How Has Your Investment Process Developed?

How Has Your Investment Process Developed?

By Tim Du Toit

I do not know about you, but as time goes by I appreciate the works of remarkable people, in any field, more and more.

It allows me to start any subject not as a complete beginner, but as someone with a good or even great fundamental knowledge of any subject by reading a few books.

A major part, practical experience, is still missing, but just imagine what we would have to go through if we did not have access to the knowledge at all.

Anything we would start would be from absolutely nothing.

A good example of learning from others would be the development of my investment process.

Here is a short summary of the main developments:

• I started out with a basic correspondence course on the stock market in 198
• I lost money I pooled with my father using technical analysis
• I listened to brokers and lost more money chasing the hottest stocks while trading a lot
• I discovered a book Winning on the JSE by the mathematician Karl Posel that gave me a framework for finding, evaluating, buying and selling undervalued investments.
• From there I went on to read Warren Buffett, Benjamin Graham, David Dreman and many more.

My investment process thus moved from a process with no proven evidence of success to one that has substantial proven success with the help of other successful investors. All of this through reading and doing.

Over time my investment process has moved from the use of a few basic financial ratios to check-lists.

Until recently my favourite valuation metrics were:

• Price to earnings ratio ("PE") the lower the better
• Price to book ration ("PB") also the lower the better and
• Debt to equity where I prefer companies with less than 35%

That however changed when, about two years ago, I read a book by Joel Greenblatt called The Little Book that Beats the Market.

The book suggests the use of two ratios,

• one to identify good companies that earn high returns on assets and 
• a second ratio to identify cheap or undervalued companies.

Since reading the book these two ratios have become the main valuation metrics I use.

To identify good companies

Ratio 1

= EBIT / (Working Capital + net fixed assets + short term debt)

The higher this ratio the better. Higher means the company earns a high return on its total assets, fixed assets as well as working capital.

Where:

EBIT = Earnings before interest and taxes

Working capital = Current assets - current liabilities

Net fixed assets = Total fixed assets - depreciation (Excludes goodwill and other intangible assets)

To Identify undervalued companies

Ratio 2

= EBIT / Enterprise Value

As with the first ratio a higher value here is also better. Higher means you are paying less for the company in relation to the profit it generates.

Enterprise value is calculated as follows

= market capitalisation (number of shares * current share price) + debt - cash

Enterprise value thus expresses the value of the company to you as a private buyer of the whole company.

Firstly you pay for the market capitalisation plus the debt, which you have to repay, minus any available cash you can use to reduce the company's debt or pay out to yourself to lower the purchase price.

The added advantage of using Enterprise Value is that it already incorporates the debt and cash the company has on its balance sheet. So you do not separately have to evaluate the amount of debt the company carries.

What are your favourite valuation metrics? Let me know in a short note on the contact page on my website.

Go here for an investment checklist example.

Tim du Toit is the editor and founder of Eurosharelab. He has more than 20 year of institutional and personal investing experience in emerging and developed markets. Tim is based in Hamburg, Germany. More of his articles can be found at http://www.eurosharelab.com. Article Source: http://EzineArticles.com/?expert=Tim_Du_Toit