Saturday, February 14, 2015

The Right Way to Approach New Investment Ideas

With most situations in life it pays to go into them expecting the best outcome. No one would take a Hawaiian vacation if they thought it would rain every day during their stay, no one would buy a house if their first thought was all the repairs they'd have to make in the coming years, and so on. 

With investing, however, it pays to approach new ideas with a healthy dose of skepticism. 

In a transcript of a 2008 interview with Buffett biographer, Alice Schroeder, she shared the following observation about Buffett's own process for evaluating new investment ideas:
The first step in Warren's investing process is always to say, "What are the odds that this business could be subject to any type of catastrophe risk - that could make it (the business fail)?...It is backwards the way most people think because most people find an interesting idea and figure out the math, they look at the financials, they do a project and then at the end, the (sic) ask, "What could go wrong." (author's emphasis)
Finding new investment ideas can be exciting, but our initial enthusiasm should be tempered until we've first determined the company is highly unlikely to have meaningfully-worse results in the coming years. By doing a "pre-mortem" on our stock ideas, we can save ourselves from making some big mistakes along the way. 

Dividend investors, for example, can ask "What would have to happen to make this company cut its dividend in the next 3-5 years?" More specifically, if the company currently covers its dividend twice over with earnings or free cash flow, you could ask, "What would have to happen for this company's earnings/free cash flow to be halved?" and thus put the dividend at risk

However you frame your questions, the key is to approach each idea with a safety-first mindset. Only then can we feel more confident in our subsequent findings. 

Related posts:
What I've been reading/listening to this week:
  • A lifetime of saving and investing helped a janitor amass an $8 million fortune - Reuters
  • Masters in Business podcast with StockTwits founder Howard Lindzon - Barry Ritholtz
  • Don't be a doomster - Monevator
  • Imitating genius - Matt Brice
  • What do low interest rates mean for stock returns - Ben Carlson
  • Michael Mauboussin on contrarian investing - via ValueWalk
  • A list of good financial bloggers and writers - Morgan Housel
Stay patient, stay focused.