Financial Independence: Advanced Investing

Part III in a series of posts on getting started on financial independence and resiliency. The initial impetus for this came from COVID Career Advice . The first post in the series focusing on making yourself resilient is Getting Started on Financial Independence: Financial Resiliency .

Part II focused on getting started growing your assets and investing once you’ve sorted your basic financial hygiene out.

This post focuses on moving into slightly more advanced investment topics and strategy around building your portfolio.

If you haven’t, and even though it’s a #longread, I highly recommend reading the posts from the beginning and at a minimum going through the 80/20 financial exercise if you’re not already in a position of setting aside 10-20% of your monthly take home for financial growth.

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While just investing in ETFs as we did in Part II is a totally valid strategy (low maintenance, sustainable, inexpensive, and noting that few pickers outperform the S&P over the long term), as your knowledge of investing and companies grow, you’re probably going to want to invest in other companies who prospects you feel strongly about.

Everyone wants to brag a teeny bit at picking that 10 bagger (a stock that increases 10 times over what you bought it for) before it hit the big time. But… it’s a good idea to learn more about investing and how companies work before buying stocks on popular opinion or “gut feel”. You’re speculating and gambling then, rather than investing.

What you want is a reasonable, repeatable, validated way to make good decisions about investing and verify in the future that your decisions are still sound.

So, if you want to make better decisions, how do you get started? I’d suggest fice approaches. Mix and match them as you like:

1. Education
2. Invest in Great Companies
3. Have a Strategy
4. Keep a Decision Journal
5. Do Research and have a Decision Checklist

1. Education

Learn about how business works before going crazy with the stock investing outside of ETFs. Limit the chances you’re rolling dice or swayed by hype (of whoch there is loads).

What do you need to learn? I’d suggest the following:

1. Accounting and business basics
2. Intangibles and network effects
3. Good stock investing courses and books

Accounting is the language of business. Learn to speak it. Minimally, learn how to read an Income Statement and Balance Sheet. You will learn a lot about a company from their required stock filings and the key metrics you can derive from these critical documents.

Read up a little bit on new economy ideas as well. Lots of companies nowadays are successful because of things other than what have made traditional product companies successful and understanding the underlying value propositions there will make you a better investor. A good introduction to the ideas of network effects, intangibles, ecosystems, and similar ideas which you do not generally see reflected on balance sheets is the book Capitalism without Capital .

You can think of intangible investments that firms make, software, network effects, and intellectual property as giving them 4-S advantages: scalability, sunk costs, spillovers (other companies and people benefit), and synergies. For example, tiktok is valuable because of its network, which grows in value with the people that get added to it, which also allows them to scale, and spillovers which allow an ecosystem of creators around it which reinforces its value yet again (again though, since we find people grow and wane on platforms, whether that is a good investment or not financially is a different story, but the point of some firms being valuable because of their intangibles is hopefully clear.). Also, always remember to answer the question with these firms “how do they make money?”. A lot of companies have rather sketchy paths to profitability and its a good idea to understand if you want to take that ride.

I also recommend if you are getting your feet wet, to take some basic investing courses or read some basic investing texts. Coursera, Udemy, and similar online platforms have some great beginner investment courses and you will not suffer from spending a day or three on learning the basics of how it all works before getting plonking down money. Again, be careful to separate out the idea of speculating versus investing in any course or book you read.

Another great resource is an annual subscription to the Motley Fool , which provides stock recommendations and analysis and solid resources for building a portfolio, and in general, has a good approach to long term investing and value (imho).

2. Invest in Great Companies, not Stocks

Trite perhaps, but a good thing to keep in mind when investing.

This is what Warren Buffet is famous for and what people say is the secret to Berkeshire Hathaway’s success. Buffet never “buys stocks”. He buys companies. And he and his analysts do an extensive amount of work figuring out what a good company is and then pouncing when they believe they know what a good price for that company is. He has described their approach as “lethargy bordering on sloth” (which you kind of have to love).

Besides looking at financials, management, strategy (exhibited, not stated), and sentiment, often a more fuzzy test I think about is whether I would want to work for the company and feel excited and not worried about it from work, meaning, financial, and societal well-being (I’m often trying to encourage a future I want to be living in) perspectives.

Also, full disclosure: I never directly invest in firms I feel cause fundamental harm — exploitative resource extraction, tobacco, highly processed foods, or armaments firms. I also try to avoid “hype stocks” driven by sheer speculation rather than underlying value. I also never short-sell as I feel it’s fundamentally value-destroying. YMMV.

3. Have a Strategy

The hard thing about strategy is restraint. Choosing. Saying no.

There will always be more opportunities to take advantage of and shiny, promising equities than you have money to spend on. The hard thing is exercising discipline, having a clear, reasoned process for what you will look at (and not look at) and for making hard yes/no decisions to invest.

It’s often a good idea to think more about your portfolio that any individual stock. People get obsessed with individual stock picks, rather than being more concerned with their overall portfolio. And the reason you have a portfolio is to diversify risk while still getting returns.

Some people never want to lose money on anything they buy. If your appetite for risk is low, you will need to invest in stable stocks with lower volatility, accept lower returns, and plan for that. If you are on a fixed income, even if you have a high appetite for risk, the smarter thing to do is to move to dividend providing and lower return/risk stocks to support a budgeted drawdown rate that maintains your capital against returns.

Asset allocation is another way to handle this. Effectively split your portfolio into percentages of stocks that deal with mix categories of stocks and asset classes to insulate against downward shocks, but perhaps have a small percentage of high growth potential stocks to keep overall portfolio percentages higher than they would be with purely safe stocks.

Some people go to extreme lengths to try to have an “evergreen” portfolio, one that effectively always returns a near fixed rate of return regardless of economic conditions, using a fix of cash, gold, real estate investment, bonds, stocks etc which they believe has been shown through historical analysis and backtesting to alway give a rate of return with surety (note: however that historical performance is no guarantee of future performance).

I personally stick to stock areas I’ve learned about and have confidence in. If I don’t understand something, or can’t figure out how they intend to make money (or am dubious about their prospects and think they are overhyped), I generally avoid buying shares. This has helped me avoid some bad purchases much more than it has talked me out of stocks I would have made money on.

Even though there are stocks I sometimes find attractive, if it’s outside of strategic areas I stick to, or stocks that do not fit a certain profile (eg dividend vs growth stocks), I forego it rather than be opportunistic (though, then like most people, kick myself for not buying it when it goes up in value.).

4. Research and Keep a Decision Journal

This may sound nerdy as hell, but it’s led to me making better informed decisions on both buying and selling.

When I run across interesting stock or opportunity I throw it into a page on my monthly investing sheet.

When it’s time for my monthly stock purchases, I take a look at my notes on the new month and benchmark the portfolio. For example, if I feel I’m overinvested in biotech and tech stock in a particular month due to how the portfolio has grown, I’ll perhaps look at pure fintech plays for my picks this month.

I look through the stocks I have invested in and then research the 1 or 2 potential new stocks I might want to add vs my incumbents.

I write myself a little note on the month on why I feel good about them and why I think they have good prospects. Try to keep it to 3-5 short sentences. Document assumptions, note metrics you like, and if possible, reasons against investing as well. So, if assumptions, metrics, or reasons against change, you can easily reevaluate your decision and sell.

From simply keeping a log of investment decisions you get:

1. Better decisions about your money and buys
2. Documented assumptions to look back at (and reflect on if they change)
3. Force yourself to focus and reflect on where it will go
4. Indicators on when you should get out of a stock (if you must).

For example, one company’s major (and almost monopoly) client has recently started making moves to diversify away from the producer. If they can’t find other customers to make up demand, they’ve got a problem and I should take my profit and move on.

5. Have a Decision Checklist

Checklists are your friend. If you’re never read it, I highly recommend reading Atul Gawande’s The Checklist Manifesto which, through simple checklist procedures, unambiguously saved lives in hospital settings. Applying the same idea to your decision making might save yours.

Basically, we’re not as rational as we think. It’s easy to get emotional or swayed through confirmation bias about stocks. Your decision checklist should allow clear yes/no decisions on a purchase that you will stick to. Given the checklist, does this equity pass the threshold for purchase and based on your strategy?

My checklist is a riff off of similar ideas from @10kdiver and @BrianFeroldi, both of whom have nice approaches to thinking about this which I fused and riff on.

So, what does a check list look like? Yours should be specific to you and your investment goals, but I can broadly outline my thinking on each of these categories.

1. MOATs - competitive advantage that protects returns
2. BOATs - innovation or acquisitions that diversify and increase revenue streams
3. GOATs - management and staff that’re focused and mission-driven
4. QUOTEs - a price that makes sense in relation to financial metrics and trajectory

In general, I give a qualitative 4 rank rating to each of the elements in the categories: Bad, Weak, OK, Strong. You can assign values from -1 to 2 for these if you want a more quantitative approach to these and add up to a score, but for me it ends up being a pass/fail on the category unless something is so bad I feel it overwhelms all the other strongs (for example, a questionable CEO or something being wildly overpriced due to popularity will often make me fail a buy decicion on a stock).

The key thing is the Strongs add up to create the overall impression of the buy decision for me.

1. Moats

I like thinking of moats as company defence. What the company does to fend off competitors and keep new entrants from nibbling at profitable market segments or disrupting its business model? What is its competitive advantage in the space? I look at the following:

1. MINES (Monopoly, Intangibles, Network Effects, Ecosystems, and Synergies)

   This is about how things like brand will make people pay a premium (Lululemon), or how every person that joins Instagram adds to the value of other people joining Instagram (Network effect), or how the way everything works seamlessly together in the Apple ecosystem means you gain benefits for buying interconnected products you would not get by buying a competitor (and think of the competitive advantage and cash cow the Apple app store is).

   Effectively, how does the product increase its value to you through its peripheral effects, and increase its value and attractiveness to other people purchasing it: Techs, Patents, protections and licenses.

   Competition is great for consumers, but firms attempt to build moats to shore up their market positioning. There’re legal or technological ways to do this.

   Patents are legal protections for firms for them to encourage investment in R&D to drive innovation (though some firms use them for anti-innovation purposes such as Amazon and the infamous one-click payment system. ASML and 5nm lithography. They basically have a cornered market on the machines etching the chips.

2. Switching Costs

   How hard is it for customers to move away from the product or service once they are on it? Either due to the difficulty of finding a comparable product, perceived costs of migration, or interruption to service or benefit? Is it painful, due to investment, migration, or learning curve to switch to another competitor?

3. Durable Cost Advantage

   Can the company produce their products at lower cost than their competitors and keep their COGS (Cost of Good Sold) lower than their competitors can? For example, besides simple manufacturing capabilities through some process or efficient operations, these can include scale (buying power, spreading costs), physical location of stores or convenience, and supply chain and distribution and logistics issues (for example, Amazon fulfillment centers are amazingly located and efficient, but effectively take up spaces and locations it would be difficult for a competitor to have now, further blocking competition.).

2. Boats

Think of the world 15 years ago and how much has changed. Companies that were vastly smaller then are giants today. And the primary driver has been innovation. A company’s ability to innovate and drive into new markets through disruption is one of the things I look for in a company I am investing in. This is also sometimes called Optionality. How often does a company make a big bet on something that is often a legitimate logical extension to their core value propositions or leverages something they already are doing well. Note: Be careful here. There’re companies that may look like they are optionality strong, but are flailing into new areas in a desperate attempt to appear innovative and appease or attract investors (eg. a travel and experiences company moving into food delivery).

1. Innovation and Optionality

   Think of the world 15 years ago and how much has changed. Many companies that were vastly smaller then are giants today. The primary driver has been innovation. A company’s ability to innovate and drive into new markets through disruption us one of the things I look for in a company I am investing in.

   This is also sometimes called Optionality. How often does a company make a big bet on something that is often a legitimate logical extension to their core value propositions or leverages something they already are doing well. Note: Be careful here. There’re companies that may look optionality strong, but are flailing wildly into new areas in a desperate attempt to appear innovative and appease or attract investors (eg. a travel and experiences company moving into food delivery).

   Look at the track record of what they’ve tried and the logical reasons for them undertaking that (do not punish failures if they really did make sense though).

   How is R&D used in companies where that make sense? Are they solving serious problems that the company would have or is much of it unserious moonshot? What percentage of their actual budget is for R&D and how much of that has actually paid off for them in new products and patents (a moat in itself).

2. Counter positioning

   This is a measure of disruption. How much is the company either creating a new market or somehow disrupting existing competitors in a way that takes market away and generates revenue and profit from them, but for them to compete they would need to rethink their busines and core revenue streams.

   Examples of this would be how Amazon ordering online disrupted traditional bricks and mortar booksellers, how Netflix started streaming (and at first delivered movies by mail vouchers), and how Apple moved into phones.

   (hat tip to Brian Feroldi for this term which neatly encapsulates the idea, I feel.)

3. M&A

   Mergers and Acquisitions tells you a lot about larger companies. Are they growing organically or are they buying companies in an attempt to scale (which can work, but has its own problems of integration and be wary of companies who are not organically going - or even shrinking - but masking it with acquisitions to look like they’re growing.).

   If acquiring, but still growing, are they using Acquisitions to buy the innovation DNA they desperately lack internally? My take is, you cannot buy innovation. Acquiring company culture eats creative, agile companies for lunch. Or are they selectively slotting smart, agile, creative firms into already strong foundations?

   Another danger sign for me is buying competitors to shut them down and prevent them from disrupting the company itself. This behaviour always comes under regulators’ eyes eventually and has been the subject of much discussion in the Tech sphere.

3. GOATs

The acronym stands for the Greatest Of All Time, but ultimately, this part of the checklist is about the quality of people at the company, their drive, its mission, and how its understood in the trenches. Bad management, being an unattractive or toxic employer, or not having any purpose or real problem you are solving, for my investment strategy at least, are key health indicators.

1. Management Team

   When I was younger I used to have an ignorant view of management teams — because I worked for companies with bad ones. Not until I got into more senior roles did I realize how key they are for driving company performance. VCs will often say they only invest in the leadership team and its drive but fact of the matter is you want a competent, and serious management team focused on the right things for your company. I actively avoid rock star CEOs and glitzy management teams.

   In fact, if the CEO is a bit too present in media, I tend to look unfavourably on a company but do look at the other pillars of the management team to see if they are capable of keeping a CEO from being too stupid. Diversity is also important. A team of followers, or people with almost the exact same background, national origin, gender, or schooling is a danger sign for me since diversity of thought and opinion is key to optionality and companies innovating, rather than being a follower and playing catch up with competitors (or moving into new markets all the time to thrash about for profitability.). Innovative ideas generally come from the edges.

2. The Mission and Strategy

   Is the company solving an actual problem or an imagined one? The number of entrepreneurs or VCs investing in what I consider #FirstWorldProblems is generally worrying, since they feel faddish at the best of times, but those are generally companies I avoid investing in. I miss some fashionable up and coming brands this way, but since few of those seem to have sustainable long term returns, it’s in line with my investment strategy.

   The key point here for me is whether the company is creating value or merely extracting it. If the company’s mission is more based on achieving big numbers or some hand waving around customer experience, and it’s not clear how their strategy differentiates from that of their competitors, you need to dig deeper to see if it actually has underlying and intrinsic value or is merely a me-too copycat. Though, copying successful firms elsewhere has worked well for some companies such as some of Rocket Internet’s stable or, well… almost every first wave internet firm in China and India (though now their home grown companies like PinDuoDuo or Shein are copied in Europe and North America.).

   Do the people actually working at the company know the strategy of the company and what its mission is? Can they actually tell you if you ask and understand how it relates to their daily work? This a telling acid test for me. Why? Because great companies realize that there are trade-offs. You cannot do everything. To do some things well, and solve the right problems and not others, you absolutely must choose. Firms that try to do everything, fail or yield lower returns. Excellence is about focus.

   It also scales decision making. Firms that are too top down because they are fuzzy on mission and strategy mean that staff often don’t know what they should do in situations and have no credo or guides to independently decide on good course of action. These firms end up being slow to react, miored in group politics, and are often top down executive driven.

3. The Staff

   Is this somewhere people actually want to work and excited to be at? What is the company culture like? If you’ve had interactions with them, are you impressed at their hustle, independence, and ability to resolve problems on their own? While all big companies moving at speed have problems, evidence of toxicity, endemic employee lawsuits, turnover, too many complaints speaking to deep problematic core issues in the company (or with management) are danger signals.

4. Quote

The quote is what a stock costs you versus its value. How does the price compare to financial metrics? Is it even worth it even if it’s a great company? Do you ened to wait for a dip? You want to be paying less for companies than you think they are currently worth and will be worth in the future. This is doubly true with the outlying multiples we’ve tended to see from VC hype-driven IPOs in the last few years.

I like to look at a small set of financial metrics as a health check. This is a more technical section and if you do not know what these things are, I highly recommend if you are at this stage in your investing journey, you need to be in the position where you understand more about a firm’s balance sheet and income statement.

I like to look at:

1. Free Cash Flow, Operating Leverage, and Cushion
2. CLV vs CAC and CRC
3. Gross Margin
4. EPS and P/E
5. Growth PEG

to understand the pillars of a company’s value versus how much it costs.

1. FCF and Cushion

   Free Cash Flow is a measure of operational efficiency. Well-run firms generate free cash flow from operations.

   Another way you can look at this: if sales had not grown, would the firm still have made money? Good firms continuously get better. For older, established companies, this is actually a difficult bar to pass, so you may want to modify or sanity check this one if you are looking at blue chips. One thing you don’t want to see though is this number getting worse over time.

   Cushion is an indication of how liquid a company is. How much money (and convertible securities) does it have on hand? Arguably you could say you want to see this money either being used for driving the business or in other investments, but I like seeing a company that is not worried about debt and takes it on because it is more efficient to finance as their actual money can be used for greater returns. So, the other way to look at this is how much cash and cash equivalents are on hand versus the debt a company carries. A large cushion is good. Having a balance sheet which is too indebted is not good.

2. CLV vs CAC and CRC

   For a growing company I like to see Customer Lifetime Value at 3:1 compared to CAC (Customer Acquisition Cost).

   Make sure when looking at this number to see how CAC is calculated by the company, since a few companies have started blending in retained customers rather than exclusively new ones when quoting this figure in prospectuses (the SEC should stomp on this sort of thing tbh).

   Be wary of firms that have consistently higher CAC than CLV and it does not appear to be improving. Firms can and do simply pay for customers to use their products than they may ever earn from them while using the numbers to take VC and investor cash and “buying” customers in any attempt to dominate market share. While this works with firms with good moats, far too many firms funded by VCs use this “Amazon” model and they never have a hope of anyone making money on them other than the VCs who originally funded them. Don’t get suckered.

   An iron clad rule of business some newer (especially internet based) firms seem to forget is that your CLV must be greater than your CAC + (CRC * customer lifetime) or you are losing money.

3. Gross margin

   The difference between what something is sold for by the company versus what it takes to produce. Big gross Is good. It is more important as an indicator for companies that make things than online companies, but still a telling figure even for online or services companies.

   Everyone wants to see gross margin increasing. Decreasing gross margins need good reasons on why you may be seeing that.

4. EPS and P/E ratios - Price to earnings to Growth ratio

   EPS is simply the net profit of the company divided by the outstanding shares a company has and expressed as a (hopefully) positive number. Basically, how much profit for each share of common stock is the company generating? Negative earnings per share for a growing company are alright, but you want to see that number moving in a positive direction every quarter if they are in a scaling phase. You eventually want to see that positive or you never make back your investment. To understand the price to earnings ratio, you simply take the price per share and divide it by the earnings. P/E gives you an idea of how much the market is willing to pay for each dollar of earnings a company delivers. Generally, higher P/E ratios mean that investors believe that the stock will grow in the future, but too high a P/E ratio generally means a company is overvalued or investors believe it will grow enormously in the future - sometimes incorrectly (as an example, the S&P 500 has on average had a ~16 P/E ratio over the year though it has fluctuated from 5X to 120X).

5. Growth PEG

   Is the firm growing organically (rather than acquiring other firms and merely growing inorganically - and possibly masking poor organic growth)? What is that rate of growth? Does it appear to be increasing or is the rate of growth slowing?

   Rate of growth that is slowing for older, established companies is fine as other numbers fall into line, but in particular if a company has slowing growth and is still unprofitable, that can be cause for serious concern, particularly if they are unable to differentiate from competitors or create substantial moats to defend their business against incumbents.

   I also like using PEG which is P/E and Growth estimates to determine if a firm is worth what you’re paying for. If you take the P/E ratio and then multiple that by expected growth over something like 5 years (and do watch out for over-enthusiastic estimates of this number), you should be getting an idea of whether what you are paying for a firm is a reasonable number. If the PEG doesn’t add up to the current figure you’re paying for a share, you more than likely have a problem. And keep in mind, there are people who overpay for firms All. The. Time. They simply are overly enthusiastic about their prospects.

Note: There are a lot of other financial metrics you can use. For example, I like return on capital as an indicator as well, but think the five above make the most sense to start with. As you grow in understanding and confidence though, add whatever you think makes sense for your investing style and risk profile.

Fin

Phew. Long post, I know. But as you become a more sophisticated investor and move beyond simple ETFs and similar securities, I do think these things will add up to make you a savvier, and smart investor and hopefully get you to financial resiliency and your financial goals faster.

I also advocate automating a lot of this so you can analyze the market and look out for many of these things in a way that you merely have to buy them when your system alerts you, rather than going out hunting for things. I’ll be putting together a another post on a system to do the hunt and automation for you to help with your decisions in the future as the final part of this series - as well as some words and systems on automating things like accounting and understanding whether you can optimize your position based on well understood mathematics and economics papers like Efficient Portfolio Theory and similar useful advances in investing economics.

Let me know what you think about the post on Mastodon @awws or via email hola@wakatara.com and if it actually made a difference for you. I’d love to hear feedback about your own thoughts, processes, or approaches and what may have worked for you or tweaks to the above. Reasoned opinions on why I might be wrong and what might be even better always welcome.