Investment PhilosophyPortfolio Management

Two Types of Investments and Thoughts on ROC Part 2

This is part 2 of a long post on my thoughts on how I break investments into two main categories: Earnings Based Investments and Asset Based Investments. This post picks up where the last post left off. Both are based on my investment checklist, which I posted last week. Check My Investment Checklist here, and read part 1 of this post here.

Is the Investment Value Based on Earnings or Assets?

So I look at ROC in most every investment, but it gets different weighting depending on whether I’m looking at earnings based or asset based investments. In asset based investments, I will place a greater importance on price to tangible book value. Obviously, if I’m buying an asset based investment, I need to value the assets. I will also use this metric with most financial stocks. One of my favorite things to use screeners for is to find small community banks selling for 60-80% of tangible book value and try to evaluate the chances of the stock returning (or getting) to tangible book value.

So it’s important to determine what type of investment you’re making. Are you buying the stock because it’s cheap relative to earnings, or cheap relative to assets? But I usually know that up front so it’s not really something I think about.

How I Run Through My Investment Checklist

I first determine risk (this is the most important for any type of investment: think valuation, leverage, and business risk). Asset investments will usually have a lot of warning signs with business risk, but that is a risk you have to take, and that’s why a basket approach can work well with asset investments.

For earnings bases investments, I want to know EV/EBIT and ROC. For asset investments I’ll check P/B and other balance sheet metrics. Leverage is a more important risk factor for me with asset investments. Business risk is important to both, but especially with earnings investments if they don’t have assets to provide the margin of safety.

Insiders are important to both, but usually I focus more on insider ownership with small cap stocks (large caps are too big for it to usually play a role). And usually this is key in determining the fate of small cap asset based investments.

Capital allocation is important to both types. So is management effectiveness, quality, and incentives.

The questions are important to ask for both investments also:

  • Is the business a melting ice cube?
  • Does the business operate in a cyclical industry?
  • Are the earnings normal or peak?

Of course for asset investments you’ll want to evaluate the quality of the assets (are they tangible? are they worth what they are carried at on the books?)

Stating the investment thesis is important for each investment. I write this down on my investment diary I have on a Word doc and I can quickly search for any thesis using the ticker symbol later to reevaluate my original thesis if need be.

And finally, the two most important questions apply to both earnings and asset based investments:

  • Can I see the stock doubling in 2-3 years?
  • Would I want to buy more if the stock drops after I buy it?

So as you might have noticed, each checklist item is somewhat different and each investment opportunity will have different weighting applied to each category. Some categories will have greater weighting in asset investments, other categories will be more important for earnings based investments, some will be important for both, etc… You can run through the list pretty quickly and you’ll know what to look for based before you start because if you’re running the checklist, you already know the reason you’re interested in the business.

It’s just like a pilot… He or she knows how to fly the plane, they already have their flight plans in place, they know where they are headed and how long the trip will take, but they just run the checklist as a reminder to check a few important things prior to takeoff. It’s a precautionary measure. The investment checklist is just a reminder to focus on the big picture and check a few relevant metrics. You already have your thesis and you likely already know the metrics. The checklist is just a tool to make one aspect of the process more efficient, and to catch any obvious errors you may have overlooked.

Protecting the downside (in flying and in investing) is the most important thing, and the checklist reminds you to do that.

Thanks again for all the emails and feedback. I appreciate the thoughts on your own lists and processes.

4 thoughts on “Two Types of Investments and Thoughts on ROC Part 2

  1. I find asset based investments much more easier to value than earnings based investments. (Ex: cheap communitybanks with simple balance sheets trading below book value)

    How would you value earning based investments? Would you do it with simple ratios like EV/EBITDA, price/cash flow, cash yields etc?

    I’d love to hear your insights on this topic.

    1. Asset investments are much easier to place a value, but good companies tend to reward long term shareholders much more in aggregate. That’s why Buffett liked componders. I like to buy assets cheap and sell them back when they get revalued. I think of it like a retailer or a grocery store owner restocking the shelves. As long as there is cheap merchandise, on balance, buying assets for 50 cents on the dollar works very well over time.

      But good businesses are always great if you can find them cheap enough. I use simple metrics there as well like EV/EBIT, or EV/EBITDA less capex. Basically, the idea is to figure out the normal earning power of the business and determine what that is worth to you…

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