Stock Picking: 5 Question Framework
Jack Laffan
Trying to Beat the S&P 500 in Just 2 Hours a Week | Follow to come along for the ride
Last week’s newsletter focused on simplifying investing. Maintain return, and reduce downside (loss). We do this by selecting certain actions or controls. These might be regularly reviewing the company reports, buying the business at a discount, waiting until certain events have occurred.?
In this newsletter we’ll go over the 5 questions that can be used to find great businesses, and expose mediocre and high risk investments.
When I was starting my investing journey there was so much information. It was so hard to make sense of it all. It was like everyone was speaking an entirely different language. Eventually I found a framework that worked for me, based on the knowledge of the great investors I studied.
Keep it Simple
There are a number of reasons why beginner stock investors don’t make sense of the core areas of risk management
But don’t worry, this is exactly what we’re about to cover.
5 Questions That Need to be Answered
I’ve boiled it down to 5 key questions. To find exceptional investments, there shouldn’t be a “hell no” for any of them. These are:
Let’s break down each one of these with examples.
Can I Assess its Future
We want to invest for the long term. To do that, we need to know if this business will be around in the future or is it going to fizzle out.
No-one can predict the future so the best thing we can do is find businesses that are unlikely to change. They are consistent like Coca-cola. They haven’t changed their product in decades. Alongside consistency of product, we need consistency of leadership, the industry, and what competitors are doing, just to name a few.
As there are a lot of things to understand about a business, you need to actually understand how the business operates. You need to have competence to be able to know these details.?
Warren Buffett calls this a “circle of competence”. Sticking to what you know, before investing in it. You can expand your circle of competence over time by continually learning.?
Is it Great
What makes a great business? Exceptional products and services
Think Apple and the iPhone - I used to hate Apple products with a passion. My reasoning? I didn’t have one based on evidence. But when I tried one I loved the user experience, it was so easy and intuitive. I was converted in 1 week.
To make sure the business stays exceptional into the future, the business needs a durable competitive advantage
For Apple, they pour money into research and development to keep their products current. They invest in marketing to spread their brand - the association or feeling of owning the product.
Warren Buffett refers to competitive advantages as a “moat”. Like a moat around a castle. The deeper, wider, and more crocodile infested the better (maybe even sharks with laser beams on their heads).
Is Management Trustworthy
Even if you understand the business, it’s consistent, and the products or services are exceptional, if it's run by idiots it won’t last…
When people think about assessing management, don’t complicate it. Us humans are great at sniffing out bullshit.?
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We want competent business managers
We also want to see ownership in the company; they have skin in the game. This is to make sure they are aligned with long term shareholders and want to increase the business value.
Can I Get it for a Discount or on Sale
As an investor in stocks, you have very little impact on the direction of the business (unless you own enough to be on the board). Buying the business when it's “on sale” reduces your risk of losing money.?
Let’s use an example; you want to buy a second hand car. You do some research and find the type of car you want, and then what the market is pricing those cars at. You come up with a value you’d be happy to pay for the “perfect” version.?
But what if you find one that hasn’t had a service in years? Or that it has bald tyres, damaged seats? Well you wouldn’t pay the “perfect” price, the value of the car is less. When you buy it, you might also find other things that need work as well (unknowns that you haven't accounted for).
This is how value investors think of businesses. What is the value and what could go wrong. To take into account, they buy when the price of the stock is at a discount to the value they come up with. This discount is called a “margin of safety
If the stock is priced by the market that nothing good is happening, then there is less risk it will decrease further. This is because all the optimism has left the price already (generally speaking).?
Overpaying can be disastrous. If you had bought Microsoft in 1999 at its peak of the tech bubble, it would have taken you until 2016 to reach the same peak (0% return for 16 years).
Is this Better than what I have
Finally, the question that keeps you honest to yourself. Sometimes there are no exceptional opportunities. Sometimes you just need to wait patiently.?
Reviewing what you already own is an excellent way to maintain your investing standards. Ensuring you stay consistent with your strategy
How do you stay patient? Find something to do in the meantime. Keep busy turning over investing ideas or just go and live life.
Those are the 5 questions I use:
Leave me a comment about the high level questions you ask yourself before buying a stock.
Cheers,
Jack
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