Over the years I’ve read a lot of books about investing and value investing in particular.
Out of all those books, only a handful had a major impact on how I invest.
In fact, that handful of investment books has probably helped me to generated excess profits of more than a thousand times their combined cover price, which certainly sounds like a good investment to me.
So in this blog post I summarise 39 of the most important things I learned from three books that had the greatest impact on how I invest.
The New Buffettology, by Mary Buffett
This is the book that launched my move from Ben Graham-style deep value investing (buying micro-cap companies for less than the scrap value of their tangible assets) to Buffett-style defensive value investing (buying consistently successful dividend-paying companies at attractive prices).
I read it in 2010 at a time when I was getting fed up losing money on turnaround situations that never turned.
The book had almost everything I wanted and even today it forms the kernel of my strategy.
Here are some of the many things I learned from The New Buffettology:
1) Most investors are driven by today’s news rather than the long-term expected performance of the companies they own (I already knew this when I read the book, but it’s still an important lesson).
2) Good companies with long track records of success are much more likely to turn around than weak companies with histories of so-so results (this is important because value investing often involves buying companies that are turning around to some degree).
3) Good companies are ones that have some sort of low-cost durable competitive advantage so they don’t have to compete primarily on price.
4) The best low-cost durable competitive advantages are based around well-known brand names combined with products or services that customers need to purchase repeatedly, preferably more than once each year (e.g. Colgate, Nurofen, Coca-Cola, Google).
5) As with all forms of value investing, buying shares at attractively low prices is critical. This means that bear markets are good and bull markets are bad. It also means the best time to buy good companies is when they’re facing (preferably minor) problems and are out of favour with other investors.
6) When analysing a company, look at the financial results for the last ten years.
7) Good companies have consistently high rates of profitability because they can either charge a higher price for their goods/services or they can provide the same goods/services at lower cost (according to the book Buffett uses return on shareholder equity and return on total assets to measure profitability).
8) Good companies have steady earnings which increase over time.
9) Good companies have low levels of long-term debt.
10) Good companies can generate high rates of return on retained earnings.
11) Using simple school-level maths to value companies is much better than going by how you “feel” about a company, or what your uncle/brother/mate-down-the-pub said.
12) Using an investment checklist is by far the best way to analyse companies because a) it forces you to be consistent in your analysis from one company to the next and b) it gives you a blueprint which you can improve as you make new mistakes and learn new things.
I must admit that I love this book, especially the bit at the back where it has a long and detailed checklist of quantitative and qualitative questions to ask when you’re reviewing a company.
I basically used a pure Buffettology approach when I first switched to defensive value investing in 2010 (or selective contrarian investing, as the book calls it). In a bit more detail, I:
- Started looking at revenues, earnings and dividends, rather than just assets and liabilities
- Began investing in FTSE 100 and FTSE 250 companies, rather than just small and micro-caps
- Looked at ten years of financial history for each company, rather than just one
- Went beyond simple ratios like price to net tangible assets and started to look at each company’s business model, competitive advantages and other qualitative factors
- Wrote everything down in an investment checklist
Today my strategy is substantially different in detail, but the basic goal of using a checklist to look for good companies at low prices is the same.
For balance, here’s something I don’t like about the book. I might be wrong, but from memory there’s very little about portfolio management, i.e. position sizing, number of stocks, diversification, that sort of thing.
I think portfolio design and management is incredibly important, so this is a bit of an oversight in my opinion, but perhaps Buffett or the author disagrees.
The Intelligent Asset Allocator, by William Bernstein
I read this book somewhere in the early 2000’s. Back then I was a passive index-tracking investor and – in the depths of the 2003 bear market – I’d just panic-sold out of my FTSE All-Share tracker.
I thought there was probably more to this investing lark than just owning a FTSE All-Share tracker (yes, I had all my money in just one tracker), so I bought this book.
I wanted to learn about how to build a diverse, low-risk portfolio of multiple indices, covering international stocks, bonds, commodities, real estate and so on.
What I basically got was a first class education in risk and return, asset allocation and portfolio design.
Here are some of the most important lessons from this fantastic book:
13) Asset allocation can have a massive impact on a portfolio’s performance.
14) Risk and return are usually joined at the hip (risk is defined in the book as standard deviation or volatility of annual returns while returns are defined as long-term annualised returns).
15) If you want higher returns you need to be willing to accept higher risks, i.e. more volatile annual returns and a greater risk of loss (although Buffett strongly disagrees with this premise).
16) As individual asset classes, stocks and bonds can be incredibly volatile; more volatile than most people can tolerate (e.g. the novice version of me panic-selling in 2003)
17) In general, the longer a risky asset is held, the better the chances of a good outcome (in other words, investing is a long-term game of years and decades, not weeks or months).
18) Dividend yield + dividend growth is a good way to estimate long-term future returns from the stock market.
19) Mixing assets with weakly or negatively correlated returns can reduce risk and increase returns at the same time.
20) Some form of rebalancing is essential because a) it keeps your portfolio’s actual asset allocation in sync with your desired asset allocation, and b) it forces you to be contrarian (i.e. a value investor) by selling the best performing assets (selling high) and buying more of the worst performing assets (buying low).
21) The future cannot be predicted, so an asset allocation should be chosen which will perform reasonably well over a wide range of possible futures.
22) It is possible to value the entire market using price to earnings, book value or dividend yield (although long-term measures like the CAPE ratio are better).
23) Good companies are generally bad stocks, and bad companies are generally good stocks (because good companies are usually expensive and bad companies are usually cheap. However I would say that good companies at low prices are even better).
24) Dynamic asset allocation is a turbo charged version of rebalancing with the aim of increasing returns and reducing risk even further. It works by deliberately allocating more of a portfolio towards whatever has gone down the most and away from what has gone up the most (which sounds a lot like value investing to me).
In fact, The Intelligent Asset Allocator may well have been the first place I read about value investing and Ben Graham, and for that I am eternally grateful.
This may be my favourite investment book of all because, for some reason or other, I find portfolio design and asset allocation very interesting; much more interesting than picking stocks and analysing companies.
But even if you’re a bottom-up stock picker rather than a top-down portfolio builder, I think you’ll still find this book extremely interesting and useful.
On the downside, there are quite a lot of equations, charts of various kinds and numbers in general. But this is a book about investing, so a few numbers should not be the end of the world. But still, it’s quite a dense read, but easily worth the effort I think.
As for how this book affected my portfolio, it made me:
- Increase my holdings to the point where I now hold about 30 stocks
- Invest in a geographically diverse way, with companies operating in many different and hopefully economically uncorrelated countries
- Invest across many different and hopefully uncorrelated sectors
- Have a policy of selling down winners (selling high). I also top up losers if the original investment case is still sound (buying low)
- View the portfolio as a single entity rather than as a collection of stocks. For me, the portfolio’s overall performance is far more important than the ups and downs of individual holdings
So The New Buffettology taught me how to analyse companies to see if they’re high quality companies at attractive prices. The Intelligent Asset Allocator taught me all about the power of broad diversification and regular rebalancing.
The final book in this list taught me about the importance of focusing on the value-adding traits that some stocks have, rather than on the individual stocks themselves.
It also taught me an ingenious and robust way to compare hundreds of stocks against each other in an instant.
The Little Book that Beats the Market, by Joel Greenblatt
As well as being a part-time professor, Greenblatt is a legend in the world of investing and his long-since closed hedge fund, Gotham Capital, had a track record that was quite simply ridiculous (40% annualised returns over 20 years!)
I bought the book because I’d watched some interviews with Greenblatt and what he said made an enormous amount of sense. His message was basically to buy above average companies at below average prices, rebalance once a year and ignore pretty much everything else.
Of course, the devil is in the details, so here’s what I learned from this book:
25) Investing is hard, so having a disciplined, methodical, long-term investment strategy that both works and make sense to you is essential.
26) The true value of most listed companies does not swing wildly from high to low, or low to high, despite their share prices doing precisely that.
27) Stock market volatility is driven by emotion or other factors that have little to do with economic realities.
28) Buying stocks at a big discount to fair value is a good idea, but figuring out fair value is very hard because fair value depends on future profits and the future is hard to predict.
29) A stock with a higher earnings yield is better than a stock with a lower earnings yield (all else being equal).
30) A company with a higher return on capital is better than a company with a lower return on capital (all else being equal).
31) A company with high rates of return on capital has the potential to generate high rates of return on reinvested earnings (i.e. earnings not paid out as dividends).
32) Companies with high rates of return on capital usually have some sort of competitive advantage.
33) Buying good companies (with high returns on capital) at low prices (high earnings yields) is a good idea.
34) Over the long-term it is the average performance of your holdings that matters, not their individual performances.
35) Absolute measures of quality can be excessively restrictive during bull markets (if your minimum standards are a return on capital and earnings yield of more than 15%, there may be no such stocks available).
36) Relative measures of quality work no matter what sort of market we’re in (even in a bull market there are companies with the best combination of return on capital and earnings yield).
37) An excellent way to find companies with the best combination of quality and value is to use ranking. Just rank the whole market by each factor (so the company with the highest return on capital gets a return on capital rank of 1, the next highest gets a 2, and so on) and then add up the factors for each company. The companies with the best (lowest) overall rank are the most attractive.
38) If a good investment strategy worked all the time then everyone would use it and it would stop working (as per the efficient market hypothesis).
39) So counterintuitively, the best strategies will usually have long periods of underperformance, which will shake off all the uncommitted bandwagon chasers and allow for outperformance again. Once the strategy is unpopular it should start working again.
There are a lot of great ideas in this book. For me the two most important are 1) focus on the performance and characteristics (growth, yield, etc.) of the portfolio rather than individual stocks, and 2) find attractive stocks by ranking the whole market by each attractive factor in turn, and combining those ranks into a single “super-rank”.
The point about ranking stocks is especially important because my stock screen is now largely based on that one idea, and so far it’s worked extremely well.
Thank you, Mr Greenblatt.
What are your favourite books?
So that’s my list of dessert island investment books, ones I have a special attachment to because they’ve helped me so much.
The first one got me into defensive value investing in the first place, the second taught me about diversification and rebalancing and the third one taught me to focus on the portfolio and how to rank stocks.
If you have any favourite investment books that have really helped you out, please mention them in the comments below so that other readers can benefit from your experience.