"Trust the process."
That's what highly regarded Florida State University football coach Jimbo Fisher tells his players, over and over again. Trust the system we've created here. Learn it, and you'll be successful.
Fisher is a brilliant gridiron tactician who has built a first-class, state-of-the-art training and development system. My nephew is a redshirt freshman on this year's team… And he has nothing but high praise for "the process," which is drilled into them during daily six-hour practice sessions.
A superior process and greatness often go hand in hand in athletics. This is also true for investing.
Serious investors would be wise to learn to trust the process that generates winning investment results…
I'm referring specifically to the process recently laid out in "Reflections on the 10 Attributes of Great Investors," an essay by Michael J. Mauboussin. He's a prominent value investor, author, and longtime adjunct professor at Columbia University.
Investors seeking a winning process they can lean on day after day should consider Mauboussin's list an early holiday gift. Today, I'd like to review the first five of Mauboussin's 10 attributes.
||"Be numerate (and understand accounting)."
You don't have to be a savant or an accountant to be a successful investor. You do, however, need to be comfortable with numbers to find companies worthy of your investment capital.
Mauboussin says the first goal of your analysis should be to "translate financial statements into free cash flow." That's what's left after you subtract capital investments from cash earnings.
Ultimately, free cash flow ("FCF") is the precious capital that management has at its disposal to enhance shareholder returns (dividends or share repurchases) without jeopardizing the company's future value-creation prospects. That's why it's far more important than net income. As regarded economist Alfred Rappaport likes to say, "Cash is a fact, profit is an opinion."
||"Understand value (the present value of free cash flow)."
Great fundamental investors never forget that a business' intrinsic value is the present value of all of its future FCFs. That's why they're just as concerned about cash-flow sustainability as they are about magnitude.
Half a century ago, legendary value investor Warren Buffett knew he had found a winner in insurance agency Geico because its hard-to-duplicate low-cost business model ensured annuity-like FCFs that would continue through today.
When you're evaluating a company for the first time, ask yourself: Does the company consistently generate FCF year after year, even during difficult economic periods? When the answer is yes, it's a business you definitely want to learn more about.
||"Properly assess strategy (or how a business makes money)."
Mauboussin says great investors can clearly explain how a company makes money, can grasp any changes in what drives its profitability, and will never own a company's stock if they don't understand these crucial factors.
In other words, there's absolutely no shame in keeping it simple. If you don't understand how a business makes money, move on to the next one.
||"Know the difference between information and influence."
Mauboussin says it best…
Great investors don't get sucked into the vortex of influence. This requires the trait of not caring what others think of you… Success entails considering various points of view but ultimately shaping a thesis that is thoughtful and away from the consensus. The crowd is often right, but when it is wrong you need the psychological fortitude to go against the grain.
||"Compare effectively (expectations versus fundamentals)."
Mauboussin believes that what really separates great investors from everybody else is their skill at comparing a given company's "fundamentals" (i.e. sales growth, profit margins, capital structure…) with the "expectations" implied by its stock price.
Rather than attempting to estimate how future FCFs might look over the next decade for a given company, the idea here is to estimate the level of growth currently baked into the stock price, then correctly anticipate any changes that aren't yet fully reflected in that price.
Buying a stock before other investors recognize the disparity creates the opportunity to earn a superior return.
It's also important to keep in mind that great businesses with bright, long-term outlooks don't always deliver superior returns. That's because the lofty growth expectations are already baked into the stock price.
For instance, if a business is likely to grow 20% per year for the foreseeable future, but investors have pushed its share price so high that said growth is already reflected in the stock price, you're destined for modest investment returns (or worse) – unless the company can somehow accelerate growth expectations even higher.
In short, as Mauboussin sees it, those aspiring to investment greatness must become adroit at comparing a company's fundamentals with the expectations implied in its stock price. Superior returns await those who do.
Tomorrow, in Part II, we'll review Mauboussin's remaining five attributes of great fundamental investors. Until then…
P.S. If you're interested in improving your investment knowledge, be sure to check out my colleague Dan Ferris' book, World Dominating Dividend Growers: Income Streams that Never Go Down
. In it, you'll learn why certain companies are incredible income investments… how to identify them… and how they can produce safe, double-digit annual income streams. Get your copy here