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Big ideas to guide an investment process
Asset Management Lab (FINC 910) / Philip C. Ordway
Preamble
Here we will use investing as a term to describe the art and the practice of deploying capital, only after careful
thought and analysis, in such a way as to maximize our odds of getting our principal back and – only then – earning
a satisfactory return on our capital.
There is no single religion in investing. Several methods and philosophies have merit. Condescension and narrow- mindedness are not helpful.
Articles
• Think for yourself. Figure it out. Don’t stop asking “Why?” until you have the real answer.
• Know what you don’t know.
o Avoiding stupidity – or being less stupid than everyone else – is often a better path to success than
brilliance.
o Overconfidence is deadly.
o Have the courage to declare something too hard or unknowable. Have the courage to act when
something is well understood and attractive.
• Learn something every day. Go to bed a little wiser each night.
• Read as much as possible.
o Track and measure what you read. Set a daily/weekly quota.
• Never assume anything. Turn every page. Trust, but verify.
• The best way to solve a problem is often by looking at it backwards or upside-down.
• Think in probabilities.
o There are no certainties.
o Always seek redundancy and/or a margin of safety.
• The most important subject in investing is psychology.
o Overconfidence is the 8th deadly sin.
o Incentives matter almost to the exclusion of everything else.
o Being rational is far, far more important than being intelligent.
• Two important questions to ask in investing:
o Who doesn’t know that?
o And then what?
• Many, if not all, aspects of investing have ideas that seem to contradict each other.
o Many great failures – in investing or otherwise – come from the inability to hold two ideas at once.
• Pricing and valuation are distinct exercises and not to be confused.
• Big events or outsized results are almost always caused by a confluence of factors.
• Many great mistakes begin by forgetting what one is trying to accomplish.
o Investing is the art of laying out money today to get that money back in the future, plus a satisfactory
return. Everything else is secondary to this aim.
o The value of any financial asset is the discounted present value of future cash flows. Everything else
is a derivative of this concept.
▪ Some cash flows are more reliable than others.
▪ Detailed, complex, mechanical DCF calculations often do more harm than good.
• Investors value companies. The future value of a company is the sole focus.
o Securities are simply a means for making an investment in a company.
• There is nothing wrong with speculation, but never confuse it with investment.
o Speculators rely on future changes in price and often need ready buyers at that price to achieve a
good outcome. Investors focus on future changes in cash/economic value and would own an asset
regardless of available buyers.
• The valuation process results in a range, not a number.
• The best valuation processes leave plenty of room for error and randomness.
• Multiples are a blunt, crude proxy for a real valuation process. Multiples are a way to quickly price an asset,
not an (effective) way to truly value it.
o Some multiples are better than others, and some are unhelpful.
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• The best valuation processes follow a particular order.
o Start with the materials a company is required to disclose: regulatory filings, audited financials, etc.
o Then review what a company chooses to disclose: press releases, presentations, conference calls, etc.
o Only consider opinions at the end, and then seek out opinion on both sides with an emphasis on
disconfirming evidence.
▪ Bias is inherent and unavoidable; don’t succumb to an anchor before the real work has even
begun. (Remember the utility of a blind valuation.)
▪ Valid judgments can only be made after gaining enough perspective to argue the other side at
least as well as its proponents.
• Valuation is not possible without a thorough understanding of a business’s competitive environment.
• Data reflect the past. Market prices reflect expectations about the future.
• Markets are capable of crazy, improbable things.
• Temperament and behavior are far more important than IQ and analysis.
o Very high-IQ investors have little if any advantage over above-average IQ investors.
• Allocating capital requires the humility to prepare and the arrogance to act.
• There is such a thing as a dumb question.
o Lazy questions that could be easily looked up or answered elsewhere show lack of effort, awareness,
and consideration.
• Genuine curiosity is the most powerful tool an investor can have.
o Most great investors act like bright, relentless, highly-caffeinated investigative journalists.
o There are diminishing returns to research, but most people err on the other side by cutting corners.
• Earnings are a matter of opinion. Cash drives economic value (and is much harder to fudge).
o Financial statements originally focused on liquidity and solvency; many financial statements today
focus instead on earnings or, worse yet, “adjusted” earnings or, worst of all, “adjusted” proxies for
earnings like “adjusted EBITDA.”
o Balance sheets are more useful than cash flow statements, and cash flow statements are more useful
than income statements.
• www.sec.gov is the best resource available, and filings should make up the majority of a research process.
o The footnotes matter. A lot.
• The “cost of capital” is determined by opportunity cost. Precise calculations of the cost of capital are useless.
• Incentives matter, almost to the exclusion of everything else.
o Businesses are dynamic, ever-changing, and run by real human beings.
• Regardless of the problem, turning it upside down and/or working backwards is often helpful. Inversion is
often the most powerful problem-solving tool available. See below.
• The best investors understand psychology and history.
• The spread of excellence – also known as the paradox of skill – is real.
• Reflexivity is real.
• Conditions change, but principles remain.
• Scramble out of mistakes as quickly as possible.
• Remove ignorance step-by-step, every day. Always look for blind spots.
• Knowing too little is obviously dangerous. Knowing too much can also be dangerous if it forces attention
away from what matters.
• Longevity is underrated in companies and investors.
• Human + machine is more powerful than human or machine in isolation.
The Seven Sins of Investment Process
1. Separating securities (stocks, bonds, etc.) from their underlying businesses.
2. Ignoring probabilities, or assuming only one possible state of the world.
a. Related: Ignoring base rates
b. Related: Using point estimates instead of ranges.
3. Accepting “facts” without thought or curiosity. Remember to trust but verify.
a. Related: Failing to ask “Why?”
4. Reversing the proper order of investment research by starting from the outside and working inward.
5. Forest-trees problem: Losing sight of the two or three big ideas that matter to any investment.
6. Confusing valuation with pricing.
a. Related: Relying on multiples in the valuation process.
7. Ignoring psychological factors (i.e., forgetting the lessons of The Psychology of Human Misjudgment,
Thinking, Fast and Slow, etc.)