Corporate Governance: Do Microcap Stocks Do Wrong by Shareholders? - Small vs. Young - Gannon On Investing - Gannon On Investing

A post worth reading if you're thinking of getting into small & micro caps.

Corporate Governance: Do Microcap Stocks Do Wrong by Shareholders? - Small vs. Young - Gannon On Investing - Gannon On Investing: "

"...microcap frauds tend to be in more speculative and young companies rather than purely small companies. A lot of small companies are also young so people get the two confused. Old microcaps are often like old big caps and young microcaps are often like young big caps..."

Goals of the Investment Plan

What I want to develop is a framework for investing that allows for the following three outcomes:

1. Preservation of capital
2. Income
3. Capital growth

I believe that all three can be achieved through a careful and thoughtful process that is backed by a disciplined and patient behaviour. Too many times I have seen (and experienced) jumping into a situation at the wrong time because of a lack of discipline caused by some other external factor.

So how am I going to go about achieving my three goals? Basically, the only real way I have experienced that has demonstrated any sort of robust results is one that views each company as a long term investment where the short term price shows a mismatch with the long term value of the company. Moreover, only when the short term prospects are largely ignored can the longer term prospects be understood. And at this point, we start to get a far clearer picture of the true intrinsic value of the business.

In fact, focussing on the short term prospects of a business is too difficult to get right in the broad majority of cases. This is where the visibility is highest and thus, the most information is reflected in the price. As I see it, market efficiency certainly exists - in the short term. In the long term, where business prospects are less certain, yet can be understood within a bounded range, pricing inefficiency is far higher.

However, taking this view is far harder to achieve than one may think. Sadly, the investment world is hell bent on achieving "outperformance" from month to month, quarter to quarter, and year to year. As soon as the focus moves to month to month and quarter to quarter the chances of out performance starts to diminish rapidly. Here, it is the short term market noise that becomes important rather than the true economic characteristics of a business. As the time horizon increases, so do the chances of market beating returns.

One of the key disciplines I'm hoping to achieve is not losing sight of what an investment really is. In fact, it would be safe to say that an investment is one that:

1. Protects the original investment
2. Gives some sort of income either through returning dividends or reinvesting back into the business at an attractive rate of return.
3. Shows an increasing output as the company grows over time.

This all seems very much like the goals for the framework I'm trying to achieve. In fact, this framework is just another way of articulating a set of steps for successful investing. So how will this be achieved? In short, the plan is to approach this whole thing in a systematic way that reflects a total purchase of the company. This is what could be called "the total purchase basis". As an approach to investment, this is where things start to get interesting as it forces the view of looking at each investment in a more business like fashion. What will I get out of the business, what are the prospects, and what am I going to pay?

Pretty quickly, it can be seen that the view of each business starts to resemble a true economic investment. There is little difference from buying a business with publicly listed stock and buying a business that is closely held. In the favour of the investor in publicly listed shares, prices are quoted daily and they may represent an undervalued, fair, or overvalued valuation.

This last point is important because it forms the basis for achieving the selection of investment candidates with the original three investment outcomes in mind. Companies that are cheap should see better yields, should see a better opportunity for preserving the original investment, and they should see better chances for capital appreciation as their prices move back to a fair valuation.

It is patently obvious that buying low and selling high is the foundation of most investment. Right? However, in practice this is easier said than done despite the fact that it offers some real an understandable way of achieving the three investment outcomes. For this reason, this methodology will focus on understanding the intrinsic value of each investment as a way of understanding the real position of each investment and the overall portfolio. In fact, it could be said that intrinsic value is the center of the process. If there is an understanding of roughly what something is worth then there is a rough understanding where the risk is. In abstract terms, could it be any simpler than this?

The Process of Investment

Now it's time to start developing a framework for investing. I've been meaning to do this for a few months now as I think I've now come far enough to see that there is a real need for a set of boundaries from which to operate within. What I will try to do is write down a set of overall principles and then expand on those principles as I go along. This is a totally iterative process that I intend to develop over time. It may not be right first time around but with numerous iterations I hope to get closer to the goal of something that is both cohesive and structured.

There are five general themes that I hope to expand upon:

1. Goals
2. Investment selection and disposal
3. Risk Management
4. Emotions
5. Academic & real world theories

These five themes provide enough of a breakdown for an end to end process of managing a well rounded portfolio designed to achieve its investment goals. This is not an over reaching, step by step set of hard rules, rather it is based on a set of principles that can be adapted to each individual situation spanning market caps and asset classes.

Like most plans, the best place to start is by defining the goals which being worked towards and at what point these goals are being successfully met. Capital appreciation, income, preservation of principle. Whatever it is, by setting an overall target the development of the plan is obviously far easier. This is probably not far off comon sense. I personally look first for preservation of principle over the long run with capital appreciation and income in between. Because of this, I'll write with these goals in mind.

Investment is a funny game because it plays with your emotions more than I could have ever imagined. It always feels like everyone has an opinion that they are happy to give and the market is apparently "always right". Brokers, colleagues, analysts, the press. It's always easy to let these external influences shape your investment thesis for better or for worse making true investment difficult in all but the best cases.

Having experienced the academic side of investing, it's striking how large the difference between academic investing and real world investing really is. In fact, I can see that the practicalities of academic studies are limited at best if they are not used to simply gain some sort of general insight into the workings of the world. There is a reason why Post Earnings Announcement Drift and the Price to Book value anomalies exist. Would you really want to invest in a company purely because it has beaten consensus forecasts or would you really want invest your pension fund into a basket of low Price to book value stocks despite the stocks having a low ROIC or being less than financially sound? In many cases this is not practical. However, these anomalies do provided an excellent place to start thinking about where to start looking for potential investment candidates.

Obviously, we also have the actual investment selection. This can only really be done in the light of the a holistic process the takes into account end to end thought and care. This is where a careful analysis of each investment case is done with the overall portfolio goals in mind. Here, we need to distinguish between investment and speculation along with what the investment gives you that you don't already have.

Often the focus is purely on what to buy rather than what (and when) to sell. I'm not a big fan of buying and selling for the sake of it as I often think the only ones to win out of this strategy are the brokers. However, at what point have we introduced too much risk into the portfolio through not selling out when the market cap has advanced too far. It could be argues that holding onto an over valued stock is the same as buying an overvalued stock.

Finally, tying all of this together is the risk management process which I believe should be at the center of the whole portfolio. Are we looking to preserve capital, build capital, or a combination of both? How is this going to be done and with what type of assets? How diversified will we be and what do we need to achieve our returns? These are all basic questions that need a set of principles from which we can work within. Once this part of the management process starts to break down then not only will the portfolio start to take on unwanted risk but the portfolio will start to resemble a set of random bets on success.

Of the five areas of this methodology, no one area can be used without the others. Understanding these five areas should create a holistic process for investment and investment management. At the end of the day, this process aims to create a way to allow for investment that is "business like" in order to achieve its goals.

The Problem With Being Qualitative

Qualitative analysis forms an important component of the analysis process however it should not be the start point. The problem with the qualitative factors is that there is no measurable way to determine just how much each factor is worth to the overall investment value. Adding to this, it needs to be asked just how much of the qualitative facts are already factored into the current price. This is impossible to accurately say.

One of the real problems with qualitative (as compared to quantitative) analysis is that an accurate appraisal can only be given after taking in all the influences on the business. In reality, this may prove to be impossible due to the unpredictability of everyday life and the lack of accurate comparators between different opinions. Quantitative analysis on the other hand takes given, measurable inputs to help evaluate any given model. By comparison, these inputs are far simpler to digest and model than what can be provided by qualitative factors alone.

Quantitative data is easier to obtain, easier to measure and compare, and there is less of it. Once the thorough quantitative analysis has been done can a qualitative analysis really only take place. In all cases of investment, an investor is looking to measure the value of an investment in way that can be compared and easily understood.

In fact, the numbers can probably tell a lot about the qualitative factors of a business. A good example of this is companies that have demonstrated a high return on capital over a number of years (long term). This is probably quite a good indication of a business that has some sort of competitive/strategic advantage over its competitors. Could a qualitative analysis show this? Most likely but it would not show the magnitude of the advantage. This is where I think many people go wrong. They attach too much to the qualitative factors without taking into consideration that these factors are already in the numbers contained within the accounts.

So where does the qualitative come on? One answer may be that they can be used to help gain understanding of how the situation could change going forward. How durable is the advantage and where will it come from in the future? What is management trying to achieve and are their ideas workable? What could destroy the advantage? Only when taken in this context does qualitative analysis begin to be useful for investment. Moreover, in many cases it is pretty difficult to put any value on the qualitative factors above and beyond what you've read in the financial statements.

Margin of Safety

The margin of safety is a concept tightly linked to the concept of intrinsic value. Without an intrinsic value, there can be no way to determine how large (or small) your margin of safety is. Understanding this relationship is important when trying to minimise risk in security investments.

Intrinsic Value
Intrinsic value is true value of an underlying investment based on factual information. Warren Buffet defined intrinsic value as "the current discounted value of the future cash flows that can be taken out of a business" whilst Ben Graham defined it as "the value which is justified by....assets, earnings, dividends and definite prospects".

Margin of Safety
Without an understanding of intrinsic value then this difficult to determine. This can be defined as the spread between the purchase price per share and the actual calculated underlying value per share. The wider this spread, the greater the buffer the investor has against downturns in the market and bad investment decisions brought about by the difficulties in evaluating businesses.

Simply, if you can't work out the intrinsic value for your business then how will you know what price to pay?

Random Nature

It's been a long time since I wrote my last post. I've been settling in at a new job, wrapping my mind around a whole new area, and getting life back on track after the last year of study. There has been a lot of changes in the markets since my last post (obviously) so it's interesting to reflect back on what has been happening and what it really shows. It turns out that even the main man, Warren E. Buffett, has made some bad calls. Undoubtedly he is still the king but it goes to show the random nature of the world we live in and how little we really know of what we are dealing with. Certainly, what is quite clear from all of this is that we have an incomplete understanding of randomness and its role in investment returns. Food for thought.

And again...

OK, I'm going to have another shot at this. I'm finding that I've got so many things going on that the last thing I want to do is sit in front of the computer in the evenings. Nonetheless, I'll try.