Saturday, February 7, 2015

A Fresh Look at the Simple Formula

Earlier this week, a reader* of the blog had a look at the formula I laid out in "A Simple Formula for Investing Success" and cleverly suggested that the formula should be rearranged from:

Investment + Good Company + Right Price + Patience


Good Company + Right Price + Investment + Patience

How did I miss that? 

Clearly, "GRIP" is much more memorable than "IGRP", and more importantly, it's the correct order of operations when investing. I don't know many successful investors who invest first and learn about the company later. 

So while we're on this topic, let's review the formula in the proper order.

Good company: Continuously learning about the business over the life of the investment is an essential component to investing success. Initially, your focus should be on determining whether or not the company possesses durable competitive advantages (i.e. an economic moat), what it's growth runway looks like, the skill with which management allocates shareholder capital, the company's culture, the strength of its financials, and so on.  

Even after you've invested in the company, it's important to stay on top of these items and review the business's progress at least twice a year. After a few years of following a business, you'll be surprised how much of an expert you'll become on its operations relative to the average investor, which itself, in turn, becomes an advantage.

Right price: Even a good company can make for a bad investment if you overpay for it, so it's important to consider valuation before making any investment. That said, investing is about dealing with uncertainty and no valuation model will be perfect. In my experience, the simpler the model, the better. Each investor has his or her own approach to valuation, but the key is to get a feel for the range of potential valuation outcomes and look to invest when you think the market price provides a suitable margin of safety. 

Investment: This may seem to be an obvious point, but I have a feeling that most of us have done a lot of research in a company, liked what we saw, but failed to actually make the investment for one reason or another. 

I know I've done that before, the most painful example being Tractor Supply (TSCO) in March 2009 -- a company I failed to invest in even after doing extensive due diligence and liking what I saw. As the market began to rapidly recover from the depths of the financial crisis, I got cold feet and waited for a pullback that never came. The stock's since gone up over 1,000% and has been the costliest mistake of my investing career. The lesson here is that investing success is impossible unless money is actually put to work.

Patience: If you've followed through with the first three steps -- you have a good company, think it's trading at the right price, and make an investment -- the only thing left to do is be patient. Patience, of course, also happens to be the hardest part of the formula, but it's critical to give the business a chance to compound your capital over time. 

Bottom line

Following this simple formula is far from easy; however, if you can consistently apply it over a long investing career, I truly believe it will produce very satisfactory results indeed. 

*Many thanks to Dev at the Stable Investor blog in India for pointing this out!  

Quote of the week:

What I've been reading/watching this week:
Stay patient, stay focused.