5 Stages of
the Investment Process
1
Understanding Investment Targets
The first step involves understanding the target company, its competitors, and the industry they belong to. This process ultimately aims to determine the target company's economic moat, i.e., the extent of its competitive advantage within the industry. The stronger and more durable the competitive advantage, the higher and longer a company can sustain its return on capital.
"The most important job (for investors) is to try to find companies with wide and enduring moats. A moat is an economic castle strongly guarded by a virtuous knight." - Warren Buffett
Exploring the concept of economic moats further, this term was first introduced by Warren Buffett in the 1980s through the annual reports sent to Berkshire Hathaway shareholders. Buffett highlighted the moat as the most critical factor in selecting investment targets. A moat, initially a ditch dug around a fortress to strengthen its defense, is used by Buffett to refer to barriers that prevent competitors' pursuit and market erosion.
Elements that constitute an economic moat include intangible assets, cost advantage, economies of scale, and market dominance due to restricted entry. Prominent among intangible assets are brands and patents.
The first step is crucial in investment, relating to Warren Buffett's notion of staying within one's "circle of competence." Confucius stated in "Analects, Wei Zheng" that "to know what you know and what you do not know, that is true knowledge."
FOCOM Asset remains within its circle of competence, constantly learning to deepen and expand this circle without overstepping.
2
Filtering for Earnings and Asset Reliability, Financial Stability, and Management Quality
If the first stage is qualitative criteria, then the second stage is quantitative criteria. Just as the two sides of a coin are interconnected, it's essential to ensure that the movement is identical in quantitative terms as well. The passing criteria for the second stage are as follows:
Earnings Reliability: Operating Cash Flow / Net Income of 1 or higher
Asset Reliability: Cash / Assets of 10% or higher
Intangible Assets: Intangible Assets / Assets of less than 15%
Financial Stability: Debt Ratio of less than 50%
Management: Whether there is deliberate, systematic, and continuous management of key financial indicators
For the purpose of Asset Reliability, cash includes short-term marketable securities. The majority of companies are filtered out in stages one and two, with over 90% not passing. The truly great companies that deserve focus are very few and scattered across the globe. Investing in companies that are exceptional in every aspect, including products, services, management, accounting, finance, marketing, human resources, and business management, is a probabilistically winning investment. Investing in companies that ensure long-term, certain prosperity is the best approach if the investment is not intended to be a one-time occurrence.
3
Valuation
In stage three, only companies that have maintained a return on equity (ROE) of at least 10% for over five years are selected.
To achieve this, we calculate the future ROE for the next 5 to 10 years by considering past accounting and financial data from the last 5 to 10 years, along with the current competitive advantage (moat).
ROE corresponds to the interest rate on bonds and is directly linked to the investor's return on investment. Bond-like companies capable of reasonably calculating the range of future ROE constitute less than 1% of all listed companies worldwide.
4
Pricing
The appropriate Price-to-Earnings Ratio (PER) for an investment target company is calculated using the following formula:
Appropriate PER for the investment target company = Stock market's PER × (Investment company's ROE / S&P 500 average ROE)
This formula is based on Warren Buffett's insights. Buffett has commented on the PER as a gauge for determining if a company's stock price is reasonable, stating:
"The Price-Earnings Ratio (PER) used to determine the fair price of an investment target is based on the capital productivity, like ROE and ROIC, of S&P 500 companies." - Warren Buffett -
The idea is to assign a PER in proportion to the extent the company's ROE exceeds the average ROE of the S&P 500, which is a collection of the world's top companies. This is similar to determining the selling price or the magnitude of goodwill based on how much a company's profitability exceeds the average profitability of the market's companies. The stock market's PER should be adjusted annually based on interest rates and inflation (the devaluation of currency).
5
Determining Whether to Buy
If the Price-to-Earnings Ratio (PER) of the target company falls within the purchase price PER range, then proceed with the purchase.
If the target company's PER exceeds the range of the purchase price PER, it indicates the absence of a safety margin.
In such cases, wait until a safety margin emerges.
The companies purchased should be regarded as business partners, and rather than being swayed by short-term fluctuations, they should be held until the end to enjoy the benefits of compounding.