The art or science of investment decision making

In my last article, I wrote about why I think valuation is critically important in investment, just as it is in so many decisions we make every day, be it grocery shopping, switching utility providers, renewing insurance or buying a house.

We are all used to making rational decisions based on assessments of relative value, but in investment, these considerations are too often either ignored or overridden by emotion. FOMO (fear of missing out) is an especially strong motivation that all too often drives investment decisions that, with the benefit of hindsight, look irrational. As J P Morgan once said, “Nothing so undermines your financial judgement as the sight of your neighbour getting rich”.

It is also worth saying that many successful professional investors and highly regarded fund managers weight other factors in their investment processes above valuation criteria. However, for me, it has always been front and centre of all the investment decisions I have made for myself and my clients. Of course, that does not mean it is the only consideration in the process of making an investment decision, far from it, but for me, it is the most important.  

How I make investment decisions

This is not intended to be a guide to company analysis; instead, it is a brief summary of the process I go through when deciding to buy and sell shares in a business. Perhaps a good starting point is to remember that the process of analysing a business is not scientific. Some aspects of the process do involve basic maths and, most obviously, during the analysis of financial reports, but the most important bit of the process is, by definition, the product of informed judgement because it relies upon a prediction of the future. A future that is inherently uncertain and affected by known and unknown variables.

In my view, the job of an analyst or fund manager is to try to focus on the variables that will have the greatest influence on a company’s fortunes and then formulate a view about how those factors will play out in the future. Some factors, such as macroeconomic factors, competitor behaviour, regulation, legislation, commodity prices, or geopolitical events, will be beyond the control of the people running the business, and others will be the product of the decisions management makes.

The objective of this process is to establish a well-researched and coherent view of how a business will perform in the future, both in the short and longer term. Inevitably, this process leans on the analysis of competitive advantage, the quality of management, the underlying characteristics of the business, and a thorough understanding of what might be changing in the business over time, for example, whether its returns on capital are on a rising trajectory, or if its capital intensity is changing maybe as a result of technological change. This is not an exhaustive list, and different businesses in different industries may be analysed in different ways, but the end product is the same: a good understanding of how the business will perform in the future.

The next crucial step is to try to understand if the returns the business is expected to deliver in the future are reflected in its valuation today. Simply, what I look for are businesses whose futures are under appreciated by other investors, effectively undervalued assets.

Of course, not all undervalued assets are necessarily good investments. Some confront risks that are just too hard to quantify, but in general, a good starting point for the final part of the decision-making process is to know that the intrinsic value of the business you are contemplating investing in is significantly higher than its market value.

Predicting the future is not easy and inherently fraught with uncertainty. The clear objective of this process of analysis and associated valuation judgement is not to eliminate this uncertainty but to understand it better and shift the odds of success in your favour.  It’s also important to remember that all investors make mistakes, but these shouldn’t undermine the validity of this process, whose only alternative is the equivalent of flipping a coin and hoping for the best.