Warren Buffett often stresses his approach to focus on the business that he can understand and analyze. What does it mean to the professionals of active equity investment management?

 

High Conviction (market-oriented approach)

 

Many experts and funds say they put “high conviction” as the top attributes of security selection. It is not surprising at all because you cannot put your investment in low conviction areas more than in high conviction areas. So, it does not seem to matter whether you are investing in conviction or not – because you do so virtually as long as you are an active investment manager.

However, if the meaning of “Conviction” is not carefully defined and shared, it does not do any good for investment process and portfolio.

For instance, high-conviction labeled funds tend to be accompanied by concentrated investment approach. (There are new debates lately about the usefulness of active shares as a proxy to measure the real activeness of the fund, though) They tend to state that high risk-adjusted return over time is the primary target and because the concentration does not give full usage of the portfolio diversification effects across the region, size, capital structure, and industry, individual security tends to have either low price volatility or high expected return of future price. In this case, the conviction is primarily evaluated on the expected price behavior. So naturally, this process ends up with bringing more and more bias toward price forecast-oriented management and measures such as ‘hit rate,’ ‘hit rate consistency,’ etc. The managers are forced to act as skillful traders, while the marketing cliché says the approach is value oriented and genuinely fundamental.

 

Visibility of Certainty of Cash Flow

 

On the contrary, a thoughtful fundamental approach focuses on the visibility of certainty equivalent cash flow to estimate the fundamental value of the core of the business operation. Then keep them and monitor the price moves regularly until it becomes reasonably purchasable as an investment. The real fundamental approaches know that high-convictions are rarely obtained in the end, and the market prices are not forecastable. To find the sources and elements of reliable cash flow and the business structure to generate it is a key, and the future investments have to have a certain level of sequentially so that the value of the excess return from future investment can be guaranteed.

Warren Buffet’s famous principle leads him to a concentrated portfolio, but it is very unsurprising as a single investment professional can handle as many as 20-25 stocks at once. (The smaller, the better. Never can do 50 unless you do not mind any sleep) The position size is a product of the number of the managers that share the same and very consistent principles and objectives.

That is why the former high-conviction market-oriented traders cannot evolve ever into fundamental investors.

 

Intensive Analysis of Balance Sheet to Find Unique Return Opportunity

 

Any analyst would feel the accounting standard has problems. Although many years have passed, I do not believe the accounting and bookkeeping processes have progressed enough to provide more accurate information to the financial world.

I once worked for an investment house that has a division of high-yield security investment and the team worked very hard and read lots of filings and prospectus and legal documents to find an opportunity. Document analysis and big data software applications have changed the way these approaches to take, but even today, flawed accounting and financial reports are both a headache and opportunities.

The right approach is to use adjusted figures across balance sheet, income statement and cash flow statement. I do not think that even professionals do not take such approach accurately enough to differentiate it as an alpha-seeking active fundamental investing. The divide between investment and market-oriented trading approach is so blurred for the ones who have not emerged fully with the fundamental approach.

We picked up the visibility of certainty of cash flow as a measure of ‘investment”, but then can this value discovery approach through digging in financial statement be called as ‘investment”? Is it too complicated?

Regardless of the application of financial statement analysis, the fundamental investors need to know the fact about what asset & liabilities the companies have in reality. Accounting has so many issues.  The management tends not to disclose everything to the public. The cost of assets is measured at a particular point of time, and they are not revalued equally. There are many off-balance sheet items. Investments in other business are not measured in the same way as the parent company is valued. If invested affiliates use multiple layers of pyramid investment schemes, even auditors do not tell exactly what the net exposure of asset and liabilities are.

I believe the complexity of financial statements due to corporate structure primarily determines the credibility as a candidate for investment (Do not spend much time on complicated business and operations) but for some investment companies with considerable assets of professional expertise, it can be an opportunistic low-priced investment target. Remember when you take this approach, there is no assurance as to whether and when the market can find the value of gap that you encountered during the research, as long as you do not take the pro-active approach to accelerate value realization such as using an additional catalytic process and external consultants.

 

<Guidelines>

Do not attempt to cover and analyze as many companies as possible

Try to start from broad coverage to gain insight and shrink it as much as you can

Thoughtful Disregard = The Narrower, The Better

As such, research universe selection is crucial

High Certainty is not Low Price Volatility

Many tend to get confused here

Numbers are Useful but Fundamental Structure Matters

You need to know what structure matters in what way and apply it

Focus on Uniqueness, Customer Value, and Flexibility of Business

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