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Investing is competitive. What’s more, competition is fierce. Formulaic strategies are quickly rendered useless by imitators.
Benjamin Graham is considered the patron saint of value investing. Graham, along with David Dodd, wrote Security Analysis in 1934.
The rules presented in Graham and Dodd’s book were new, but they were also formulaic. They sought companies with stocks that were trading below intrinsic value. That value was determined through simple ratio and trend analysis. Any investor with stamina and a degree of intelligence could incorporate the same rules into his own analysis.
The Graham-and-Dodd franchise lasted for decades, but this was due mostly to lack of modern technology. There was a limit to the quantity of analysis one could undertake. Today, Graham and Dodd’s strategy offers no competitive advantage. We live in a world where such analysis can be performed in seconds.
This means that number crunching will never lead to superior returns. Today, superior returns are the product of an alert, curious, unquantified mind. The fact that Graham’s most successful student, Warren Buffett, long ago abandoned Graham and Dodd’s methods speaks volumes.
Unfortunately, most investment books focus on the formulaic. Therefore, most instill no competitive advantage. This isn’t to say that learning to read financial statements or understanding Graham and Dodd’s insights are unimportant, but knowing how to read an income statement doesn’t make a Buffett.
To read Microsoft’s (NASDAQ: MSFT) balance sheet and to note its $88.5 billion cash account is to belabor the obvious. Every investor interested in Microsoft knows that it sits atop a mountain’s load of cash. An investment based on that fact alone is meaningless.
It’s the unknown future of Microsoft’s cash that matters.
How will an entrepreneur use that money to generate future returns? Will $40 billion be squandered on Yahoo! (NASDAQ: YHOO), as it nearly was, or will it be invested in an enterprise, such as cloud computing, that will grow earnings 20% a year for the next decade? No formula will reveal that future; only entrepreneurial thinking will.
Entrepreneurial thinking involves pondering uncertainty as opposed to risk. Risk is probabilistic, like the odds of rolling a six on a fair die after many rolls. Uncertainty, on the other hand, is incalculable.
Let’s say we know that 50% of new restaurants close within two years. That’s risk. Unfortunately, it says nothing about how a particular new restaurant will perform. That’s uncertainty.
Nevertheless, you’ll often hear a pundit say something like “the economy has a 50% chance of falling into recession next year,” or that “Microsoft has a 30% chance of hitting $75 a share in 12 months.” That is gibberish. Risk is being confused with uncertainty. There is no way to place percentage odds on the market or a stock price.
As an investor, always keep in mind that you are an entrepreneur dealing in unquantifiable uncertainty. This knowledge alone will put you one-up on most investors.
So, crunch the numbers to quantify a company’s financial position. But then apply an entrepreneur’s qualitative foresight. To arrive at investment value, think how a company could use its resources to create future returns. More important, think in a way that few other investors are thinking.
To think in such a way is to think like a successful entrepreneur, and a successful investor.
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