Michael J Mauboussin: 9 points to grasp to become a good stock picker

Michael Mauboussin is an author and head of Global Financial Strategies at Credit Suisse.

According to him, a high-quality business is one that is profitable, typically as a result of high margins, has relatively low debt, a very capable management team, and a business that is unlikely to change abruptly in the near term. So essentially it is a business with a high return on invested capital and stable prospects.

Here are 9 points that investors must understand if they want to be smart stock investors.

1) Understand how a company makes money.

The idea is to distill the business to the basic unit of analysis. For example, the basic unit of analysis for a retailer is store economics. How much does it cost to build a store and fill it with inventory? What revenues will it generate? What are the profit margins? Answers to these and other questions should allow an investor to assess the economic profitability of a store, which he or she can then roll up to understand the overall company.

Great investors can explain clearly how a company makes money, have a grasp on the changes in the drivers of profitability, and never own the stock of a company if they do not understand how it makes money.

2) Understand a company’s sustainable competitive advantage.

A company has a competitive advantage when it earns a return on investment above the opportunity cost of capital and earns a higher return than its competitors. The classic approach is to analyze the industry and how the company fits in, and the common tools include the five forces that shape industry attractiveness, value chain analysis, assessment of the threat from disruptive innovation, and firm-specific sources of advantage.

Great investors can appreciate what differentiates a company that allows it to build an economic moat around its franchise that protects the business from competitors. The size and longevity of the moat are significant inputs into any thoughtful valuation.

Strategy and Valuation need to go together.

3) Understand how to link a company’s strategy with how it creates value.

One simple way to do this is to compare, line by line, two companies that are in the same business. Are their expenses comparable? Do they use capital in a similar way? Noticing differences in how companies spend money and allocate investment resources offers insight into their competitive positions.

(Strategy is about deliberately being different than competitors and requires making tough choices about what activities to do and not do. Operational effectiveness relates to the activities that all businesses need to do and hence does not entail choice.)

You can do a simpler analysis just by looking at the path to return on invested capital (ROIC).

You can break ROIC into two components: profitability (net operating profit after tax/sales) and capital velocity (sales/invested capital). Companies with high operating profit margins and low capital velocity are generally pursuing what Michael Porter, a professor of economics, calls a “differentiation” strategy. Companies with low operating profit margins and high capital velocity are following a “cost leadership” strategy. The analysis of how a company makes money spills directly into an assessment of how long the company can sustain its advantage (if ROICs are attractive) or what the company has to do to improve its economic profits.

ROIC provides less room for manipulation and is financing neutral. Other measures can be manipulated by changes in capital structure. So whether a company has no debt or a lot of debt, its ROIC is the same. But there are practical issues too that one needs to deal with when calculating ROIC, including the treatment of goodwill. For some companies, the difference is huge. For example, in fiscal 2016, Cisco's ROIC excluding goodwill is roughly 3x higher than it is including goodwill. If a company has been acquisitive and I would expect them to remain so, I would lean toward leaving in goodwill. If the company did a huge deal, is saddled with a lot of goodwill, and is not active in M&A, I would lean toward removing it. The basic idea behind excluding it is that you get a better sense of the underlying economics of the business.

4) Understand the importance of free cash flow.

Free cash flow is the lifeblood of corporate value. You calculate free cash flow by starting with cash earnings and subtracting the investments a company makes to generate future earnings. Investments include increases in working capital, capital expenditures above and beyond what is needed to maintain plant and equipment, and acquisitions.

Free cash flow is what is left over after investments have been subtracted from cash earnings. It is also the sum that a company can return to its claimholders in the form of interest payments, dividends, and share buybacks, without jeopardizing a company’s value creation prospects.

Earnings are the most widely used metric of corporate performance. But it is easy to show that growth in earnings and growth in value are distinct. Companies can increase earnings and simultaneously destroy value if the investments the company makes don’t earn an appropriate rate of return.

5) Understand value (the present value of free cash flow).

The landscape of investing has changed a great deal in the past three decades. It is interesting to consider what about investing is mutable and what is immutable. The investable universe is in flux. Conditions are always shifting because of unknowns including technological change, consumer preferences, and competition.

One concept that is close to immutable for an investor is that the present value of future free cash flow determines the value of a financial asset. This is true for stocks, bonds, and real estate.

Valuation is challenging for equity investors because each driver of value—cash flows, timing, and risk—are based on expectations whereas two of the three drivers are contractual for bond investors. Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow.

Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within its industry, barriers to entry, the economics of the business, and management’s skill at allocating capital.

A corollary to this attribute is that great investors understand the limitations of valuation approaches such as price/earnings and enterprise value/EBITDA multiples.10 Indeed, multiples are not valuation but a shorthand for the valuation process. No thoughtful investor ever forgets that. Shorthands are useful because they save you time, but they also come with blind spots. As Al Rappaport says, “Remember, cash is a fact, profit is an opinion.”

6) Understand that expectations differ from fundamentals.

Fundamentals capture a sense of a company’s future financial performance. Value drivers including sales growth, operating profit margins, investment needs, and return on investment shape fundamentals. Expectations reflect the financial performance implied by the stock price.

Making money in markets requires having a point of view that is different than what the current price suggests. Michael Steinhardt called this a “variant perception.” Most investors fail to distinguish between fundamentals and expectations. When fundamentals are good they want to buy and when they are poor they want to sell. But great investors always distinguish between the two.

Horse racing is a good example. The amount bet on a horse gets reflected in the horse’s odds, or probability, of winning the race. The goal is not to figure out which horse will win but rather which horse has odds that are mispriced relative to how it will likely run the race. Fundamentals are how fast the horse will run, and expectations are the odds. You need to consider those elements separately.

7) Understand probabilities.

Investing is an activity where you must constantly consider the probabilities of various outcomes. This requires a certain mindset. To begin, you must constantly seek an edge, where the price for an asset misrepresents either the probabilities or the outcomes. Successful operators in all probabilistic fields dwell on finding edge, from the general managers of sports franchises to professional bettors.

When probability plays a large role in outcomes, it makes sense to focus on the process of making decisions rather than the outcome alone. The reason is that a particular outcome may not be indicative of the quality of the decision. Good decisions sometimes result in bad outcomes and bad decisions lead to good outcomes. Over the long haul, however, good decisions portend favorable outcomes even if you will be wrong from time to time. Time horizon and sample size are also vital considerations. Learning to focus on process and accept the periodic and inevitable bad outcomes is crucial.

Great investors recognize another uncomfortable reality about probability: the frequency of correctness does not really matter; what matters is how much money you make when you are right versus how much money you lose when you are wrong. This concept is very difficult to put into operation because of loss aversion, the idea that we suffer losses roughly twice as much as we enjoy comparably sized gains. In other words, we like to be right a lot more than to be wrong. But if the goal is grow the value of a portfolio, slugging percentage is what matters.

8) Understand the role of luck.

Luck plays a huge role in determining results in investing, especially in the short term. Luck is also prominent in business strategy and card games —including blackjack and poker. One way to think about the difference between the results for pianists and poker players is to visualize a continuum with all luck at one end and all skill at the other. Then place activities along that continuum. Roulette wheels and lotteries are on the luck side, and swim and crew races are on the skill side. Most of the action in life sits between those extremes.

The reason luck is so important in investing is not because investors are not skillful in the aggregate. It's actually the opposite. Investors are collectively pretty efficient at incorporating information into stock prices, which suggests that only new information moves stocks. I call this the "paradox of skill." As skill improves it tends to become more uniform, which means that luck becomes more decisive in determining results.

So how should you pick your mutual fund? The answer is to focus on process. When luck is involved, a correct decision leads to a good outcome only with some probability. Play your hand perfectly at the blackjack table and you still may lose because of the bad turn of a card. It's also true that a poor process can yield a favorable outcome by dint of luck. But a good process provides the highest probability of success over time.

9) Understand the importance of knowledge.

A multidisciplinary approach is best for solving complex problems, including those in investing. Too much of our learning narrows perspective. We can gain great insight by learning the important ideas from various disciplines and appropriately applying them to investing. Almost everything you can read—from science to literature to psychology—can make you a better investor if you’re willing to make connections.

The multidisciplinary approach requires lots of time with no clear assurance that what you learn will be directly applicable to investing—at least not immediately. Also important is temperament and a willingness to make connections or draw analogies across apparently disparate topics.

Most investors get caught up in busy work such as excessive trading or trying to absorb the torrent of information that the financial community produces.