Stock Investing Is More Of An Art Than Science

Here is an amazing read about investing philosophy by our guest writer, Manish Jauhari. He is a great source of wisdom.

I think Investing is part art and part science.

Art Aspect of Investing

The topics that I consider in the Art part of Investing are.

  • What business the company is in? What is the market like for that business?
  • What are the long-term prospects and short-term prospects for the company and the business that the company is in?
  • What is the barrier of entry in that business? What are the industry trends?
  • Who are the competitors? 
  • What kind of pricing power (flexibility to raise prices without severely impacting the demand) does the company have?
  • Is the company and the industry/business susceptible to any disruptions, for example what is the impact on the Hotel industry from the likes of companies like Airbnb; and for example what’s is the impact on rental car industry from the likes of companies like Uber; and for example what is the possible impact on a database software company like Oracle from open source software and other possible threats like SAP’s acquisition of Sybase?

So, generally in the art piece, I am looking at the company and the industry. Also, I look at the management of the company.

  • Does the management have short-term goals or long-term goals?
  • Is it more concerned with results of the next quarter, next two quarters; next year or is it more concerned with the long term health and growth of the company?
  • Is the management solely driven by a single person/ founder or is there a deep bench?
  • Is the vision of the company too much reliant on a single person/founder?
  • How much priority does the management give to spending on research and development and making sure the company’s products/services don’t get obsolete and the business is resilient against disruptive forces?
  • What are the Management’s efforts to increase the revenue, earnings and the cash flow of the company over the long term?
  • How much the management earns?
  • Is it more concerned with lining up its pockets at the expense of shareholders and employees or is it getting reasonably compensated in accordance with the results of the company?

While I evaluate the company and the industry, I generally don’t pay too much weight to the macroeconomic trends. For example, how is the domestic economy or the world economy going to fair in the next quarter or even in the next year. I believe that if a company is managed well, has the right products and the right strategy it will do well regardless of the macroeconomic factors over the long term.

Science Aspect of Investing

The topics that I consider in the Science aspect of Investing are its financial conditions.

Cash Flow

  • I look through the financial statements of the company and one of the main things I look for is Cash Flow statement.
  • I look at operating cash flow and free cash flow (operating cash flow minus capital expenditure).
  • I consider the capital investment which the company needs to make to maintain its business.
  • I look at both types of capital investments:
    • Company needs to make to maintain its business.
    • Company needs to make to grow its business.
  • In my free cash flow calculation, I consider subtracting only the capital expenditure needed to maintain the business from the operating cash flow. So, for example, if Starbucks is opening five stores a day and spending capital like crazy to do so and as a result, its free cash flow is less. That does not necessarily mean that Starbucks should not be opening new stores. However, the capital that Starbucks is using to remodel its existing stores, close them down, and make changes to stores are definitely part of running a business. And that should be deducted from operating cash flow to arrive at free cash flow.
  • I look at the ratio of free cash value to market capitalization and consider that a key measure to decide if investing in the company makes sense at the current stock price.

Income Statement

Besides looking at the cash flow statement, I also look at the income statement to consider the revenue pattern.

  • Whether it’s growing or not? How much is it growing? so on so forth.
  • The gross margins; Selling, General and administrative expenses. How they’re growing or decreasing with respect to revenues and also the net margin.

Balance Sheets

Then I look at the balance sheet. The critical piece there is total liabilities because the liabilities are real and assets may not be.

  • I consider current assets like cash, accounts receivable, inventory so on so forth and I try to arrive at roughly net liabilities by subtracting current assets from Total Liabilities.
  • I don’t pay too much attention to long-term assets. Definitely not Goodwill and not much to PP&E (Property, Plant and Equipment).
  • I also look at the diluted share count. If diluted share count has been decreasing then that may be a major plus which means the company is buying back its shares.  However, it may not always be a plus because buying back shares is a good strategy only in certain circumstances.  One has to see if that’s the best use of the free cash flow that the company is producing. Sometimes companies will buy back shares at prices much higher than their intrinsic value sometimes to offset the dilution because of options vesting and therefore in some cases buying back of shares may not be the wisest thing management could do. However, in a lot of cases if a company is buying back shares that may mean a company is aware of the fact that shareholder equity need to be preserved and the share count should be reduced (if that’s the best use of free cash flow) thereby enhancing the shareholder value.
  • I also consider how much dividend a company is paying. If it is paying dividend and just like buyback of shares dividends payments may be a good thing or it may not be a good thing because sometimes it may be the right thing for a company to invest the free cash flow generated to grow its business, but it can’t justify sufficient return on equity on reinvesting the cash generated in its business. Then the buyback of shares and/or paying of dividends may be the optimal thing to do.

I look at the other things in statements or in reports, example if the company has any pensions (defined benefit retirement plans). That usually is a negative factor in my mind because sometimes companies may need to put in a lot of money to fund their pensions. I think a 401k plan (defined contribution retirement plan) is definitely preferable over pensions because the liabilities (expenses) are limited in those plans.

Additionally, I prefer that the company has no stock options but that’s asking for too much in today’s corporate world.

I would prefer that companies pay cash bonuses however the reality is most companies these days like to issue stock options so I like to see limited usage of stock options.

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