Meaningful Methods For Assessing Investment Performance

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In the last post, I talked about how misinformation in assessing investment performance leads to a spiral of poor investment decisions, which results investors accumulating losses over many years while being stuck in their investment careers.  I also explained the reasons behind the misconceptions, and how they are related to two crucial factors that come into play when evaluating the performance of investments.

The two factors mentioned were (1) How to tell if an investment is actually doing well or not, and (2) How not to be automatically disappointed when you see a negative price change (as the change is not necessarily an indicator that an investment is doing poorly).

After reading the last post, you have obtained the knowledge to recognize, acknowledge, and understand the reasons behind the problem.  The knowledge will also help you to form the correct mindset and habits required to use better practical methods for evaluating investment performance.  This addresses the first crucial factor.   I will present techniques and tools in the first section of this post.

The last post also briefly touched upon the second crucial factor of how not to be automatically disappointed when you see a negative price change, by tempering expectations and being disappointed about the right things. In the last section of this post, I will finish discussing how to overcome the disappointment.

Together, the knowledge and practical methods, will help investors consistently achieve serious success in investing.

 

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Techniques & Tools (Metrics For Gauging Performance)

When assessing investment performance, you really need to assess investments on an individual basis.  In the first post, on why yearly performance numbers don’t matter, I discussed how total portfolio performance doesn’t really tell you much and actually hides real performance.  Looking at the portfolio’s cumulative numbers as a whole will mislead an investor.  Investors should only evaluate their portfolio as a whole, when doing so from a perspective of function and purpose, not returns or performance.

 

With stocks you only really look at the stock’s price when you intend to buy, and when you intend to sell. Market prices do not accurately reflect the underlying investment’s intrinsic value, and is largely affected by non-related factors (the broader market, investor sentiment, geopolitical issues, and even the economy).  If you don’t intend to sell, and won’t be forced to sell at unfavorable prices, then the market price is largely a useless indicator.  But we do need something.

Between when you buy and sell, changes in price is referred to as unrealized gains & losses.  Because you haven’t sold anything, your gain/loss on the price change will actually be $0 until you do so (hence unrealized). Instead, what you want to focus on in the meantime are (1) business metrics, and if applicable, (2) realized gains/returns (such as dividends received, in certain situations).

We’ll discus the general metrics first, and then discuss the realized returns.

 

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(1) General Business Metrics

By far, the most important thing to look at and keep an eye on, is the performance of the underlying business (and it’s management).  After all, the closer a business is to going bankrupt, the closer your stock will probably get to $0.  But not the other way around.  i.e. A decline in the stock price does not affect how a company’s ability to generate cash from operations.  As a reminder, private businesses don’t have a publicly traded stock, so their tradeable stock price is $0 at any given time.

As part of the mindset change, you truly need to embrace looking at stocks as pieces of companies, and that you are holding real businesses. There is overwhelming evidence that looking at stocks in this way has produced successful investors and more importantly a sustainable way of producing serious money.  Again, Buffett has also advised this for decades!

 

There are generally three business areas to look at:

  • Strategy & direction – This is the long term direction of the company and a reflection of the management and their values.  You need to be able to trust the management, and that’s what everything boils down to at the end of the day.  If you can’t trust management, you can’t trust their numbers either.  More on that later.***
  • Milestones – What is their schedule?  Expect delays to it.  Things are very much tied to what the company does, not what it’s stock does.
  • Results (financial) –  Earnings per share, Free Cash Flow (FCF), Book Value (BV), Funds From Operations (FFO), Net Operating Income or Operating Income Before Depreciation & Amortization (NOI, OIBDA, etc).  Make sure you are looking at the right one for the kind of business you have, and understand what these are telling you (limitations):

 I’ve listed the most common below with some comments:

EPS and Operating income – For businesses that have some kind of normal operations that report income like banks, retailers, manufacturers, etc.  Limitations include capital expenditures, acquisitions, write-downs, etc, which in any given year can impact earnings numbers downwards. An uneven operating environment can result in some years experiencing better results than in other years making the next year look worse (when in fact the previous year was unusually profitable), the opposite is also true.

Free Cash Flow (FCF) – Cash Flow after subtracting expenses.  Most straight forward of indicators. This is a great indicator for companies that operate outside of the financial and insurance industries, and that are not holding companies.   If you are a business, it’s what you pocket at the end of the day from your operations after paying the bills.

Funds From Operation (FFO) – It’s pretty much the real estate equivalent of FCF.  Think rent minus expenses.

Book Value – This is particularly useful for financial, insurance, and holding companies.  Companies like Markel [MKL] and Berkshire Hathaway [BRK.A] have both Book Value and EPS generating components.  However, the simplest gauge to use for them is the change in book value, which is a good reflection of change in intrinsic value.  Buffett has mentioned this many times for $BRK.

There are more, but these are the main ones that will be useful in the majority of cases.

 

****Bear in mind that it really comes down to being able to trust the management of the company.  If you can’t trust management, and they want to hide or manipulate numbers in the financial statements, they will.  Unless you are extremely familiar with corporate accounting, it will be difficult to find something funny in their numbers that their finance department is hiding, which can get past the auditing accounting firms.  Keep in mind that the bank losses that were piling up during the housing crisis were for the most part visible in the financial statements, as increasing loan loss reserves.  But again, without looking at that, the best managed banks (Wells Fargo, US Bancorp) kept their companies away from such a mess.  Management matters!

 

 

Additionally your expectations need to be inline with reality, by (1) knowing some general aspects of the industry, and (2) focusing on the purpose behind your investment:

 

Industry:

  • How many years does a turnaround take?
  • How long does something take to complete.  Examples: How long does it take to bring a metal mine to production? (exploration, permitting, building, etc.).  How long does it take produce a new version of software, or release a new product?
  • How much money do certain projects take to complete? (i.e. how much cash will a company need to do it?).
    What are the typical profit margins, lead times, challenges, growth rates, etc. (to compare with).
  • Industry problems/pitfalls?

You do need to make sure your expectations are inline with them.  For example, you can’t expect exploration, permitting, and mine development, to all be completed within a very short period of time like 2 yrs.  Exploration takes a few years, permitting takes at least one year, and development another 1 year at a minimum.

 

Purpose:

Look at metrics related to the purpose of your investment, as those metrics should have a higher priority.

Examples:

  • If you bought the investment to appreciate with inflation and it gains roughly 3-6% by the end of the year then it’s done it’s job, assuming inflation is within that range. Note that calendar dates aren’t particularly useful, but roughly 12 months (plus or minus a few) is reasonable.  Also, it doesn’t really matter what happens in between that time period, as long as it does what it should within the expected time frame.
  • If you bought an investment to counteract the rise in food prices, then it should do just that.  If food prices decline, then you can expect a related tracking index to also decline.  You shouldn’t be disappointed with such a result, as that is the intended purpose.  Conversely, if food prices rise, then you should expect index to rise by a proportional amount.  Anything above that is just a bonus.

 

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(2) Realized Returns

The realized return from selling an investment is the capital gain (acquisition cost minus the market price it is sold at) plus all dividends collected while holding it.  This is good gauge of performance if you sell an investment or part of an investment.

Aside from the returns realized by selling an investment, some investments distribute dividends or interest payments while you hold them.

Realized returns from distributions are good gauges of intermediate performance, only if the purpose of the investment is income, or if distributions are directly linked to the business performance (like REITs, pipelines, etc).  If you bought an investment to produce income, and it is outputting the expected amount or more, then it is performing well regardless of the stock price.  However, there is one important caveat, which is that any past distributions issued give no indication of it’s future sustainability.   For that we must look at the business metrics.  Therefore both realized gains should be used in combination with business metrics in such a case.

Realized returns from dividends/distributions should not be used as a metric if income was not the purpose of the investment, or if distributions are not directly linked to business operations as mentioned.  The reason is that the real purpose of the investment would then likely be for capital appreciation (rise in equity value), for which the gauge of intermediate performance would be just the business metrics.  Many investors make the serious mistake of using small dividend amounts received as the gauge, without looking at the business metrics.  The financial crisis has shown this fallacy as most investors were collecting pennies in front of the steam roller!

 

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Managing Your Emotions and Going Against The Herd

After sorting all that out, the only thing that really remains is knowing yourself.  That is being aware of when you are being swayed by emotion… and then stopping yourself or just avoiding the situation from happening altogether (ignore price).

Buffet says there are only two things you can do wrong in stock investing.  (1) Pick the wrong company (2) Sell at the wrong time.

The first is much easier to avoid, with all the modern stock screeners, and publicly available information, you can avoid bad companies and bad management.  The second is easy too, but most people have a lot of difficultly with this.  To make things worse they lack the knowledge, so there is nothing to stop them from making the sell decision on misplaced disappointment.  The effect is magnified when the herd mentality kicks in, and everyone else is selling and panicking.  With knowledge and the proper metrics, there is now a filter in place to ensure that you don’t sell at the wrong time (i.e. for no reason).  It makes dealing with any real disappointment less frequent and much more manageable.

 

Therefore the problem is now reduced to self-control & self-management, which gets easier over time and with practice (i.e. forming good habits).  It also reduces you to the first problem of picking the wrong company, by making your selection criteria more stringent (i.e. skill refinement).

 

All successful investors have experienced and have overcome disappointment from seeing a temporary negative position (sometime for years) or real losses (sometimes very large), at some point earlier on in their investment career.  Crashes can have the effect of essentially numbing your sensitivity to these kind of experiences, so that you can think and act rationally.  Unfortunately for most people they are missing the knowledge part, so they don’t benefit from the numbing, and make the same mistakes.  After the last two posts, you now have enough knowledge to handle that.

However, to become desensitized through an extreme event, is usually outside of your control.  Alternatively, this can be achieved in a much more comfortable manner.  Positive discussion with knowledge seeking individuals and reinforcement of what you know, versus what the crowd thinks you should know, will help solidify good habits and the right mindset.  Selective reading (ignoring most financial commentary in the media) can also help clear your thoughts whenever any disappointment that come from the wrong metrics (sometimes unavoidable to look at it, especially when you are in the buying mode).

 

Hope you’ve found this enlightening, entertaining, and useful!

DISCLOSURE:  I own shares of Markel and Berkshire Hathaway, and buy/sell their shares from time to time without notice.

Thanks and Happy Investing!
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© 2015

Author: The Investment Blogger

I’m a private investor, who developed the “function-centric investing” paradigm. I am an investor who blogs a little here and there, rather than a blogger who invests a little here and there. I'm passionate about investing and sharing investment knowledge!

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