I think being rational – making decisions inspite of your emotions telling you otherwise, based on facts and data is very critical to successful investing. I try very hard to be rational in making my investing decisions (though I am not successful a lot of times). So if rationality is an important goal for me, what do you think would be one of my most irrational activities?

I would say without hesitation – writing this blog. I have written over 400 posts on this blog and have been writing for close to 6 years now. 90% of the content on the blog is original – I don’t cut paste someone else’s content. If I cannot write something interesting, then why bother?

Now each post takes me around 1-2 hours to write. So If you do the math, it means almost 800-900 hrs of effort till date. This would amount to almost 3-4 months of lost income, as this blog makes next to nothing. So the point is why am I doing it?

I can list quite a few reasons now, but when I started in 2005 I had none. I tried thinking of some rational ones then, but as I could not think of anything I realized that the only reason was that I loved doing it. Some people like to watch TV, some like to paint and I like to invest and write (talk of a boring interest !!)

The start of investing
If I dial back time a bit further, the same situation existed at the time I started learning about investing. The first 3-4 years in the late 90s were a complete wash in terms of income. I made quite a few mistakes, but still managed to do fine in terms of the returns.

However if I look at the absolute amount of money I made in those days, it was peanuts. The only reason I kept doing it was that I enjoyed the process a lot. The income is now meaningful, but I love the process even more.

Being better at it everyday
I personally look at investing as an intellectual activity, where my measure of progress is not the returns alone, but also if I am becoming a better investor over time. It is always difficult to be very objective about it, but I feel I am a much better investor now than I was in 2005 – though I have no quantitative measure to prove it.

I will make a bold claim now. If some of you like me are not professional investors and are into investing because you love the craft, then it is a given that you will improve year on year, inch by inch and will do well in the long run. How will it be otherwise?

What about the money?
By the way, in case you are thinking that I am being hypocritical and don’t care about the money, that’s not true. I do care about money – have a family to feed :). Its just that investing and blogging in my case is more than just about money. If it was only about money, I would have never started it.

A surprising conclusion
I have come to a very surprising conclusion due to the above experience and based on what I have read about others. If you love doing something and really don’t care what others think or whether you will succeed or not, paradoxically you will get better over time and actually be more successful at it than you originally imagined.

What makes me think I am now more successful at investing? My wife now thinks that this odd thing her husband does on the side may amount to something 🙂

A typical research report provides you with a few years of historical data and a year or two of forecast, especially of sales and netprofit. The better reports may also include some kind of valuation based on PE and discounted cash flow to arrive at an estimate of fair value.

Most of these research reports, atleast the ones for which you don’t pay much will stop at this point. To be fair to the producers of these reports, you get what you pay for – in this case next to nothing.

The point is that these free reports provide only the basic quantitative information needed for a decision. One cannot make a purchase only on the basis of numbers without understanding the context of these numbers

What is the meaning of context ?
A company usually operates as part of an industry and is impacted by the various competitive forces of the industry. For example – if you operate in the FMCG industry, advertising and distribution is a major part of the expense. In a similar fashion, fuel, raw material and power are big expenses for a cement company and advertising is nice add-on, though not a competitive differentiator.

So if you are analyzing a consumer goods company, you have to focus on the advertising expenses. In addition you will also have to understand the width and depth of distribution, brands recall, performance of new products and similar such non-quantitative details.

In case of a cement company, one has to compare the cost of production of the company with other competitors and understand if the company has a sustainable cost edge over other companies.

It is important to understand that the financial numbers of the company have to be evaluated not only on the basis of time (past numbers) but also with reference to other companies in the business (national and international). It is a rare report, that goes into this level of detail.

Beyond the context
The exercise of calculating fair value of a stock is essentially trying to estimate the future of the company. It is silly to attempt mathematical precision in this task. One of the common criticisms of analysts is that their forecasts are generally wrong. I think it is stupid to expect any better from them. The world is far too complex for any person to be able to forecast anything in short term, forget the medium and long term.

I have a fairly elaborate template for analysing of a stock. An elaborate template does not make the analysis any better – it only ensures that I do not missing anything important. If you scan through the template, you will notice that I have a few sheets for DCF (discounted cash flow) analysis.

Now if I don’t consider DCF to be the end all of a stock analysis, why do I still do it? The main reason for doing a DCF analysis is to play around with various scenarios (in terms of sales and profit growths) and attempt to see how these scenarios have an impact on the fair value.

The standard approach for doing a DCF analysis is to look at the past numbers and to simply project them into the future, with minor variations in the numbers. The problem with this approach is that it is too simplistic.

A good starting point is to project the past numbers if you strongly feel that the past is a good indicator of the future. However it is important to look at possible scenarios in your valuation – try an optimistic scenario where everything works as planned and a pessimistic scenario when almost anything which can go wrong will do so. This approach will give you an upper and a lower bound to the fair value of the company.

How do you know what numbers to plug in for the two scenarios? This is where context of the current numbers and a qualitative understanding of the industry and the business comes into play. One has to have a sense of the business and the industry to put any meaningful numbers

The above approach takes away the need to make precise forecasts. You are now working with a range of values, which can re-worked as new data comes to light over time.

But this is all fuzzy !!
Absolutely right ! I personally feel that quantitative aspect of value investing is not more than 20% of the effort (and even that is an over estimation). The ‘numbers’ part of investing is the minimum. I will not invest in a company which has a high debt, is losing sales and has been making a loss for the last few years.

The first step I take is to look at the numbers to figure out if I need to dig deeper into the company or just move to the next idea. This step usually takes a few hours at the most and with practice and some automated options, it can be done even faster.

The real work starts after this first stage. There is no fixed formulae or approach for investing, but I will usually read through a couple of years of the annual report of the company, read about the competitors and understand the economics of the industry. Once I am done with a round of qualitative analysis, I fire up my DCF spreadsheet and plug in numbers to arrive at a range of the value. Over time I have realized that this step rarely throws any surprises.

If you do this exercise for a decent amount of time, you get a rough sense of the valuation as you are looking at the numbers. For ex: a company growing a 10-12% with an ROE of 15-20% would come to a PE of around 17-20 times current year’s free cash flow.

An example
Let me give an example from my past experience to illustrate my point. I analysed a company called MRO-TEK in late 2007. You can read the analysis here. One of the key negatives for the company was that it was a small company in an industry which is dominated by the likes of CISCO and LUCENT who have R&D budgets which are a 100 times the annual revenue for this company.

I identified this negative fact, but there was no way to quantify this business risk. The last few years of data looked fine and stock appeared to be undervalued at the time. Fast forward to 2010 – The result for 2008 was a high water mark. The performance of the company has been sliding since then with the topline having dropped by 50% and the operating profit has turned negative. The company is simply operating in a fast changing hypercompetitive industry, where it is very difficult to make a profit.

I had a sense of this fact, but did not appreciate it fully (I am a slow learner 🙂 ). If I had not been lucky in getting a quick exit, I would have lost money on this. This idea was a case of sloppy analysis, where numbers would not have helped.

Is there a secret formulae?
There is no secret formulae for investing (if you are into quantitative investing, it’s a different story). At a certain level effective investing is very subjective in nature. It involves reading and digesting a lot of information and then combining it with your existing knowledge and experiences to come up with an estimate of fair value for the company

Unfortunately there is no shortcut in becoming a decent investor. One has to love the art of investing and be willing to learn and make small amounts of progress each day. Over time, the learning accumulates and you keep getting better at it.