Building an Effective Investment Process
In our last post we discussed The 7 Benefits of an Investment Process. Today we discuss how to design a process that delivers these benefits effectively.
At its most basic, this is a three step process.
Step 1: What questions should I ask ?
Step 2: How do I answer them ?
Step 3: How do I act upon my answers ?
We’ll take you through each of these below.
What questions to ask?
The first step in building your process is to build the list of questions that you want answered about an investment opportunity.
There are literally thousands of things you might want to know about an investment, so working out which questions to ask can be daunting. Here are some guidelines:
- Start with a handful of very important questions
Use your investment process as a filter to eliminate poor prospective ideas and monitor change in others. These questions should help you reject clearly unsuitable companies quickly, so that you can focus on better prospects.
- Examine multiple aspects of the company
Your questions should provide you with different tools to solve the problem of risk and reward. Ask a balanced group of questions. For example, if your goal is to buy fast-growing companies, don’t just look at revenue growth – consider balance sheet health, cash flows, management capability and integrity, and competitors.
- Ask questions that are relevant to YOUR objectives:
Journalist Jason Zweig notes that you can’t beat professional investors at their game, but you can win at yours. Make sure your questions are relevant to your personal goals – whether that be reducing volatility, following ESG principles, or delivering absolute returns.
- Ask questions you can answer
Like dieting, there is a trade off between creating an investment process that is perfect and one that you can follow. Stick to questions where you have some competence. Remember that the biggest contribution to your returns is not necessarily from finding a brilliant insight, but from being disciplined and avoiding obvious mistakes.
Your initial process questions might look something like this:
How to answer them?
Initially, you should focus on avoiding obvious mistakes. In his book The Checklist Manifesto, Atul Gawande notes that the history of the checklists used today by pilots all around the world to make flying safe dates back to a pre WWII fly off between Boeing’s “flying fortress” and a smaller less functional plane designed by Douglas. The Boeing design could carry five times as many bombs, was faster and could fly twice as far. But during the test flight, the experienced pilot forgot to unlock the elevator and rudder controls and the plane crashed soon after take-off.
Boeing engineers came up with the concept of the checklist to stop such errors in the future. The “flying fortress” went on to fly 1.8m miles without accident – the army ordered 13,000 of the new planes, which played a decisive role in defeating the Nazis.
First pass of the process:
Your first pass of your investment process is to answer your questions in the negative – have I checked for something obvious that might blow me up? Here you are looking to eliminate investment ideas that are not suitable for you. It should be relatively quick and free up time for more prospective ideas.
- Does the company have competent and honest management?
- Is the balance sheet healthy?
- Is the company an established enterprise with a moat?
If you get to the end of your first pass and your investment opportunity still looks ok, it’s time for a second, more detailed review. This involves iterating on your investment process in two ways.
Second pass of the process:
Dig deeper into each aspect of a company. If you are looking at Balance Sheet strength – maybe you need to ask further questions such as:
- Does the company have net positive or negative working capital?
- Does the company have off balance sheet liabilities or commitments?
- Cash flow – is it positive or negative? Sustainable at current levels?
- Are there possible liquidity traps in debt refinancing or capital commitments?
- Does the balance sheet point in time snapshot represent the position through the year?
Secondly, broaden questions for context. For example, if you are looking at the ability of the company to generate high incremental returns, examine this in light of the specific industry. For example, in the case of a software company you might want to ask:
- What are gross margins?
- What is the cost of acquiring a customer?
- Expected lifetime of a customer?
- Rate of customer churn?
In this process you might once again find some obvious hurdles to an investment. Your software company has unacceptable churn? The balance sheet has significant off balance sheet liabilities.
But you might also start to uncover the opportunities. There is a surplus plot of land that can be sold to realise value. The total addressable market for the software is much bigger than expected. At this point you need to move on to step three.
How to act upon your Answers?
Having put in the work to evaluation many investment opportunities how do we act upon that work? There are a number of different approaches.
Out preferred approach uses a combined quantitative and valuation structure but applies judgement. Rather than simply buying the highest Return On Equity or the cheapest valuation, these checklist outcomes are overlayed with judgement. As Gawande notes
“under conditions of complexity, not only are checklists a help, they are required for success. These must always be room for judgment, but judgment aided – and even enhanced – by procedure.”
In this framework, even if your process is the same for each opportunity, there are three things that will be different in each case that will require judgment.
The first is that the importance of your factors will differ. In one case Balance Sheets might be the answer, in another it is management quality. You need to subjectivity work out which factor is important in which situation.
The second is that your degree of certainty of your answers will differ. Where do I have high conviction versus where am I uncertain? Importantly – where is the distribution of my errors? How different is the most likely outcome from the possible outcomes?
The third thing is how your factors impact each other. Does the balance sheet strength add positive or negative risk to how I assess the strength of the business franchise? For example the ability to continue investing in R&D to compete longer term. Your checklist questions can be asked individually, but must be interpreted as a whole.
Putting it all together
Investing is complex. There are a thousands of variables impacting thousands of companies being interpreted by thousands of different investors.
But your approach to dealing with this complexity doesn’t have to be complex. Having a process to guide you on the things you do know and that recognises the things that you do not can be both simple and highly effective. It doesn’t have to be perfect, it just needs to be better than what you have now.
Over the next few weeks we’ll write more about investment processes. I’ve been a professional investor for 30 years and I’ll walk you through my process in detail to give you a good starting point for your own work.
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