Follow the script

Last year ended introspectively, with a failed trade in Armour that was both expensive and misguided, but before then I felt I was losing my grip on some of the constituents in the Thrifty 30 portfolio.

My resolution this year is a simple one to make and perhaps a more difficult one to achieve. It's:

Only to add a company to the Thrifty 30, or hold a company, if I can articulate my reasons in less than two minutes in words a teenager can understand.

You probably know this is an unoriginal idea. It comes from one of my investing heroes, Peter Lynch. This is a quote from One Up on Wall Street:

Before buying a stock, I like to be able to give a two-minute monologue that covers the reasons I'm interested in it, what has to happen for the company to succeed, and the pitfalls that stand in its path. the two-minute monologue can be muttered under your breath or repeated out loud to colleagues who happen to be standing within earshot. Once you're able to tell the story of a stock to your family, your friends, or the dog (and I don't mean a guy on the bus says 'Caesars World is a takeover'), so that even a child could understand it then you have a proper grasp of the situation.

There's more meaning in those obvious words than you might at first think. Most share write ups cover the reasons the author is interested in a stock. Mine are predominantly statistical. The company looks cheap and financially strong.

Those are characteristics of a good investment but they can lead to a kind of myopia, where the investor is only interested in absolute bargains and financial fortresses when in fact companies are rarely both at the same time. 

Lynch conceived of six situations in which an investor could make money. In each one we have established the company is undervalued using a benchmark like the price to earnings or price to book ratios and are trying to establish what needs to happen for the value to be realised. Here are his categories, and the kind of information that might be included in the corresponding script (let's call them two second templates):

1. Slow growers: Determine the company's record of many years of reliable profits and dividends and any new opportunities or threats.
2. Cyclicals. Examine the state of the industry, whether sales are increasing after a slump, and capacity in the form of factories and employees has fallen.
3. Asset plays. Focus on the balance sheet, what the company owns compared to its value on the stockmarket.
4. Turnarounds. Determine how the company got into trouble and evaluate its recovery plan. Is it working so far?
5. Stalwarts. Consider what the company is doing to continuously improve itself, and whether the shares are cheap relative to past levels?
6. Fast growers. Analyse the market: is there room for the company to grow? Does it have the financial resources, and something of a niche to grow in?

The script is the investors' edge. It helps identify the catalysts that cyclicals and turnarounds need to recover, and the competitive advantages stalwarts and fast growers need to succeed.

A script is not a prediction, it's a statement of what an investor thinks needs to happen. It should be tested by talking to management, reading the annual report, monitoring events, and soliciting the thoughts of other investors. It's a working document that reminds you what you don't know and gives you a framework for deciding when to sell; when things don't go according to script.

My scripts fall short of this goal. They're dusty, frayed parchments, reports that identify a company is cheap but often fail to identify the source of the value and what it will take to realise it, I file them and forget about them for at least a year, and sometimes more. When I revisit them, I can get a rude shock'

Had I thought more clearly about Armour I might not only have recognised it was a cyclical stock, but also that the signs of recovery, both in the company, and in the industry were quite weak. I might not only have recognised it had expanded dramatically into a completely new market, home entertainment systems, but that this was a huge risk that might plunge the company into financial difficulty. I might have recognised that although it looked cheapish and strongish, the chances were it would get cheaper and weaker. I might not have added it to the portfolio.

Two minutes is about 350 words. I'll be publishing my two minute monologues of course, and republishing them every time they change.