun – I look forward to it!