In analysis, you search the facts about
the security and make conclusions based on them. These conclusions
should be based on a sensible logic and the principles planned before
the analysis. Analysis takes time. It can take anything from hours to
months. Depending on how far you need to go in the analysis. Most of
the time, you should understand quickly that there is no need for
further examination. Most analyses never get to the point, in which
there is a decision to be made, whether to sell or buy the security.
You have to accept this ”waste of time” as part of the analyses.
There is no way to avoid this. All the greatest investors make their
own research about the securities. And they make their own
conclusions. You can only get better in analysing securities by
practicing. It is a skill like most of the components of successful
investing.
Different securities need different
analyses. For example, corporate bonds and stocks need to have
different kinds of analysis. Bond analysis is focused on the
company´s economical survivability. When you analyse stocks, you are
interested in the future profits of the business and the price you
have to pay for them. You need to use a lot more time to analyse the
future profits than the economical survivability. Graham was
particularly interested in bonds and stocks. Graham´s primary
sources were financial reports from the companies. His analyses
focused on the companies, their businesses, financial situations,
results and competitors. He also analysed the industries they were
focused on and their future prospects.
All the analyses are made in
uncertainty. Nobody can predict the future precisely. Randomness has
an effect on the correctness of the analysis. You need to evaluate
the past, the present, and the future of the business. Future is the
hardest part. Past and present give some clues about the future.
Unrealistic expectations about the future of the businesses will
likely cause the biggest failures in analysing them. Evaluation of
the future cash flows must be done with different assumptions. The
purpose of the evaluations is to define the range for the present
values of the future cash flows. According to Graham, all the
analyses should be based on preplanned principles. They should work
in all the time periods, exclusive the great catastrophes. You cannot
use only one method in every analysis.
Graham divided analysis into two
different parts: Qualitative and Quantitative analysis. Qualitative
analysis describes business at a common level. It means evaluating
business through the quality of the directors and the future of the
business and its industry. Qualitative analysis describes the
security primarily through the numbers. It describes the security
through the income statement, balance sheet, dividends, statistics of
the business and the capital structure. It is easier to analyse the
quantitative factors. Some of the qualitative factors are hard to
evaluate. For example, the abilities of the directors are sometimes
based on opinions rather than facts. You need to consider both, the
qualitative and quantitative factors for making any useful
conclusions. Qualitative analysis should confirm the quantitative
analysis, and vice versa. Without this happening, conclusions are not
very useful.
Two main limitations in analysing
businesses
There are two main problems in doing
the analysis. First, it takes time to analyse a business. Finding the
necessary information about the business takes time. Going through it
to find all the important things about it, like competition, future
prospects of the industry, takes from days to even weeks. Many
investors cannot spend so much time. Second problem is the bandwith
of the brain. You and I have our own limitation about how much
information we can process. Depending on the research the optimal
amount of different pieces of information in decision making is
between five and twelve. Too much information have been found to lead
to bad selection of what are the most important things you should
know. When you have an information overload, you start focusing on
the less important things.
There are many tools to overcome these
problems. You can specify the requirements for businesses, which you
want to analyse in advance. For example, no net debt, no losses in
the last five years, etc. And then you can use a stock screener which
helps you to find those businesses. This saves a lot of time. The
amount of businesses to analyse will be diminished. You can also use
spreadsheet programs like Excel to combine some factors from the
income statement or balance sheet into bigger ensemble. For example,
you can design a system which collects all the relevant information
of all small components over certain factor of the business like
financial strength. You can combine these smaller components like net
debt, cash, and so on, into bigger ensemble that describes the
financial strength as a whole. Then you don´t have to consider so
many pieces of information. This also saves time.
I hope you will take some time and
choose a business you are interested in. I would like you to figure
out the most important facts about the business. Then I hope you will
analyse these facts. Do it shortly.
©
Tommi Taavila 2018
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