As the name of the blog suggests, I am interested in absolute performance – not relative. So, I am not going to try to beat the S&P or Dow. Instead, my goal will be an absolute return.
My absolute return goal is: 20%. I am not going to achieve this every year, but over long stretches of time, say 5 years or so.
It is very important to understand how I am going to generate such a return. Here are the rules I select my investments with:
Financial Strength: A very good balance sheet. I look at litigation risk, interest cover, pension liabilities and most importantly Net Debt should not be larger than 3 times EBITDA.
Management: The company should run by reasonable and honest management. I look at management’s compensation practices, their contract when leaving the business, as well as write offs. Write offs suggest that the management has made mistakes in allocating capital. Ideally, I would like the board to be run by the owner family with skin in the game or a management with large holding of the company stock.
Competitive Advantage: I try to ascertain what the sustainable competitive advantage of the business are. This is akin to finding out the depth of the moat. A good question to ask is: Is the business going to be around in 10 years ? Furthermore, I also like to ascertain the risk of regulation of the industry.
Price, Margin of safety and circle of competence: I should be able to come up with a reasonable estimate of the price of the company. Given the estimate, I would like to have a large margin of safety. If its a great business with a huge moat than the margin of safety can be smaller. But I generally target for something between 30%-50%. I will not buy anything with a smaller margin of safety than 30%.
Confidence: An important aspect of value investing is patience. If the people around you are panicking then there is only one way you can maintain your composure: a confidence in your analysis. A very good test of confidence is asking following two questions before you buy a stock 1. Will you buy more if the stock price drops by 50% tomorrow ? and, 2. Will you be comfortable in putting 25% of your portfolio in this one stock ?
Some of the stocks I have do not qualify one some of the requirements I describe above. These were bought in the early years of my investments and they were undervalued enough that I have kept on holding them. The situation should change as my portfolio recovers from those early mistakes.