“Value investing is an art”
This is one of the most common thing you will hear from the great value investors. Even though I accepted their opinion, it always annoyed me. Because if something is called an art, it implies that it is abstract, and therefore, cannot be methodically learned. If you and I are not born with the artistic knack for value investing, we cannot become a successful value investor.
I believed it until I read Josh Waitzkin’s book The Art of Learning. This book made me realize that:
– Grandmasters (so called artists) of any fields have entrenched fundamentals of the field and models (frameworks/principles/heuristics) deep into their brains through years of curiosity, practice, introspection, and learning. These fundamentals, and models become second nature to them. Overtime, their subconscious is able to automatically apply these fundamentals and frameworks needed to excel at the task at hand, without much or any effort consciously. And because the spectators cannot see the subconscious, they often equate the great output without lack of conscious effort as Art.
– One can methodically become an “Artist” (great at something).
With that clarity in mind, and learnings from the Josh’s book, I came up with a blue print/pathway to become a good value investor. But before we get to it, here are the prerequisites and a few disclaimers:
- This pathway focuses on “HOW” but not “WHAT”. It will help you improve your process. “WHATs” of value investing are covered in my other posts.
- My pathway will help you with learning, and introspection. But you need to be internally curious to pursue value investing.
- I am not an experienced value investor (investing only since 2019). Therefore, take it with a grain of salt. Don’t accept any steps of the framework as given. Question them at each step of the way.
- As I go through my own journey, I will sharpen, expand on or modify the framework.
- The points in this framework are not totally linear and not totally parallel. Learning anything is a continuous process in which feedback from outcome goes back into updating your process, information or both. Therefore, use the steps in the framework as continuous, linear and also parallel.
Having established the groundwork, let’s explore the “HOW” to learn art of value investing over time.
1. Master Fundamentals using separation and investigation.
Obviously, understanding key terms related to investing is essential. We need to know meaning of different terms in accounting, finance, business, markets, and economics. In short, we need to learn the language spoken in the world of investing. The issue is that even though most of us read through these terms, we don’t internalize it. We fail to fully absorb and apply these concepts.
Example: Almost every investor knows what “buybacks” mean in the stock market – 2% buyback means buyback means that the number of outstanding stocks of the company has reduced by 2%. But most of them would fail to internalize the impact of the buyback – How does the buyback result in cash back to investors? What will happen in 5 years, if 2% buyback continues every year? What will happen to buybacks if the company also issues Stock Units to its employees?. Most of the new investors have no idea.
To make it easier to absorb real meaning of this terms, you can use the separation and investigation method. Instead of learning many terms together, as we often do when we start, separate the term, and investigate to absorb it.
For instance, if you are learning different tools of capital allocation like buybacks, stock issuance, IPOs, dividends, etc. Don’t learn the meaning of each of these terms together. Separate pieces. Pick up one – buybacks. Then use investigation to absorb. At a minimum ask 5 questions (more the better) and cover What, How, Why, When?. How does the company do buybacks? When should management avoid buybacks? What happens to the stock if there are buybacks? Why do growth companies avoid buybacks?
This will help you understand each term beyond its definition, and entrench it in your brain. In future, while you are researching a company to invest, your brain wont have to work too hard to recall what the term meant, and it will free up brain power to understand the business better.
2. Learn time-tested Principles, Frameworks and/or Heuristics.
Once you understand the language of investing (at least the common terms), learn the time tested Frameworks, Principles and/or Heuristics that high achievers in the value investing field use. These are often formed through years of observation, learning from mistakes, experience of the greats in the field.
These will help you filter out the noise that comes with so much information related to the company, market and the economy. It will also help you structure your thoughts, filter out risky businesses, gauge management quality, narrow your focus on better businesses, etc.
The best way to get started is by finding the list of great investors, and read about them from the first level source – biographies, autobiographies, or self-written books, and also from second level source – books/papers that deconstruct great investments and talks about the frameworks used to find these great investments.
3. Apply Frameworks “Consciously”
Once you learn and absorb a framework, try to apply them consciously. By this, I mean intentionally applying a single framework to analyze few businesses and see what it tells you. Did it help you with what it was intended to do? Did it simplify the process for you or help you with filtering bad options?
For instance, after you learn about “How to use payment terms of the business to understand strength of its moat” , use it to analyze multiple companies (at least 5). And consciously ask yourself on how did the framework help you filter out bad companies from the good ones. What made the good companies better w.r.t payment terms than the bad companies.
This method will help you solidify the framework’s important or application in your brain. It will add to the tool-set you can use for analyzing potential investments. And by asking questions after applying the framework, it will also help your brain understand the effectiveness of the framework.
4. Apply frameworks “Subconsciously”
Overtime, as you develop deep understanding of basics, and frameworks, your brain will develop strong connections among different pieces of information, fundamentals and frameworks in your brain. This is when you will find your brain perform the magic.
While analyzing a company, you will find that you are able to reach to a qualitative decision much faster and without less effort. Even without consciously applying any frameworks. It is simply because now your have pre-programed your brain with enough tools, and rules it needs to figure things out for you. In short, your subconscious is in action. Some also call it “In the flow”.
To get better at it, it is important to keep repeating steps 1 through 3 regularly. It will help your brain to make those connections even stronger.
However, there is a catch. To unleash the power of your subconscious, you need to make a conscious effort to not overwhelm your brain. Personally, I have observed that my brain works best w.r.t analyzing businesses if I am happy, relaxed, and not overstimulated.
5. Gather Feedback from Experiments and Experiences to update your Operating system.
With time, you will improve at investing but also experience many failed or missed opportunities. It is important to deep-dive into these and find out what were your blind spots that caused it.
For instance, if your investment failed – was it because you didn’t understand the company or industry well? or was it because you didn’t understand the management well ? or was it because you didn’t understand the capital structure well and therefore missed that company’s debt was a major red flag?
Once you identify the reason, find out if there was a way to know it before hand? is there any framework or Heuristic that you can use to catch it next time. Then go back to step 1 to 3. Overtime, you will find out many blind spots. One way to tackle them at least while you are in the process of internalizing related framework is to have a comprehensive checklist. Use this checklist to analyze the business before making the decision. Here is the example of the checklist I use – Checklist to analyze businesses for long term investing.
Final Thoughts
By now, you can see that there is no magic or shortcut provided in this framework. It is simply a process to preprogram and strengthen your brain, improve your awareness, and invoke the power of subconscious while practicing value investing. That is what makes it effective. Since the last 3 years, it has helped me improve the quality of my investment decisions immensely, and also eventual results. It will help you too.
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