Value Investing and Mathematical Precision

Traditional value investors tend to be left-brained and logical. They love the precision and certainty of buying an asset for less than it is worth.  The "net-net" investment is a favorite of most value investors - buying stock in a company whose assets are worth more than the company's market cap.

This can certainly be a successful way to invest, and it does protect investors from some of the risk that all investors take that the economy could decline while you are holding your investment.

But "net-nets" and value investing are not the only way to invest. Ultimately, investors are attempting to buy a series of cash flows in the future for as little money as possible in the present.  Value investors love the precision of being able to calculate the future value of their assets to the dollar or even penny.  But precision should not be substituted for certainty.

The best investments involve the compounding returns that come from of investments in a business that grows over time.  These cannot be precisely calculated, but they can be estimated.  A lot of value investors shy away from the uncertainty of estimating future business performance, preferring to calculate something they are certain about, and they miss many great investments along the way.

There are some general rules we can use to estimate future business performance.  This post attempts to list some of them.  I am still hammering these rules out, and they will change over time:

1. When in doubt, assume the market has priced an asset or business as efficiently as possible given the available information.

2. Rule 1 is not always true.

3. If you believe an asset or business is priced inefficiently, you must try to find the reason why before investing.

4. People tend to act rationally as a group.  You should assume that they will do so.

5. Customers are people.  If it is not rational to buy a company's product, over time customers will stop buying it.

6. Brands that have a personality and are differentiated tend to make the most profits.

7. Businesses that get money up front before deciding on how to allocate their costs tend to have higher profit margins than businesses that are required to decide to invest large amounts of capital in their product before they make any sales.

8. Products with variable prices tend to have lower profit margins that products with fixed prices.

9. The market generally does not like uncertainty and lack of liquidity - these are two reasons why a company may be undervalued.
10. Newton found that "an object at rest stays at rest and an object in motion stays in motion (unless acted on by an unbalanced force."  Similarly, an unprofitable company tends to stay unprofitable, and a profitable company tends to stay profitable unless acted on by an unbalanced force.
11. All companies are fighting for their share of customers, profits and future cash flows in an evolution-like game.
12. A company must adapt and improve over time, or its future cash flows will be eaten by other companies that offer better services.
13. The laws of thermodynamics also apply to competition in business, with "entropy" being the shift in returns on the capital investments among competing businesses: (1) returns on investment cannot be absolutely created or destroyed forever - they shift from business to business because of innovation and social change; (2) over time, the return on invested capital among equal, competing businesses with similar capital and equally competent management will gravitate toward equilibrium (I will have to think about this one).

More to come...