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Saturday, April 28, 2007

from an email I sent about investing

I've posted this here in case someone might find it useful.


The reason I don't like companies with massive liabilities and hardly any assets makes sense if you translate that into a real life analogy (it's very important in investing to be able to take a set of financial numbers and understand what that really means in the real business). Let's say someone has $50,000 in total credit card debt, they owe $10,000 on their car (which is only worth $12,000) and the sum total of everything else they own is less than $3,000. Their assets are $15,000 and their liabilities are probably more than $60,000. What sort of person gets into that situation? It's almost always bad news how they got there. Things aren't working for them. How much flexibility are they going to have? People like that often end up paying more for food, a home, and stuff because they don't have flexibility. They typically live paycheck-to-paycheck and can't take advantage of good situations when they occur. They can't invest in education and probably can't take risks in their employment.

You can imagine all sorts of scenarios involving what people have, what they owe, how much money they make, and when they get to take it home. The above situation changes entirely if they have a goose that lays golden eggs. In that case, you'll see big revenues and wonderful margins (i.e. the cost of the eggs is nearly zero). Their financial situation will very quickly


I refuse to advertise because of two reasons. The first is that I don't want to answer to advertising, either directly or indirectly. What would happen is that I would start to measure the number of page hits I get and I would unconsciously start adapting the blog to increase the advertising revenues which would be pointless considering that I make or lose far more money based on investment decisions.

The second reason is that the benefit I get from advertising (in dollars) is much less than the annoyance it would cause the readers. It has a negative producer/consumer surplus. It would reduce the value of the blog by more than the amount of money I might receive. While the readers would pay for it in the short term, in the long run the cost would come back to me in reduced readers (especially the readers I care about most: people who make sizable investment decisions).


Much of what I'm looking for when reading financial statements are patterns that signify something bad. There has been a lot of benefit to simply reading lots of reports for lots of companies. In fact, I believe that this is a major rule of life that the book Blink describes. Lots of experience combined with careful observation allows a thinking person to learn a great deal about complex systems.


Much of my investing is based on an intuitive understanding of how a business works. Consider sailing a boat. I learned to sail by sailing very small boats. I spent a lot of time figuring how the various forces on boats work both in theory and in practice. BOTH ARE VITAL! Theory without practice/exeperience doesn't give you a full understanding of any complex system. Practice/experience without theory causes the important things in experience to be lost. So with sailing, I got to a point where I could sail a small boat without a rudder simply by shifting the weight and forcing the center of drag to be horizontally offset from the center of effort of the wind. I wouldn't have been able to do that without both theory and practice (try going around in small circles that way).

I've spent a lot of time reading books about marketing, about business history, about various types of complex systems (everything from weather to the game of Go). So when I look at a business, I try to get an understanding of the forces that affect that business. When I bought a partner ownership in a gym, I knew the costs and revenues and I knew what would happen if more members were added (it would go profitable very quickly, as it already has). I knew that the new employee who I've known for many years would instinctively bring in new members (which has already happened). I also knew that the other partner would be an even keel to keep the business from going unstable (which has already been demonstrated to some extent).

Understand the system and how it will respond to various changes! Then try to understand what those changes will be in the future.

With investing there are three categories of companies:
1) good investments
2) bad investments (i.e. good short opportunities)
3) don't know

Almost all companies fall into the third category, even a large number of companies that will turn out to be good investments. It's important to adjust the filtering so that nothing bad goes into category 1. Even then, some will. That means you need to "know what you don't know".

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