Your investment philosophy is the set of rules, axioms, equations and gut feelings that you use to try and answer the basic questions faced by every investor: should I buy or should I sell? If you don’t have an investment philosophy it is better to just buy an index fund as buying and selling stocks purely on emotion is a recipe for failure.
My investment philosophy is based on the concept of value investing and is fairly simple. I buy a stock when it either trades at a price to earnings (P/E) ratio below 10 or when it trades at a discount to net asset value. For real-estate trusts I use the AFFO instead of earnings to value a company. It is a fairly simple rule to follow and I found it has worked well for me. This simple rule has allowed me to avoid emotional conflict and have defined buy and sell targets for any stock I want to invest in.
So why did I choose this to be the rule I follow? Well there are many ideas about how to buy and sell stocks. The one that most appeals to me is the idea of value investing. Value investing recognizes that when you buy shares in a company you are buying a part ownership in a business. Every business has a certain intrinsic value based on the value of what it owns and it’s ability to earn a profit. The goal of value investing is to try and evaluate what the intrinsic value of a business is and then buy it at a price that is below the intrinsic value. Then while you own it if the price ever goes above what you believe the intrinsic value is then you should sell.
Value investing sounds great, but how do you know the intrinsic value of a business? That is the whole challenge of value investing. I have decided on a four prong approach. If the business is a stable operating business then I believe the intrinsic value is ten times the earnings the business is able to generate. If a business earns on average $10 million per year then it’s worth $100 million. Why do I use ten times? Well there is no real reason for this number, you could use twelve times or eight times, but I find that ten times does a good job of limiting down the number of companies to invest in without limiting it too much. I suspect that this value will also need to be changed based on the decade you live in as in the 1970’s almost all companies traded at less than ten times earnings.
For the second prong if the business is asset based then I buy it when it trades at a discount to net asset value. An example of an asset based business is E-L Financial which primarily owns a pool of stocks, bonds and closed end funds. If the total value of all the things a business owns is worth $100 million, but the company is valued at $60 million then that is a good investment. If the company ever trades at par or a premium to asset value then I sell.
For the third prong if the business owns real estate I use the AFFO ratio instead of the earnings to value the company. I then buy if the price is less than ten times the AFFO. AFFO more of less represents the cash flow generated from real-estate.
The the fourth prong is if a business does not fit into one of the above three categories I generally don’t invest in it. I conclude that the company is either over-valued or I simply do not understand how to calculate it’s intrinsic value.
I use these rules to narrow down the list of all possible stocks to invest in into a short list. From there I look in depth into the companies and try to pick the best of the best.
Take a second to examine your investment philosophy and try writing it down. Think if it makes sense and share it with me if you wish.