Financial Frameworks Blog 6: Value Investing - Trusting Your Judgement by Getting the Right Data - a Method

Introduction

Welcome to Financial Frameworks. Financial Frameworks’ goal is to increase your financial decision-making skills by building on what you already know and providing decision-making insights that improve the clarity of your focus. 

This blog and two previous podcasts at Financial Frameworks (http://finframeworks.com ) have been and are about what, for me, are the hardest tasks in value investing. The four major hurdles that I consistently work to overcome in making good value investing decisions are: 

1.           Doing sufficient homework to be clear about a margin of safety when pricing an investment,

2.           Trusting my own judgement when information is conflicting, or my thinking is counter to an “expert’s”, or when markets are choppy or challenging,

3.           Knowing when enough of the critical information is in place to say yes, (because there will always be information gaps), and

4.           Passing on something that is close but doesn’t quite measure up.

I divide the trusting my judgement task into two sets of actions:

One set of actions diminishes my biases so that my choice will be as objective and as analytical as possible. 

The other set of actions that I work at are about gathering data and having research methods that produce a solid investment judgement. 

Both of these tasks go hand in hand but are different enough for me to cover them separately. This blog tackles performing research correctly and in a disciplined manner and the next blog will address biases.

So, let’s look at some situations that make objective data gathering difficult.       

One situation, especially if you are following Peter Lynch’s advice to look at stocks of small companies, occurs when information is scarce – as when the company/stock may not get a lot of coverage.  A second situation is when brokerage firms have concerns about the industry in which the potential investment operates, and they expect an industry wide downturn and you don’t.  Another headwind is when news from a brokerage house or general news source believes that the company you are looking at will have lower earnings and your analysis disagrees.  

Something that occurs pretty frequently is when one news source you read regularly is headlining an optimistic outlook about the market in general and another that you consult with frequently is predicting doom, gloom and disaster at the same time.  Because bad news sells newspapers, disaster abounds; the Four Horsemen of the Apocalypse are just around the corner and a market collapse will show up shortly thereafter.  You and I see variations of these situations every day and have to separate the noise from the signal.  

So, the question for me is: “When am I at a point when researching an undervalued and underpriced stock where I am satisfied that I am making a solid choice, especially when information is hard to get or is conflicting?”

My short answer to that question is:  

“To be confident in my decision I need to feel that I have framed the research process – choices about what information I gathered and how I posed my questions -  neutrally; that I have countered all of my biases when processing information, and that I have all of the critical information I need.”

This podcast will answer that question in the usual Financial Frameworks format – questions posed and answered, first in terms of concepts and tools, then by applying the concepts to examples.   I strongly believe in learning by doing, so we will apply the concepts to your own investing practice.  This way, you can test the ideas, or tools, immediately to see if they make sense for you. 

Trusting Your Judgement – Especially When the Wind Isn’t at Your Back

Trusting one’s judgement, for me, is based on doing these five things:

1.    Have the right information and sufficient critical data. 

The foundation of my process is having enough relevant information for me to feel confident that I’m not missing anything important.  I know ahead of time that I won’t have all possible data and that it is natural to be concerned about missing something – because these are money decisions – but I have to have enough of the critical business and financial information available. 

The information sources I start with are the prospective investment’s financial and forward looking statements.  I need to understand that they have a solid business, that their financial data meet my criteria and that their plans for going forward make sense to me. Most company websites have an “Investor Relations” section. I start there because I’m using the Buffett/Munger approach of buying part of the business, not just the stock.  If you find limited information on the company website, check EDGAR – the Securities & Exchange Commission (SEC) website because any listed corporation will have filings with the SEC. The sources that I find useful are Value Line, Securities and Exchange  Commission (SEC) filings, my brokerage firm’s research webpage and major new sources such as Yahoo Finance, Bloomberg, Reuters, Marketwatch and individual analysts whose writings I follow.  Value Line sells subscriptions, but most local libraries, like mine, subscribe to it, so it would be available for your use there. Value Line is solely a securities analysis and reporting service and it is unbiased, comprehensive, current and thorough.  Data is presented at both a high level – a ranking for Safety, for instance – and in detail regarding recent history.  I recommend it for your use.

After I have finished my analysis and made the decision to invest or not, I need to know and feel that I have based the decision on the most important information. This includes gathering information that counters, or recommends against, my proposed choice.  Also, selecting the correct information implicitly speaks to my having a circle of competence and that I understand what I’m looking at.

2.    Validate the data.

When I check my information, I check for a number of things.  I need to confirm its accuracy; that it is current and I check to see if there is a slant, or angle to the information that make it more, or less, accurate.  I check the data for completeness – is anything left out.  Finally, I look for comparative information in the data: “Is this prospective investment similar to any other investments I know of, and is there information available I can use to make those comparisons?”

Accuracy, for most stocks, is usually not an issue as there are penalties for misrepresenting substantive business information.  To check whether information is current requires checking the dates of publication, datelines for articles, or in cases where the data is not current, clues or references to when the information was published.  If the date of publication is not upfront, there is a clue right there.  Again, this should not be too complicated.    

Checking data for a slant and completeness requires attention to more levels of detail.  First, regarding slant; “Is the information focusing on something that causes me to not see something else?”  I remember a supervisor telling me to include information in my presentation that I wanted to be asked about, and leave out data regarding questions and topics that I didn’t want to address.  Is the article that I’m reading doing that? Also, if I perceive a slant to the article, I ask; “Does the information provider have any motives that I should take into consideration?  Does the information provider hold a position in the stock and need it to go up or down?”  If you read articles coming out of The Motley Fool, for example, they are always very clear about whether the author and the firm hold positions in what they are writing about.  Other questions I ask, include; “Are the news source statements affected by the need for advertising revenues?  Or does the news source have some history with this stock that I should know about?”

Regarding incomplete information, I ask; “Has the reporting left out pieces of information that I might find important? Are there assumptions in the presentation of data, that are not my assumptions?  For example:  Does the piece recommend an investment with the underlying assumption that it will be a short-term holding while you or I are seeking a long-term return? Does the information being presented contain factual analysis or are there opinions added that frame the information in one light or another?”   All of these questions, or questions that are similar, need to be considered when vetting information.

Additionally, at this point I recommend that you perform some comparative analysis regarding your planned investment.  Most of us understand that when looking at something critically, we are analyzing that data.  However, there is a more rigorous form of analysis that occurs when one is examining something by comparing the planned investment with other similar companies or similar situations.   Research shows that making these comparisons is harder work; it requires more attention to detail and requires more careful reading of the data than when reading about a single company.  I recommend that, when you are doublechecking the data you have gathered that you compare the information with other similar, or contrary situations to insure a more detailed and thorough comprehension of all of the facets of your decision.  If this is a new subject for you, I recommend that you look into a book, interestingly enough, titled “How to Read a Book” by Mortimer Adler.  It has a solid description of comparative analysis and reading for comparative analysis.

3.    Apply the criteria. Be complete and clear.

As I am gathering data which I feel is solid, I fill in my framework. For me, this is a back and forth process because I’m thinking about how the pieces fit and what I think is more or less important.  To the surprise of some people, decisions do not usually happen instantly. For most of us, there is some rumination, need for clarification and awareness of gaps as we are completing our analysis. So, whatever your framework, or model or set of criteria, the most important thing is to be clear and thorough, forward looking, countering your personal biases, and using criteria that are clear and actionable.

Financial Frameworks over the past year and a half has provided a number of frameworks for you to choose from, ranging from the (on the surface) simplicity of Charlie Munger and Warren Buffett’s four element model to Professor Bruce Greenwald’s detailed asset, current earnings and earnings growth model.  In Financial Frameworks Podcast 32, I provided a five-element framework for listeners to build on and adapt.  All of the frameworks that Financial Frameworks has presented are solid analytical frameworks and they have been provided with the intent that you will find them insightful and build on them to fit your way of thinking. Whatever set of criteria, or evaluation framework you are using, it needs to be forward looking, countering your (and my) personal biases, complete and using criteria that are clear and actionable.

4.    Prioritize and weight the criteria.

When filling out your framework with the data you’ve gathered, make sure that your criteria are clear and measurable.  That sounds so straightforward that it seems obvious. But remember that when you come to this point, even after all of the work that you have done, there will be, 1) information gaps; 2) some subjective assessments, like gauging management ability, and 3) because we are trying to look into the future regarding earnings, there is uncertainty there as well.  So, being clear about how the criteria, or framework elements, relate to each other and carry more or less importance is essential.

In practical terms this means that you have decided which factors are most important and you are clear about the relationships between your most important and less important criteria. For example, ask yourself; “Are one or two more important than the others? Are the criteria of equal weight and mutually supportive or conflicting and disjunctive?”  That sort of thing. One of my practices is to weight my criteria, as I did in Financial Frameworks Podcast 33 with the example regarding my assessment of Berkshire Hathaway’s margin of safety.  By assigning a percentage, it forces me to be clear about what is important.

 5.    Measure Twice and Cut Once.

After assembling the data, review the criteria for selecting the stock to confirm that it matches your investment goals and objectives. This task needs to be done a number of times as you are working through the data and one final time when you are close to your decision. Selecting an investment needs to be disciplined in the sense that it matches your stated goals. It seems obvious that this would always be the case, but you would be surprised at how often and in the variety of ways people stray from their stated objectives.  The whys and wherefores of how this happens is food for another podcast and is the basis for behavioral finance – the analysis of how and why people make mis-choices or poor choices.

An example that I often think of is General Motors investing in the data processing company EDS in 1984 for $2.5 billion dollars. By late 1986 the investment was struggling and in 1996 General Motors decided that EDS was not contributing to its core business – building and selling automobiles – and spun it off. At best, EDS was a distraction to GM and at worst a drain on its balance sheet, focus and mission at a critical time when imports were gaining market share. Despite GM’s initial intentions, the EDS acquisition did not help GM build better cars.

To sum it up; you need to have stated goals for your choices and stated criteria and need to use those goals and matching criteria as your anchors and foul poles when collecting information and deciding. Warren Buffett’s take on this is worth quoting.  This is taken from the Berkshire Hathaway 2014 annual report, the Letter from the Chairman: 

"Charlie and I frequently get approached about acquisitions that don’t come close to meeting our tests: We’ve found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels," Buffett added. "A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: 'When the phone don’t ring, you’ll know it’s me.'"

You and I need to have that same discipline.

Learning in Practical Terms – Applying the Concepts

Now let’s apply these information gathering concepts into actions.   I’ll use questions and examples to help you apply the concepts because, as a teacher, I reviewed a lot of financial educational materials for use in my classes, and while most of them were very good at providing overviews and logical explanations of subjects, most of them spent little time on realistic, contextually rich, “how to” steps.  The “how to” steps and examples that we went over in class, combined with basic theory, were what my students found most useful when solving work-related, or personal finance problems.  Providing an overview of the physics of how nails and screws hold pieces of wood together is very different from learning how to hammer those same nails, or drive those screws, correctly. Financial Frameworks’ job is to provide you with the conceptual and “how to” information and make those connections between the overarching concept and implementation actions. 

So, let's look at each step of the “trusting your judgement when gathering information” process.  Within each step, I will summarize the issue, look at an example – GE in this case – then provide you with some sample questions that you can use, or rephrase in your own language, to illustrate how to be as clear and objective as possible when gathering data.

The first step in Trusting My Judgement is to review the information gathered. 

The questions I ask are: “Do I have enough information to understand what the company is doing to make money? Do I have all of the financial, historical and forward looking information that I need?  Do I think anything is missing?”

For GE, my primary sources of information are current and recent GE quarterly and annual reports – the balance sheet and income statements are what I look at first, then details in expense reporting – that are required by the SEC.  My secondary sources are current news reports about GE from Yahoo Finance, Value Line, Investor’s Business Daily and news bulletins from my brokerage firm.

My GE questions should work for you, and you can use them to develop narrower questions specific to your prospective investment that are based on what you find.  In the case of GE, I look for data that will help me assess GE’s stated, planned spinoffs because that will be a significant event – or non-event.

The second Trust My Judgement step is to validate that the information is accurate, timely, reasonably unbiased and complete.  Here are some of the questions that I ask:

Do I need to prove the financial information – are there any questions of interpretation or footnotes that need to be explained?

Then, let’s say I’m looking at the most recent published quarter of data, for example, the 3rd quarter and it is now January.  Has anything changed since September that makes the information outdated?  In most cases, as in our GE example, for GE, the most recent quarterly or annual reports are sufficient. Again, I will have kept up with any news about GE since September.

Next I need to determine that my data sources are impartial, so I ask; “Do I see any of the biases or slants that diminish the value of the information or create questions I need to address?  In the case of GE, I know that the financial reporting in quarterly (10-Q) and annual reports (10-K)has to be accurate, so then I look through their plans for the future and other forward looking statements.  I then read commentary, and this is where I look for greater biases, or mixed motivations, that may involve agendas by the writers that are not my own.

I have recommended that you perform some comparative analysis, so let’s consider what that looks like in my GE example.  I ask if I can think of any big company spinoffs similar to GE’s. GE spun off its health care technology business during 2023 and proposes to split the remaining GE into two companies: One being power and renewable energy and the second being aviation or jet engines. My first thought is to consider whether there are any similarities between GE’s becoming three separate companies and the AT&T spinoff of 7 Baby Bells (regional telephone companies) in the 1980’s?  What are the similarities and what are the differences between GE and AT&T before and after the spinoffs? What are the similarities and differences in the economy at the time of each spinoff? What is each company’s capital position before and after the spinoffs?  And so on. Now, you will ask similar questions to perform your comparative analysis.  

The third step in Trusting My Judgement is to look at how the data fit my investment criteria, or framework.  I want the data, my criteria and framework to all fit together tightly.  One question to ask to do this is; “Do I have all the information I need and are there any data holes in my investment criteria?”

In my case, I check to make sure that I have all of the data needed to test a GE stock purchase for margin of safety, earnings projections and potential competitive advantages.  A lot is being written about GE right now and my investment criteria are clear, so completing this step is not difficult. You need to make sure that your criteria or framework checklist is filled.

The fourth step in Trusting My Judgement is to ask: “Do some of the criteria count more than others in making the decision?”

For example, in looking at GE and asking myself what criteria counts most, I remember that when I was first looking at GE a number of years ago, using it as an example for the class I was teaching, analysts were most concerned about whether GE had enough cash to meet its pension obligations and felt that cash flow was the most serious risk it was facing.  Today, most analysts are focusing on earnings projections and the balance sheet is less of a concern.  I reviewed GE’s balance sheet and agree with that assessment.  So, I will weight any decisions to be consistent with current real world analysis and will give more weight to my evaluation of earnings.  So will you.

The fifth and final step in Trusting My Judgement is to ask; “Does my choice match my investment objectives?” Measure twice and cut once.

In the case of GE, would the investment match my short-term and my long-term objectives?  Is the choice consistent with my strategy? Since my major objectives are; 1) safety of principle, 2) long-term growth, and 3) purchase at the right price, GE looks like it is worth further investigation.  If there were any concerns regarding meeting my objectives, let’s say a major concern about long-term growth, I would make a note to make that a focal point of my research as I go forward and look at GE more closely.

Conclusion

I hope that these example questions and exercise of applying the concepts has been useful to you. I strongly believe that learning by doing is much more effective and powerful than reading content and answering hypothetical questions or writing an essay for a grade.  Using analytical tools and taking action on something you care about creates ownership of the knowledge and the process.  The questions I have presented here are not exhaustive and are examples that need to be reworked into your own language and approach.

The next installments of both blogs andpodcasts will address my third hardest task – knowing when to say yes to an investment. At first glance this may seem redundant and similar to what we have just discussed, but I see it as an additional, important, step.  This is partly based on my experience with the game of golf (learned on a 9 hole course in a small town in Iowa) as well as observations by golf commentators and famous golfers.  In my case, before hitting the ball, when planning a golf shot, I would consider distance, how the ball sits on the ground, wind, hazards, hard or soft turf, and so on. After doing all of this, I still had to commit to the shot. All of the ingredients and plan were in place. But I still had to commit.  I believe that investing hard earned money should not be done without the “commit step.” 

Thank you for your time and consideration. If you have found this blog useful and insightful, please mention it to an associate for their consideration. See you next time.

Mike Lehan

Financial Frameworks