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Putting More Consciousness into Your Investing

(This article appeared in Equity, August 2008)

By John Price, PhD

Someone once said that it is common for people to spend more time buying a new refrigerator than making an investment decision. With a refrigerator they may spend weekends visiting different stores comparing models, sizes, colours, energy efficiency and so on.

In contrast, when it comes to shares, often all that is done is read an article in a magazine or newspaper, listen to a radio or TV pundit, or act on a phone call from a broker. Even when a person does put extra time into a decision, often the information that is collected has little bearing on the likelihood of the investment being a success.

Why is this? I think the main reason is that with refrigerators the questions to ask are very clear. “How big is it?” “What colours does it come in?” and “How much does it cost?” immediately spring to mind. With the share market everything is much more complex.

For a start, you may be dealing with a company worth billions of dollars, with thousands of employees, and with branches and offices around the world. So, for most people, it is hard to know what questions to ask to be able to make a reasonable assessment of a company as a suitable investment. Where do you even start?

Through Conscious Investor and in my investment workshops I provide a systematic approach to analysing companies. No matter what your level of experience and how much background you have in the share market, my workshop will give you the ability to analyse any publicly-traded company and decide two things: (1) whether it is a quality business with high likelihood of strong and sustainable growth and (2) whether it is selling at a price that indicates that it will be a profitable investment.

The workshops are in three sections: “You, the Investor” and “The Company” are the first two followed by the “The Share Price” which links them together. In the remainder of the article I will outline these three sections.

Section 1: You, the Investor

In this section we look at the subjective side of investing which is knowing such things as your investor type, your strengths and weaknesses, and your likes and dislikes.

Without at least a minimum awareness of these areas, it is easy to get knocked off course and feel troubled when things don’t turn out they way that you had hoped. Some of the investor types we consider are the trader, the scuttlebutt investor, and the value investor. Warren Buffett, the famous chairman and CEO of Berkshire Hathaway, describes himself as 30% scuttlebutt investor and 70% value investor.

Another important part of this section is understanding the behavioural and psychological pitfalls that can lead to mediocre performance. We perform a number of class examples that show we are not as rational as we might think we are.

Finally we discuss some of the concepts of ethical investing introducing the idea of a conscious investor as someone who aligns their investing with their beliefs by focusing on companies with products and services that they support.

Section 2: The Company

This is the objective part of the workshop that begins with a study of key elements in the financial statements. Each year Buffett says that he looks for “businesses earning good returns on equity while employing little or no debt.”

We use this as a starting point showing where to find the data to calculate these and other financial ratios indicative of future performance. Company data for a range of Australian companies is provided along with worksheets that cover the areas of management, growth, debt, liquidity, dividend payout ratios, and price to earnings ratios. Thresholds are established for each of these areas and they are ticked off only when a company meets them. Emphasis is put on consistency and level of these ratios and not just on current levels.

Another important topic is understanding what an economic moat is and how it helps when making financial forecasts for a company. Such moats protect a company against changes in consumer preferences, changes in the economy, and government legislation. It gives a company pricing power so that it can increase its prices as least as fast as inflation. In this area we describe the main types of economic moats using a number of Australian companies as examples.

Section 3: The Share Price

It is only after working through the information and practical exercises in the first two steps that a sensible evaluation of price can be made. For example, if you are a trader and believe that share prices have momentum, if the price goes down you would want to sell.

Alternatively, if you are a value investor, assuming that there have been no other changes, you might well buy more shares in the company. Section two is also important because the more you understand about the business, its products and services, competitors and its economic moat, the better you will be able to estimate the inputs in the various valuation methods. In the third section we look at various methods for calculating whether the share price represents a reasonable price to buy, to sell, or to do nothing.

In one sense, once you have gone through the first two sections this is fairly simple: if you put together a portfolio of stocks that you bought at sensible prices for which you are confident that earnings will continue to rise strongly, you are going to do well. We do more, though, in this section by looking at the strengths and weaknesses of a range of different quantitative methods. Looking from the outside, some of the ideas may appear a little intimidating. But it is all done with appropriate worksheets which we follow through as a group by filling in the blanks.

We first look at the “static” methods such as liquidation, replacement value and book value. Next we examine the various discount methods. For example, the discount cash flow method proceeds by estimating the intrinsic value of a stock by taking the sum of the free cash flow generated by the business over its life discounted back to present time.

This method extends the well-known procedure of valuing a bond as the discounted value of its face value and all its coupons. Instead of free cash flow, dividends can be used where they are estimated by dividend payout ratios and return on equity. To determine what action to take, intrinsic value is compared to the share price. One problem is that very small changes in the input variables lead to large changes in the output. Methods are shown which overcome this weakness.

We all have different experiences and knowledge. In the workshop emphasis is placed on using these as a basis for a framework to know how to make informed decisions in the share market … to be more conscious of what we are doing and why.

Professor John Price is the CEO of Conscious Investing Inc.

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