Which investment approach really suits you? Read & find the best fit
When it comes to idea generation, there are so many ways to find potential investment ideas.
“It's in the interest of the financial community and Wall Street to make the stock market seem overly complicated so that you will give them your money and think that they're doing such a great job for you that they deserve to get paid a lot, when, in reality, it isn't that complicated," the renowned author on value-oriented investing said in a presentation at Talks at Google, whose video is available on YouTube.
The author of The Manual of Ideas, the bestselling book on value investing, is also the Managing Editor of the acclaimed research publication bearing the same name and is the Managing Director of ValueConferences, the series of fully online investment conferences for sophisticated investors.
Different sources of idea generation
Mihaljevic says investors try out different approaches to amass large returns and falter in this process. Instead they should try and keep things really simple, as there is no real secret to finding great investment ideas.
When it comes to idea generation, Mihaljevic says, there are so many different ways to find potential investment ideas.
He feels investors can get ideas from friends, see it on message boards, or read about a company in the newspaper. They could also do a quantitative stock screen and search for the cheapest companies based on some metric.
‘Many investors invest in companies based on what they think other people think of those companies. This strategy may be successful in the short term but won't work in the long run.’
While idea generation is the easy part, it is the assessment of the right investment opportunities, which is challenging and where successful investors achieve their success, says he.
“I could give everyone the same potential company to invest in, and someone will say, ‘Wow, that's great. I want to buy’, while another one will go, ‘No way’. If you can get that decision right, you're going to be successful,” he says.
Stock market ‘a beauty contest’?
Supporting Economist John Maynard Keynes’ view, who called the stock market ‘a beauty contest,’ Mihaljevic says many investors invest in companies based on what they think other people think of those companies. This strategy may be successful in the short term but won't work in the long run.
"Everybody is trying to play a guessing game, where they are picking the ‘prettiest’ company. However, it's not the one they think is the prettiest, but the one others will think is the prettiest. Since a lot of people invest this way, this is how the stock market might act in the short term. It's highly unpredictable. Everybody is trying to outguess everybody else, but that's not how you can be successful in the long run," he says.
Stock market: A pari-mutuel betting system
Mihaljevic says the stock market should be viewed as a pari-mutuel betting system, as it is not about the best company or what others think about a company.
‘It is important to know whether a company, at the stock price it is today, is trading for more than it would take to recreate it from scratch. The idea is to know how much capital it would take to recreate the earnings flow and the basic business.’
Pari-mutuel betting is a system of betting in which all bets are placed together in a pool, and the winners divide the total amount wagered after organisers of the system deduct management expenses. The odds change based on where the bets are placed and in what amounts. A simple example of such a system is horse-race betting. The critical similarities to the stock market are that all bets go into one pool, so the price of any given security incorporates the opinions of market participants at a given point in time.
Mihaljevic says if there is a company like Google, the investment decision becomes pretty easy, but what becomes harder is evaluating that judgement versus what an investor has to pay to buy that company in the stock market.
Quoting Warren Buffet, he says: “We simply attempt to be fearful when others are greedy and greedy when others are fearful. If everybody in the world believes a company will go bankrupt, the odds on it may be so great that if it doesn't, you could do great even though it may still be a mediocre company.”
The essence of stock market
Explaining further about what the essence of the stock market is, Mihaljevic says the stock market is merely a conduit to ownership and is a place to buy and sell stock in companies. Although while transacting online and looking at a stock ticker, it may not seem that stock is a partial ownership of a corporation, but what an investor is really buying is ownership of a real-life business.
Investors resort to many strategies while making an investment, like investing based on charts or looking at different bands and trying to guess when the stock is breaking out or not. Mihaljevic says this is not the essence of what a stock really is. He feels the chances of success go down dramatically in such cases, because if the investment is made based on a chart and if an investor loses all the money, there's no recourse.
In growth-oriented investing, investors often fail to take into account that if everyone else thinks the same businesses are going to grow at a fast pace, then they become super expensive, and there is no scope left to make any money.
"You can't say the chart looked good, and in every other case, the stock did go up when that happened. There's no connection between that and what a stock legally is. Legally, it's the ownership of a business. So if you invest in a company and you're right, you can, in the worst case, take recourse and acquire a majority of the stock, kick out the board of directors, put in your own directors and management team, and take full ownership of the company. In this case, you're getting to the essence of what a stock really is. If you invest based on that essence, you'll be far more successful, because you're as close to the truth as can possibly be," he says.
Mindset to embrace & avoid
Mihaljevic says investors need a certain kind of mindset to become successful and amass great returns. He advises them to avoid a ‘small fish’ mindset having which they feel that their small investment in any company is insignificant and will not affect the market at all.
"The reason it's the wrong mindset to adopt is because your portfolio may be small, but your role in the market is not insignificant. The market is supposed to function efficiently because even small investors think about how well a company is going to do and how much one has to pay to buy it. You really shouldn't think about the scale of your portfolio, but the scale of the companies you're investing in," he says.
Mihaljevic says investors should have a ‘chief capital allocator’ mindset, as such a mentality can encourage them to really think about investing as an owner, which is very much in line with the legal essence of stocks.
Things to note in stock selection
Talking about things to note before investing and owning a business, he says first of all it is important to know whether a company, at the stock price it is today, is trading for more than it would take to recreate it from scratch. The basic idea is to know how much capital it would take to recreate the earnings flow and the basic business.
"If it's selling for a lot more in the stock market, you're not going to buy that stock, because that's telling you that there's an incentive for a competitor to come in as it can recreate the same company for less money than the stock price implies. If a business is trading above its replacement cost, we're going to eliminate it from consideration. If it's below, we go to the other extreme, which is liquidation value. Liquidation value means what a company is worth dead today. If you were to shut down the business or sell it and liquidate all the assets, how much money would you have left with?" he says.
Next, it is essential to look at the actual earning power of the company to find out how much an investor has to pay in the stock market to acquire the whole business.
'The only way to do well in investing in the long run is to find businesses an investor is comfortable with. The investment should be cheap enough in the stock market for an investor to feel that the return he is getting will make it worthwhile.'
Also, it is important to look at the business itself, as an investor will want the company to make as much money as possible in earnings or cash flow relative to the capital it takes to build it.
Value-oriented idea generation approaches
Dwelling on the value-oriented investment approaches, he says investors generally use two types of approaches to investing, namely value investing and growth investing.
Investors using a growth-oriented investment approach usually have a mindset where they invest in businesses which are growing the fastest. But investors fail to take into account that if everyone else thinks the same businesses are going to grow at a fast pace, then they become super expensive, and there is no scope left to make any money.
'Deep value' approach
Mihaljevic says that idea generation has led to different investors adopting different value-investing styles, which has led them to great success.
One of the most famous investment approaches has been the Benjamin Graham style, or 'deep value'. This approach focuses mostly on assets. "A shipping company with its ships and the scrap value would be deep value," says he.
‘Magic formula’ approach
Another popular investment approach is the one proposed by Joel Greenblatt, a highly successful investor, in The Little Book That Beats the Market.
In the book, Greenblatt talks about a ‘magic formula’, which is essentially a way to screen companies with the characteristics of potential investments. It looks at two factors. One is the high earnings yield, or how cheap a business is, and the other is the high return on capital, or how good a business is.
"Historically, a mere mechanical screen of companies ranking highly on those two metrics has outperformed the S&P500 by several percentage points a year. Over time, that is a huge number due to compounding," he says.
The Carl Icahn style, which is the sum-of-the-parts investing, is another interesting investment approach which has brought profits to investors.
In this investing style, investors look for a company with different parts to it, and then see if the values of all the parts put together is materially above what the whole company is trading at in the market today. That can happen quite often, maybe because a company has a core business that investors are focused on and value the company based on that. Alternatively, there may be something totally unrelated that the company owns, like some big piece of real estate or some other business.
"Sometimes it makes sense to analyse the different parts of a company separately and then sum up the values to decide what this business is really worth. Whether you are adding up different parts or just using an earnings yield, you really need to know or have an estimate of what a company is worth before you can even think about investing in it. If you do not know what you think a business is worth, there is no basis for making an investment decision. This is something often forgotten," he points out.
‘Jockey stocks’ approach
Another investment approach that Mihaljevic feels is very successful is the Warren Buffet style ‘jockey stocks’ approach which is to invest in companies run by great CEOs.
"It's the horse racing analogy where you have CEOs who are great not just at running a business, but also at what they do with the cash a business generates, because once the cash is there, there are many options. You can destroy or create a lot of value in a company based on what you do with the cash," he says.
Mihaljevic notes that the only way to do well in the long run is to find businesses an investor is comfortable with. Also, the investment should be cheap enough in the stock market for an investor to feel that the return he is getting will make it worthwhile.
(Disclaimer: This article is based on John Mihaljevic’s presentation at Talks @ Google, whose video is available on YouTube)