• Paul Sonkin & Paul Johnson
  • August 20, 2019
    Read, recorded or researched
A survival guide for someone embarking on a career as an investment analyst. Sonkin and Johnson are both Wall Street veterans and part-time business school professors, which make them perfect authors for a manual like this. It’s well structured and easy to read.

How to value an asset

  • Cash flow can be generated from either operating an asset or selling an asset. Liquidation value and Private Market Value approaches are used to determine intrinsic value when selling an asset. Determining the intrinsic value when operating an asset is comprised of three layers:
  • Value of invested capital
  • Value of competitive advantage
  • Value of incremental growth

How to value a business

  • The discount rate stack

How to evaluate competitive advantage and value growth

  • Must compare potential return against cost of capital to see if investing in the business makes sense
  • Great place to understand ROIC is Michael Mauboussin’s Calculating Return on Invested Capital (google it)
  • Sources of competitive advantage
  • Potential sources of cash flow

How to think about behavioural finance

A systematic bias that results in a pricing error can only occur if there is a failure in at least one of the following conditions of the wisdom of crowds:

  1. Informations is either not available or not being observed by a sufficient number of investors
  2. There’s an insufficient amount of domain specific knowledge within the collective
  3. The crowd lacks diversity
  4. There’s a breakdown in the crowd’s independence
  5. Estimates are not being expressed, aggregated and incorporated into the market price
  6. There’s a lack of proper incentives

Behavioural finance can only cause mispricings in three of these six factors: diversity, independence and incorporation.

  • Homo sapiens originated about 200,000 years ago. However, behaviourally, we reached modernity about 50,000 years ago. With new agricultural techniques and domesticated animals, our hunter gatherer ancestors started to settle into what we call civilisations only 10,000 years ago.
  • Evolutionary biology teaches us that humans have evolved to conserve energy and avoid exertion. Because food was in such short supply, our hunter gatherer ancestors who expended only the energy needed to survive, had the opportunity to reproduce and flourish. In other words, we are genetically programmed to be lazy – to take shortcuts and use heuristics.
  • Behavioural finance holds that investors may not always act rationally, and investment decisions may be driven more by human emotions than classical economics predicts. This insight leads people to believe because people are irrational, so are markets. But that’s incorrect.
  • The primary reason why individual behaviour doesn’t aggregate to explain group behaviour is because the stock market is a complex adaptive system.
  • The most important characteristic of a complex adaptive system is that they exhibit emergent behaviour. Which means, simply, the whole is greater than the sum of the parts.
  • Shiller proved that individual behaviour doesn’t matter unless that behaviour produces a systematic error in the collective.
  • Although individuals can, and will, make errors and may appear to act irrationally, the individual errors will cancel each other out and have no impact on the crowd’s error as long as the individual errors are not systematically correlated.

How to add value through research

  • A stock will be efficiently priced if it reflects all available information, meaning that:
  • Information is adequately disseminated with market participants observing, extracting, and aggregating the info.
  • Information is processed by market participants who evaluate and estimate without systematic error.
  • Information is expressed, aggregated, and incorporated into the stock price through trading.
  • The consensus will fail to produce an efficiently priced stock only if at least one of these four conditions exists:
  • Information is not available and observed by a sufficient number of investors.
  • There’s a lack of diversity.
  • There’s a breakdown of independence.
  • Estimates are not expressed, aggregated and incorporated into the market.
  • To outperform, you need a variant perspective that identifies an inefficiency and provides an advantage, or edge, to exploit the mispricing. These advantages fall into three categories (and they mirror the market inefficiencies):
  • An information advantage
  • An analytical advantage
  • A trading advantage – able to trade or hold the security when other investors can’t take or hold that position.

How to select a security

  • Because you’re trying to determine not only the fund manager’s objective criteria, but also their subjective criteria, it can be useful to have a view into investment ideas they didn’t adopt
  • Called negative space in the art world. Need to analyse not only what is there, but also what isn’t, to fully grasp all the information the image conveys.