Three Essential Points Every Investor Should Understand

I could do a week’s worth of blog posts just pulling quotes from Michael Mauboussin’s latest note, but I’d rather you just read the whole thing.

That said, I did pull this little gem out for you, because I think the three points made here are absolutely essential. No one explained any of this to me early on, but I’ve certainly picked them up along the way (after a million mistakes and blindfolded endeavors).

Here’s Michael on his introduction to understanding stocks, having virtually no experience with finance classes in college:

I believe my lack of business education was an asset because it encouraged me to ask a lot of questions and to think from first principles. I recall going to an equity research morning call and hearing the utility industry analyst suggest the slow-growing companies under his coverage deserved price-earnings (P/E) multiples in the high teens and the tobacco industry analyst imply that his fast-growing companies should trade at P/E’s in the mid-teens. How does that make sense? I was dropped into a world of rules-of-thumb, old wives’ tales, and intuitions. William James, the famous professor of psychology, suggested that upon entering the world a baby “feels it all as one great blooming, buzzing confusion.”

That captured it pretty well. My first breakthrough occurred when a classmate in my training program handed me a copy of Creating Shareholder Value by Alfred Rappaport. Reading that book was a professional epiphany. Rappaport made three points that immediately comprised the centerpiece of my thinking. The first is that the ability of accounting numbers to represent economic value is severely limited. Next, he emphasized that competitive strategy analysis and valuation should be joined at the hip. The litmus test of a successful strategy is that it creates value, and you can’t properly value a company without a thoughtful assessment of its competitive position.

The final point is that stock prices reflect a set of expectations for future financial performance. A company’s stock doesn’t generate excess returns solely by the company creating value. The company’s results have to exceed the expectations embedded in the stock market.

Josh here – I’ll take those one by one:

1. Assume that virtually every one in the game can read an income statement and a balance sheet. The numbers are important, but they don’t answer any questions on their own, especially if we’re all aware of them.
2. Of course the company’s competitive position and strategy are going to affect valuation. This is why Facebook can sell for 40 times earnings while its peers in the media stocks (yes, it’s a media company) sell for less than half that. Facebook is eating their lunches and has a much better strategic outlook than the lot of them.
3. Expectations, and the revisions up and down taking place each day in the minds of the market’s participants, are the only thing that pays. A company does its part to improve, but only by improving at a rate that is faster than the guesses of the stock players does the share price go up.

If this stuff sounds obvious to you, know that you are fortunate and probably very experienced. These things are not obvious to everyone.

The average investor thinks in linear terms, like such and such company is good or bad, or it’s cheap or expensive, therefore its stock is a buy or a sell. Good or bad relative to what? is the real question.

Okay, now promise yourself you’ll find time for the whole note:

Reflections on the Ten Attributes of Great Investors (Credit Suisse)