Investing 101: The Methodology

In general, most people do not have the time nor the patience to leaf through 10 years of 10-K submissions let alone the patience to read endless articles and industry periodicals to determine whether their investment choices truly "make sense". The research aspect of investing is not glamorous, in fact; it is probably more comparable to taking out the trash every week - the consequences exceed the frustration. The point being, most of us are reluctant to put in the time to truly understanding a businesses core operations before executing a buy order with our broker. Instead of conducting due diligence, we, the average stock market participant, look to industry "experts" (aka brokers, financial analysts, or financial advisors) who are more interested in profit than helping out the average Joe. When such resources are out of reach, we find ourselves resorting to Google Finance contributions or Yahoo discussion boards to receive the daily 411 on "The Stock Market". It is often the case that many of the free information resources are dismal at best.

Within this entry I hope to explain the simple analytical method that has helped me to establish a financial strategy that will save time, money, and the test of time. My intention is that my pursuits and ideas will help others to formulate their personal investing style. Below I have listed some common principles that work well for me that may be leveraged in your investing methodology. As a precursor, please note that I am an avid admirer of Warren Buffett and Benjamin Graham and I have plagiarized many overarching principles from their investing philosophies. While mildly distinct, to each his own.

Principle 1: The Core Competence
Every investor whether they admit it or not has a core competence of knowledge that they apply when making decisions, investments or otherwise. I know for sure that I can not describe the next biochemical breakthrough or predict the next mode of transportation, however; there are a few things and / or concepts that I can easily grasp. For example, I do not need to know how much macaroni and cheese the U.S. is going to consume next year to know that Kraft is going to be a top brand globally. Large macro trends are often easy to understand and with a little investigative research, it is relatively easy to expand a competency into an area of expertise. These areas of expertise, or core competencies, are a great advantage to the enterprising investor, and will act as the basis for future analytical reason. There are many cheap companies out there ripe for the picking, therefore, it makes little to no sense to extend into areas beyond comprehension or understanding. By understanding my personal competencies and interests, I find that I can focus my research efforts into areas that are more enjoyable and often even entertaining. You just need to know that when the big wave comes you are able and prepared to catch it.

Principle 2: The Approach
Not every person on the face of the earth has the time to commit to constantly monitoring their portfolio or making blockbuster trades all day every day. The reality of it is that each of us really has very little time and if your like me you really do not want to sit there all day and monitor your "stocks". Now if you have the time, commitment, or some superior level of intelligence to predict market trends, best of luck to you. I don't. Knowing this fact helps me to be really concise about my approach to investing. There are 2 primary things that I look for so that I do not need to spend day and night worrying about my investment choices. You may hear some people refer to a "defensive" strategy, or "value" strategy, or "growth" strategy. Well I am not quite sure were my approach quite fits into those categories but I can say that Benjamin Graham summed it up pretty well in the book "Security Analysis" when he stated that an investment provides protection of capital and a superior return, and anything else is speculative. That is a pretty simple way of saying do the analysis to understand your downside (risks) and your upside (profit). The purpose of having a sound approach or knowing your level of tolerance for risk is extremely vital in dictating how actively you can / may participate in the market.

Principle 3: The Criteria
Before beginning stock selection it is wise to establish a set of rules / criteria and analytical metrics that you are going to use as a benchmark for identifying opportunities. My approach to investing is generally to identify stocks that cost less than 20 times earnings (PE) or 1.25 times book value (price to book). Regardless of the approach that you have decided to take, it is important to identify a particular set of metrics for selection purposes. It is difficult to rationalize extremely high PE ratios, often in the neighborhood of 30 and beyond for extended periods of time. Obviously irregular market conditions may exist skewing an organizations multiple. It is important to always be cognizant of all of the variables that may impact your criteria.

Principle 4: The Screen
Once you have established criteria, determined your core competence, and established your approach, it is time to identify potential selections. A simple method for conducting such extensive screening is to utilize free online stock screeners that are provided through most of the major market watch websites i.e. yahoo, google, market watch etc.

Principle 5: The Selection
After identifying a list of stocks that are applicable to your methodology it is time to begin identifying the industries and companies that will compose your portfolio. This is probably the longest and most drawn out process. Often extensive research is conducted to identify which organizations "best" fit any and all preset criteria, and will offer the best long term value for the lowest price. Depending on the previous principles you have established for yourself within this methodology will determine the selection analytics that you choose. My preference includes a combination of valuation modeling, stress testing, and ratio comparison. The overall analysis of a particular security can be long and extensive in nature, but there are clear distinctions between poor organizations with haphazard managers and high quality organizations.

In later entries I will dig deeper into several tools that an investor may use to address their methodology applied to each principle. Depending on your personal methodology and competence you may find that you want to take a different approach than what is considered "investing" within this blog. I believe that thus far the methodology laid out is flexible enough to consider alternative approaches, however; as I proceed my personal methodology will begin leaning more towards valuation based investing and less towards trading / speculation.