I've always been a value investor, picking both "cigar butt" Benjamin Graham stocks and selectively concentrating a la Warren Buffett. What I haven't always done -- that Buffett often talks about -- is invest in simple, understandable businesses. When I look over my time as a value investor, which started in 2005, it seems like most of my big mistakes/losses have involved companies where I didn't fully understand the product or how the company generated revenues. For this reason I'm now applying the following checklist to any concentrated investments:
- The business is simple and understandable;
- the business is quantitatively cheap, based primarily on financial ratios like price to earnings, price to free cash flow, enterprise value to operating earnings, price to tangible book, and/or price to net current asset value;
- The business is unleveraged and has plenty of working capital;
- The business is not heavily regulated or heavily supported by government funding/subsidies/programs;
- The business is not experiencing technological disruption; and
- The business is not experiencing business model disruption (a la Clayton Christensen).
I'm either avoiding or investing smaller amounts in companies that don't meet all these criteria.
One of the reasons I like simple, understandable businesses is that you’re less likely to be blind-sided by technological or business model disruption, or by unanticipated regulatory changes or lost government funding. It's generally easier to see potential disruption risks with a simple business -- the risk is usually more obvious. Investing in simple, cheap businesses, and diversifying appropriately, may be the two best ways to guard against "falling knives" and surprise stock losses due to disruption or regulatory changes.
The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. This article should not be construed as investment advice.