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Two questions and one attitude

What I ask and assume before making investment decisions.

There are two very important questions I ask, and a particular attitude I assume, before taking any possible investment decision. In the never-ending quest to improve my investment decision-making, I have found these questions valuable heuristics. I hope you do to.

The questions

  • If I only had 20 investment decisions to make in my entire career, would this company be one of them?

This forces me to consider only my very best ideas for investment, not the maybe-this-will-work-out-well sort that one is tempted to get involved in when you do investment management for a living. As in life, it’s not black and white that gets you into trouble, but the grey. I believe this is one of the essential reasons why super-smart people are not necessarily the best investors. They employ their considerable intellectual powers to separate grey from grey, instead of being meta-smart in recognising that often the smartest decision is not in how you play the game, but in deciding which game to play in the first place.

  • Could this company be 10 times larger (without issuing extra shares) than what it is at present?

If you want to make a lot of money from shares you need to find a company that can increase its earnings materially, and the most sustainable long-term way of doing that is by selling more stuff or services. A company needs room to grow to achieve multiples of its current earnings. In other words, it needs to be a small fish in a big pond of demand, where it can grow by prudently (value accretively) eating its way to size, or it needs to smart about entering other ponds.

Forecasting which specific company is going to increase its earnings by multiples of 10 is no fools game, and a handful of buying such companies at single-digit or low double digit pre-growth multiples can make all the wealth difference in the world. I don’t have a recipe, but I do believe on can tilt the odds slightly in ones favour.   

You are not going to see Apple grow its earnings ten times from its current level. For that to happen, every person on the planet would need a couple of iPhones, with extra accessories! All else equal, smaller companies will find it easier to grow than their larger counterparts. This size-versus-growth relationship is not that simple as larger businesses often have differential access to resources, such as cheaper funding, which one would expect to lead to “easier” growth. But I would say (guess) that for the most part the size-versus-growth relationship holds, which implies that you are better off looking for ten baggers among smaller companies.

Secondly, if the pond (industry) that you are swimming in is relatively small compared to your current size, then I do not care what bubbles you blow. Your chances of becoming a great white are negligible. What a business requires in order to become really large, although not necessarily very profitable, is demand for its goods or services, and lots of it! Which companies, doing what, will see profitable demand for their products or services increase many multiples from current levels? If you can answer this question well more often than not, I want to be your friend. 

The attitude

  • I assume the attitude expressed by the following phrase “thank you, but no thank you”.

In other words, my default attitude towards any new investment opportunity is to say no. If you approach investment decision making with the attitude that you are going to decline 99 out of 100 opportunities, you are bound to miss a few that turned out fabulously in the end. But, I am confident that this negative frame of mind will ensure that when you do invest, it will not be an emotional decision. I want to invest in opportunities that are so obvious that even the largest cynic in the world would be inclined to declare investment heaven had arrived.

The moment that you buy an asset is the moment that you are certain that you have paid something; what you are not quite sure about is what you will be getting in return. If you are very circumspect in the price that you are paying in the present, then you don’t have to be that great in anticipating the future as there are many more ways the future can turn out wealth enhancing for you than the person who was too hasty in paying up in the now. Investment is essentially a guessing game. This does not imply that it is gambling but it does imply that the future has many more ways of turning out than what anyone expects. It is prudent to increase the odds of success by controlling one of the few things you can be certain about in this business, the price that you pay today.

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