When it comes to investing, making good decisions consistently is hard. Emotion often gets in the way. It’s not that emotion is a bad thing, but when it comes to investing, emotion hurts more than it helps.
It’s easy to be swayed by the negative sentiment around one investment, only to be overly persuaded by the positive sentiment surrounding yet another. So how do we free ourselves from this emotional rollercoaster?
Furthermore, how can a mere human make a good decision with the mountain of data available at our fingertips? How do we not fall victim to analysis paralysis when the internet provides too much information for a human to realistically process?
It seems like a tricky problem to solve until you realize it’s already been solved before…
Filters & Checklists
Warren Buffett is famous for making multi-billion dollar investment decisions in just a few hours time. He often can buy a company after only reading an annual report. He never meets with management and never tours the company’s offices.
How does he make successful decisions so quickly? By passing his investing ideas through a series of filters.
In 2009, Buffett is quoted as saying to a group of MBA students that he has a set of “roughly ten” filters that he passes his investing ideas through. But to my knowledge he’s only described four of them in public.
Other great investors like Charlie Munger or Mohnish Pabrai call their version “a checklist”. Just like airline pilots that run through pre-flight checklists before they fly, these investors run through a checklist so they don’t screw up.
Thankfully, bad investing decisions rarely end in death.
The concept is simple — Filters & Checklists keep the human mind focused by:
- Making objective decisions. Not decisions based on emotion or market sentiment.
- Avoiding mistakes that could lead to a investing disaster.
- Analyzing the most important variables instead of getting lost in the weeds of endless data.
Thankfully, utilizing filters & checklists doesn’t require you to have an IQ of 180. Neither does it require you to have an army of analysts or a super computer processing data all day.
Anybody can setup a series of investing filters. I have, and its made me a better investor.
However, the idea does require discipline to use it consistently.
Why I Like The Word ‘Filter’
Personally I like the using the word “Filter” because it captures the idea so much more clearly for me — filtering out the junk so only the good stuff remains. Just like the air filter in your car that removes all the dirt, dust, and pollen.
Why does this work in investing? To quote the famous investor Howard Marks, “If we avoid the losers, the winners will take care of themselves.”
In other words, it’s better to miss a few really amazing investments rather than to screw up and put money into junky losers. Filters help us clear out the garbage.
The idea of a “checklist” is about making certain you don’t miss important things — Did you check to make sure the cabin door was closed before flying? Is there fuel in the tank? That sort of thing.
The difference is probably just semantics, but I like the word “filter” a tiny bit better. I think it matches my investing process a little bit closer…
Typically I’ll be reading about a company and wonder if I should invest. To answer the question I quickly pass it through my filters. Most ideas won’t make it past the first couple filters.
This often takes only 10-15 minutes to rule out most investments. Only the rarest of ideas merit longer study.
No emotion is necessary, and no “special equipment” is required (other than a calculator).
A Few Of My Filters
Yes, I actually have a written list of filters. It’s a real document I’ve maintained for years.
Mine is a spreadsheet called “The List” sitting on my laptop and it’s backed-up to the cloud. Why is it in a spreadsheet? No reason. I just happened to have a spreadsheet open when I first wrote it.
Mainly I use “The List” for investing in stocks, bonds, or preferred shares, but the idea of filters could be adapted to investing in any kind of asset — index funds, real estate, or other types of business.
Today I’m going to share a few of the filters I use for stock investing. This is by no means a complete list of my filters. It’s just a sample. I use these filters because they work for me. They might not work for you.
Your filters could be entirely different based upon your investing criteria and personal knowledge.
Filter 1. How Do I Realize Returns?
The first fiter on my list is to understand how I’ll realize returns from a new investment. If my investing returns require the market to pay higher multiples for the same asset, I usually stop at this point. The investment isn’t for me.
If you’ve read this blog for very long at all, you know that I believe returns should be realized from the business, not the market.
There’s really only about 3 or 4 possible ways this can happen:
- Compounder-Payer-Carnivores. The most common way investors realize returns from the business is when the company pays out cash dividends or buys back shares. Most companies also retain some cash for growth. Do they realize more than $1 for every $1 of cash retained?
- Legacy Moats. Some good businesses have a very hard time growing. The business can even be in decline. In either case, the business is frequently still very profitable, but can’t grow easily. Altria or Coke might be good examples of Legacy Moats. These investments should be returning all free cash flow to shareholders (other than for maintenance capital expenditures).
- The ‘Net-Net’. I’ve written about the net-net value investing style in the past. These are pretty rare today. Essentially these investments are about buying dollar bills for fifty cents. The value tends to be obvious, but realizing the return is the hard part. Either the market will eventually change its mind and provide adequate value, OR the business gets purchased. I’ve had both of these outcomes happen.
- High-Speed Compounders. (Sometimes called a “capital-light” compounders.) These companies retain all cash and attempt to grow as fast as possible. More often than not, they waste A TON of money on speculative growth. I try to avoid these investments unless incredible ROIC is available at a low price.
Filter 2. Is The Business Actually Compounding?
This next filter applies to companies that retain cash. What is the company doing with the money? As cash is retained, is ROIC rising or falling as a result of those efforts (What is the return on incremental invested capital?)
Frequently management will attempt to start new lines of business OR buy businesses to expand. The results are often a horrific waste of money. Organic growth tends to work best in my experience.
Filter 3. What Is Your Margin Of Safety?
I’ve written about margin of safety before. This is mainly a defensive filter. When a company sells for below its intrinsic value it’s said to have a margin of safety. Dividends and moats can also play a part in margin of safety.
Margin of safety is all about protecting the investor from losing money. The Intelligent Investor spends considerable time on this concept.
Filter 4. Is There A Durable Competitive Advantage (aka Moat)?
I already mentioned moats earlier, but they’re SO important in investing they really deserve their own filter. In companies with moats, there’s usually some factor that allows the company to realize higher profitability than competitors, OR have more durable profits. Or both.
Companies with moats tend to have very high net profit margins. >10%
It’s the investor’s job to find out what this moat is. Sometimes it isn’t obvious and can require significant digging.
Filter 5. What’s The Relative Advantage Of This Investment?
Before I invest in any business, I try to do an opportunity cost analysis. Will this investment provide better business returns than investing in a S&P 500 index fund? What about one of my other investments?
Any new investment should pass this hurdle by a fair margin. In order to measure objectively, I try to think of the S&P 500 as one giant business. Many of the necessary metrics for doing this comparison are available on the internet.
ROIC of the new investment should exceed 15% and ROE should exceed 13%.
Filter 6. What Kind Of Market Share Does It Have?
This filter is all about understanding where the investment fits in the competitive landscape. Dominant companies tend to stay dominant (at least in non-technology businesses).
Generally I look for firms with greater than 25% market share, but I tend to avoid tech businesses.
Fast technological change in most industries means significant disruption. The outcome is typically unpredictable and thus market share is NOT a very good indicator of long-term success for technology firms.
Filter 7. What Do Cash Flows Look Like 5 Years Out?
This filter goes along with not being able to predict the future. Most humans can’t predict the future very well.
If you can’t reasonably predict what cash flows look like 5 years out, you probably shouldn’t be making this investment. Investments that require you to guess what the future looks like are quite dangerous. Avoid them.
Unless that future is an absolute cinch to predict, don’t pay a premium for rosy predictions of the future either.
Filter 8. Are Share Buybacks REALLY Buying Back Shares?
This filter is made to catch bad share buyback plans. Management often toutes the fact that they buy back shares, but when we analyze the share count over time, it never really drops. That’s because management is issuing those shares back to themselves as a reward… like a gigantic performance bonus.
I avoid companies that can’t do proper buybacks.
Filter 9. Is The Company Selling At A Good Price?
After going through all my filters, only at the end do I try to understand if the company is selling at a good price. Because I seek to realize my returns only from the business, the price I buy at does affect my return.
I’m usually looking for a EV/EBIT under 10, or a earnings yield (as defined by EBIT/EV) that exceeds 10%.
What If I Make A Mistake?
Inevitably you will make a mistake when investing. It happens to everyone. I’ve made dozens of mistakes. No checklist or set of filters is going to be perfect. Even master investors make mistakes from time to time.
The thing is — Mistakes make great learning opportunities. Once you’ve made a mistake, just add it to your list of filters.
What question should you have asked before investing to avoid making that mistake?
Did you improperly assess management quality? Was there too much debt? Did you forget to account for low cost competition from overseas? Were revenues and cash flows overstated due to boom conditions?
I have literally dozens of filters based on my own mistakes… and the mistakes of other investors.
Why the mistakes of other investors you ask?
Well, there’s no extra points for originality in investing. If we can learn from the mistakes of others, it’s to our advantage.
I hope you enjoyed this little sampling of the investing filters that I use. I find them to be a powerful tool to move investing decisions out of the realm of emotion and into the realm of a objective process.
It’s also a process that can be continuously improved as we learn.
While I know that many investors will probably scoff at this idea, I firmly believe there’s value in taking emotional hands off the investing “wheel”.
Drive safe out there my friends!
[Image Credit: Flickr]