The 7 Questions That Changed My Investing

After 25 years of investing, these are the questions that help me avoid the good-enough ideas I used to talk myself into.

I am a little embarrassed to admit, but for the first part of my 25-year investing career you could have probably summarized my approach as buying good-enough companies at cheap-enough prices. It’s not a terrible approach, but it’s both too simplistic and has occasionally gotten me into trouble.

That trouble led to introspection. I care deeply about delivering excellent outcomes for my partners who trusted me with their capital. I also have most of my family’s net worth invested in Silver Ring Value Partners.

So, unlike an environment at a big mutual fund firm where sometimes incentives cause financial success to be driven by marketing, I had a lot of evolutionary pressure to improve.

Below I am sharing my hard-won lessons with you. This series of questions acts as a powerful filter that helps me separate the outstanding opportunities from the stuff that I might have otherwise talked myself into.

A few things before we dive in:

• These are meant for experienced investors who already understand the basics. In the interest of brevity, I am not going to dive into topics like how to assess company quality, as this would make this a book rather than an article.

• You can use this as a checklist, as a source of one-off questions to add to your process or as a mental model scorecard with your own weights attached to each answer.

• Some of these questions are targeted at existing holdings, but you can still apply them to potential new investments that you are considering with a slight reframe.

1. Is this an exceptionally good company?

A logical question is what does ‘exceptionally good’ mean? We could leave it at ‘you know it when you see it.’ However, it’s worth talking about how tight this filter should be in order to be useful.

First, don’t let the perfect be the enemy of the excellent. Every company has flaws or some potential risks. If you set the bar at having none of those, you will have too few candidates, if any.

On the other hand, you can set the aperture to be too wide. If we say that there are on the order of 10,000 publicly traded companies and then define ‘exceptionally good’ as the top 10%, we are going to end up with 1,000 companies. That’s sure to allow some decent but not exceptional candidates.

My experience tells me that the right number is probably a few hundred companies globally. Some might still find that too loose or too tight. However, the combination of good business and competent and motivated management is rare.

I would rather err towards the slightly too tight than too loose for this criterion.

2. Is this an extremely cheap security?

Same issue as above: what does ‘extremely cheap’ mean? Valuation is usually best judged in the context of what you are valuing. What is a cheap valuation statistic for an exceptional high-growth company is expensive for a declining business.

However, since we want this question to work for us independently, we are going to take a stab and establish some absolute parameters. For me, ‘extremely cheap’ usually maps to one or more of:

• Market is implying a severe long-term decline in profits

• Market is implying a conservative liquidation value well above current price

• If the company just earns what it has averaged over the last economic cycle and sends its owners those earnings as dividends, the owners stand to get a strong double-digit annualized rate of return

Switching from the general to some specific examples.

• 11x EPS is not extremely cheap. 6x EPS is.

• A 7% EV Cap Rate (NOPAT/Enterprise Value) is not extremely cheap. 11% is.

• A stock trading at 0.8x Book is not extremely cheap. One trading below Net Cash is.

• A 9% FCF yield is not extremely cheap. 14% is.

You will have to establish your own parameters for this and of course take the prevailing interest rate environment into account. Hopefully you get the gist.

3. Is there an event that is likely to accelerate the timing of when the price/value gap will close?

It should be clear that the same total return achieved over a shorter period of time results in a higher IRR. The hidden benefit of events is that they lessen the risk of various behavioral decision flaws.

Many value investors fall for some combination of confirmation bias, anchoring and thesis creep that lead them to hold on to losers too long. If the crux of your thesis is an event, that is harder to do.

What constitutes an event? I categorize these into hard catalysts and ones that accelerate, but do not force, the resolution of the price/value gap.

The simplest example of a hard catalyst is a maturity date for a bond. Let’s say you invested in a distressed bond that matures in 18 months. Your thesis is that it’s money-good. The investment case does not depend on a bankruptcy process or a potential recovery after default.

When the maturity date comes, you either get your money back and earn your target return, or you don’t. There is no ambiguity.

An example of a softer catalyst might be a company that is spinning off a bad division. Your thesis is that the bad division is dragging down the overall valuation, and once it is gone the market will re-rate the stock.

Another example is a drug company that is expecting the results of a pivotal trial. Success should cause the market to substantially update its future revenue and cashflow expectations.

Notice how these two examples are different from the bond maturity scenario earlier. In their case we are reliant on the market to respond to the event and reprice the security.

Logically it should do so if the event works out in our favor. However, unlike in the case of a bond coming due, it does not have to.

Here is something that I would not consider an event: a company reporting a good quarter or raising guidance. First of all, too many investors play that game already, so it’s tough to get any edge. Second, it’s not discrete enough to qualify, since investors should and do constantly revise their future expectations based on a whole host of news items.

There is definitely a continuum between my accelerated catalyst events and what I wouldn’t count as one at all. The exact boundary isn’t that important. Being aware of events that can unlock value is.

How I Use Questions 1 through 3

If a security passes any one of questions 1 through 3, it’s interesting and is worth further work. If it passes any 2, it moves near the top of my research list. If it passes all 3, I drop everything work-related and start researching.

The danger is investing in what I call The Dead Zone. Companies that are good enough and maybe not too expensive. At best that leads to lukewarm results. At worst it causes you to lose money when something goes wrong.

You might, correctly, point out that almost no opportunities will pass all 3 filters, and very few will pass 2. That’s right. Good investments are rare, as they should be.

The natural implications of using these filters are:

• Long periods of inactivity

• Concentrated portfolio

• Occasional high cash balances

That’s not comfortable for most for reasons ranging from business constraints to inability to handle volatility. That’s not irrational. While the potential rewards of successfully following this approach can be much higher than those of a more conventional diversified approach, the risk of failure is also higher if it is not executed well.

4. Is this company becoming a better business, staying the same or getting worse?

This is an obvious question, but not one that I systematically applied as part of my process at a big-picture level. Then an investing friend pulled me aside after a presentation at a conference and told me that I needed to listen to the message and add it to my process. He was right.

What we are talking about here isn’t merely things like the rate of earnings growth. We are trying to go back to basics and answer if this company is structurally becoming better or worse. That can occur independently of the rate of growth, although in some ways the two can be connected.

When I looked at my portfolio, too many companies were either getting worse or at best staying the same, with the only positive thing to be said is that their stocks were cheap.

This isn’t an argument against cheap stocks. And yes, you can make very good returns in extremely cheap securities of challenged companies.

However, at the very least you should:

• Be aware of how your whole portfolio looks with respect to this question

• Use the answers to inform your position sizing

• Use any changes in this answer as a trigger for changing your mind about an investment

Do this: go through your portfolio and answer this question for every investment. Depending on your style you might be surprised to find how few, if any, improving companies you own. At least not ones that you have to pay nosebleed prices to afford.

5. How consistent have recent results been with my thesis?

A while back I added an Investment Thesis Tracker to my process. It forces me to record, with zero excuses, how the company’s results came in vs. my Base Case thesis.

No explanations. No “but it’s because the economy is weak.” Just the facts.

I use a 5-point, -2 to +2 grading system to record the magnitude of deviation, with 0 meaning that things are in line with what I expected to happen.

To be clear, this isn’t about modeling quarterly earnings and seeing if the company beat them or not. I always thought that was a silly game grownups play. Rather, this is about marking my thesis to reality and helping me reduce anchoring.

The next step is to then map these to actions. For example, if I have 3 quarters of results below my expectations in a row, I freeze myself from adding to a position. Severe misses lead to re-underwriting the investment case from scratch.

You can create your own triggers. The point is to be objective in tracking this and have it trigger useful actions or prevent harmful ones.

6. In which of the following categories do the problems facing the company fall: cyclical, structural, internal, balance sheet?

Some companies are pristine and have no problems. The problem with that, pun intended, is that they are rarely undervalued.

Some problems are worse than others and are harder or impossible to fix. For example, structural problems rarely get better. On the other hand, cyclical problems should go away on their own as long as the company has the balance sheet strength to withstand the cycle.

Internal problems can be nuanced. The base rate probabilities of turnarounds are low. However, once a turnaround shows evidence of turning, the odds flip in our favor. It’s also hard to combine a turnaround, already a difficult endeavor, with other problems.

A stretched balance sheet can be benign if everything else is going well. However, if you combine it with a severe recession, what might have been an easy fix becomes an existential threat.

A company that has more than one category of problems is in much bigger danger than one that has a problem in a single category. So, if we were to have any problems at all, we would like them to be in the single category of cyclical issues.

Warren Buffett pointed out in one of Berkshire Hathaway’s annual letters that even if we are going to be correct 80% of the time answering a single question, if we need to answer 3 different such questions correctly, then we are only about 50% likely to be right.

Sometimes there are extenuating circumstances to take on the challenge of investing in a company with multiple types of problems. However, that is rare.

So be aware of what you are signing up for and be sure that is what you want to take on. Investing is like an exam where you can skip as many questions as you want with no penalty. Under such rules it’s foolish to try to answer the hard ones.

7. To what degree does the thesis rely on what has already been happening continuing vs. a change from the past?

One pattern that I have observed from working on the Investment Autopsy series is that both successful and unsuccessful investing theses tend to have something in common among themselves. Successful theses frequently involve betting that what has already been happening will continue. Nothing new needs to occur. Management just needs to keep doing what it has already been doing.

On the other hand, unsuccessful theses have frequently been of the ‘this time it’s going to be different’ variety. Whether that’s a company executing an unproven turnaround or a secular threat suddenly abating, that has not been a fertile ground for success.

Sometimes things do change. Successful results stop for internal or external reasons. Other times turnarounds do occur. However, you should start with the understanding of the base rate probabilities and invest accordingly.

How I Use Questions 4 through 7

These questions work for both new ideas and existing positions. They also allow me to gauge the portfolio to make sure that it’s not skewed towards just one kind of investment idea.

What all of these have in common is that they help me weed out the almost good-enough ideas that used to dominate the portfolio years ago. Think about this: what is the problem with a decent company with a kind of cheap stock?

Well, these usually have some of the exact characteristics that questions 4 through 7 are meant to guard against:

• Business that is getting worse

• Problems in multiple categories

• A thesis that isn’t tracking

• A long shot hope that it will be ‘different this time’ with limited evidence that it will

Frequently, these negatives more than justified the low valuation, making these seemingly good enough investments bad in practice. By explicitly applying questions 4 through 7, my intent is to keep the deservedly cheap stocks from sneaking into the portfolio and only allow in the genuinely undervalued investments.

Conclusion

I hate sensational claims like ‘if you only do X, Y and Z your investing results will be amazing.’ Investing is really hard. After 25 years doing it I think it is harder, not easier. That’s not because I got worse, but because I substantially underestimated how hard it was when I started out.

However, I can tell you that applying these questions to my own investing, and furthermore building them into a mental model scorecard, has really improved my investing. It made me much more balanced and multi-dimensional, and more aware of the hidden risks in my portfolio.

I hope this framework does the same for you.

If this article helped clarify your thinking, please restack it to help others.

Disclaimer: Not financial advice, for educational purposes only.

About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.