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Focus on the essentials: 5 rules for stock analysis

Focus on the essentials

Looking a little closer at the investment approach of Bruce Berkowitz and Fairholme Capital. One of Berkowitz’s rules that stuck in my mind (and which I would subscribe to as well) is:

If valuing an investment doesn’t do 6th-grade math, then there’s a problem.

– Bruce Berkowitz

In this article, I would like to try to make this “Keep it Simple” approach even more tangible. For this reason, I have written down a few rules that will make life as an investor significantly easier for us, provided we stick to them, and at the same time (in most cases) should not have any negative consequences on the quality of our analysis or our results.

1. Avoid complexity

The first and most important rule could be titled something like “reducing complexity”. For this, I once borrowed two starting points or rather guidelines from James Valentine (former research analyst at Morgan Stanley and author of the book Best Practices for Equity Research Analysts ):

  • Occam’s Razor (after William of Ockham, a 13th-century Franciscan friar): Given several satisfactory explanations for something, we should choose the simpler one, that is, the one with fewer variables
  • A quote often attributed to Albert Einstein: “One should make everything as simple as possible, but not simpler”.

The more complex a connection, the less certain we can be about the expected result… simply because many more variables (in our case these would be the concrete value drivers), etc. play a role.

The simpler we can explain a connection, the better. In case of doubt, however, this does not mean that we should simply ignore certain variables relevant to development.

Instead, it is about not making the explanation for a fact unnecessarily complicated if there is also a simple explanation.

2. Use Excel correctly

Tools such as Excel or Google Sheets can be very useful or in some cases even indispensable for the creation of valuation models ( I imagine it would be difficult to make a detailed forecast over 5-10 years including the subsequent calculation of present value and terminal value with pen and paper).

However, spreadsheet programs also have disadvantages: For example, it is easy to use Excel to produce mountains of sometimes unhelpful data points and confusing formulas that are difficult to understand later… which saves us valuable time and mental capacity both in the creation and in the later interpretation can cost (and has already led to the so-called “Stay-Up-till-Midnight-Syndrome” for some 🙂 ).

Such an approach becomes a problem when investors or analysts can only concentrate primarily on mastering their tools and no longer on the actual value-adding work, namely the evaluation and interpretation of the data and the decoding of patterns and causal relationships.

If we were trying to be a sculptor, we probably wouldn’t spend as much time picking the chisel.

So, if we use Excel or another spreadsheet program, we should think very carefully about the level of detail we want to use. Here, too, it is important to avoid unnecessary complexity.

3. Consider a maximum of 3-4 critical factors per share

As a rule, when evaluating a company, everything ultimately revolves around answering two questions:

  • Which factors or value drivers will influence the future profits or cash flows of the company (and ultimately the share price)?
  • How can we gain insights into these value drivers that are not yet priced into the share price (ie insights that are not yet known to the overall market in this form)?

Regarding the first question: Of course, there are always umpteen factors that have or will have an influence on the result somewhere, in our case the company profit or the free cash flow. However, if we rank these factors in order of relevance (ie list those with the greatest influence and the greatest probability of occurrence first), then we will find that a maximum of 3 to 4 influencing factors are responsible for a large part of the profit development (80-20 rule).

The best analysts and investors therefore usually only focus on the three to four most important value drivers per share.

Or to put it briefly again: we shouldn’t allow ourselves to be distracted by subordinate influencing factors and should rather deal with the main value drivers in the little time that is usually available to us for stock analysis.

4. Use the consensus scoring method

When it comes to choosing the right method for valuing a company, I would say there are basically three different options:

  1. We use our preferred valuation method for all analyzes (e.g. use a DCF model in all cases)
  2. In each case, we use the valuation method that is most common for a company in a specific industry, ie most frequently used by investors and analysts
  3. We use neither our method nor that preferred by others, but possibly also alternative approaches

In many cases, the consensus method (be it DCF, P/E, EV/EBIT(DA), etc.) represents the best valuation approach. For example, if analysts tend to take a sum-of-the-parts (SOTP) approach, then that might be a cue to do the same.

We should only use an alternative approach if it offers added value or enables new insights and is therefore not a waste of time.

5. Focus on what we understand

When we sometimes read something about how many stocks some investors or fund managers have in their portfolios, we are amazed and ask ourselves how one can still keep any kind of overview when there are 100 or 200 stocks.

Generating an excess return (“alpha”) with such an approach should not be easy, especially since most companies are influenced by very individual value drivers.

Admittedly, there are sectors in which the companies develop more or less parallel to each other because they all depend somewhere on the same factors… here one could name airlines, for example, whose profitability is strongly influenced by fuel costs.

However, in most sectors, such as biotechnology, the individual companies will be subject to very diverse and sometimes difficult to quantify value drivers and may therefore develop very differently… and therefore of course also require additional attention.

To cut a long story short: we as analysts cannot analyze everything, nor do we know everything. It is therefore important that we do not get bogged down and focus on those topics/industries where we can create added value with our knowledge (keyword ” circle of competence “).

Conclusion

There are a whole series of stumbling blocks that can lead to us not concentrating on the essentials when analyzing possible investments or making life difficult for ourselves.

This can include, for example, spreadsheets that are overloaded and provided with unnecessary details, but also the consideration of an excessively long list of possible (and therefore possibly largely irrelevant) influencing factors.

For this reason, it is important that we keep asking ourselves to what extent a certain analysis that we carry out or a certain formula that we create in our Excel is essential for our understanding of the connections and to what extent a forecast that we have worked out, has an impact on the development of the intrinsic value.

Or to put it another way: What does it mean for us to know that the price of oil will rise sharply in the future if it only has a marginal impact on the profit or cash flow of the company we are analyzing (e.g. because energy costs only make up a very small part of the account for total costs)?

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