24th February 2015 by The Value Perspective
By Kevin Murphy
The scientific calculations involved in, say, delivering an accurate free kick in football or taking a catch in cricket are extraordinarily complex so how come sportsmen manage to pull off such feats all the time? And even if we accept the possibility David Beckham and Kevin Pietersen missed their true vocation as theoretical physicists, how do we explain the fact the average dog can catch a Frisbee?
Clearly something else is going on here besides complicated maths being solved in a matter of seconds. While we cannot speak for the average dog, we can for the average sportsman and it comes down to what behavioural scientists call a ‘heuristic’ – and most other people call a mental rule of thumb – that allows us to hope we might deliver a football, if perhaps not bend it, like Beckham.
The heuristic for taking a catch in cricket, for example, is essentially to keep the ball in the centre of your field of vision as you run – all the time adjusting your speed and direction of travel so the ball stays at the same angle in your field of vision. Do that and you will end up in the right place to catch the ball – and one imagines the Frisbee dog is following a similar rule of thumb. Or paw.
The more complicated we make the world, the harder it becomes to act with precision or achieve anything on a repeatable basis. While that is as true in investment as it is in sport, however, it does not stop some professional investors churning out pages of theories and formulae as they attempt to explain how they manage money for clients.
We take a somewhat different view, with all of our efforts centred on solving one fundamental question – what is a particular business worth? That may sound an odd idea but this approach removes a lot of unnecessary noise from the equation. After all, in articles such as Off-target, we have often highlighted an unhelpful tendency among investors to focus on the wrong information.
So we do not try to forecast what economies might do. We do not try to forecast where exchange rates or interest rates or levels of employment might head. We do not even try to forecast when a business might turn around or what its competitors might get up to. All we do is focus on an individual company and seek to gauge what it is worth.
If you like, you can break the process down into a few more questions – but only a few. What are a company’s normalised profits and what multiple should we pay for those profits? The combination of multiple and profit number is the ‘reward’ part of the puzzle – a share price target. The ‘risk’ part meanwhile can be defined in many ways but, for us, essentially comes down to balance-sheet strength.
And that is all we do here on The Value Perspective. We spend all our time looking at companies to assess what they are worth and how risky they are – and, if we decide one is cheap and we are happy with the state of its balance sheet, then we will buy it. Simple really – and as Dutch computer-programming pioneer Edsger Djikstra once observed: “Simplicity is a prerequisite of reliability.”
We were reminded of that line by a column on The Motley Fool website by Morgan Housel, entitled How to win by doing less. It suggests the most successful investors are rarely “brilliant minds who can calculate complicated things with precision” but are closer to sportsmen – “able to solve complicated problems with simple rules of thumb”.
The simplest investment process Housel mentions is that of a value-oriented manager who topped the performance tables in the US some 30 years ago. Asked to explain his secret, the manager said he had never heard of Benjamin Graham or modern portfolio theory or anything like that but simply invested in the very cheapest stocks highlighted in a newsletter from investment research business Value Line.
Here on The Value Perspective, our process is a little more complicated – even if we were minded to make our lives easier, Value Line does not cover UK stocks. But while forming our own view of whether or not a business is good value is not necessarily straightforward, we have developed a number of rules of thumb to help us to go about doing so with confidence.
We are not seeking absolute precision – when you are overlaying conservatism on conservatism, as we do, it should provide a large enough buffer against being very wrong on any single assumption – but we do want simplicity. Simplicity should enable us to repeat our process – compounding returns as we go – and thus, over time, reward long-term investors in a value strategy.