The Personal MBA and Personal Investing

UPDATE, 2/14/2011: My personal investing philosophy has changed, and now revolves around passive indexing. For more details, see Fail-Safe Investing by Harry Browne.

The Personal MBA won’t just help you increase your effectiveness at work… it can also help you manage your savings and investments.

One of the most interesting long-term applications of the Personal MBA is personal investing: knowing how to evaluate the financial and competitive position of a company well enough to notice when the market is underpricing a company relative to its likely future prospects. Investing is a way to profit directly from your knowledge of business, and it provides a great deal of motivation for mastering accounting, finance, and other traditionally difficult subjects. (It’s always easier to gain competence in a subject when there’s a reason you really want to understand it.)

Frankly, 95% of people are much better off passively investing their savings in a total market index fund vs. attempting to manage their money actively. Successful active investment management (higher returns than the total market over a given period of time) takes a great deal of knowledge, patience, effort, and emotional mastery. If you don’t approach investing in the spirit of learning and mastery, it’s easy to get carried away and lose your shirt or give up in disgust before you’re really able to put what you’ve learned into practice.

As Warren Buffett, one of history’s most successful investors, wryly observed in his 1982 letter to Berkshire Hathaway shareholders:

“The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do.”

If you do know what you’re doing, however, developing an investment strategy and learning how to actively manage your money can be both personally and monetarily rewarding. In the past year, my returns have been roughly 25% (vs. 14% for the S&P 500), and I have learned a ton about business along the way.

I’m currently an active member of the Motley Fool discussion boards and the American Association of Individual Investors, both of which I’ve found enormously educational. At the moment, I’m working with a small, dedicated team of experienced investors to develop a systematic method of identifying promising small companies that are selling at a large discount to what they’re worth. There are no assignments or grades: we’re working on this together in our spare time because we believe it will help us become better investors.

Today, one of my posts was featured by the Motley Fool as the post of the day. It’s about due diligence: what you really need to find out about a company before you decide whether or not to invest. Here are the questions I ask myself before purchasing a company:

Here’s my shot at developing a list of [due diligence] questions to answer when either opening a small position or accumulating additional shares in a company. My objective is to apply the Pareto Principle to this list: I want to have a relatively short list of questions that can be answered in no more than an hour or two that provides at least 80% of what I need to know to make allocation decisions.

Before opening a small position:

Understanding the Company
1. Do I clearly understand how the company makes money?
2. Do I clearly understand what key factors drive the business?

Understanding the Current Valuation
3. What is the company’s current cash, debt, and profit margin situation?
4. What is my best estimate of the company’s reasonable value per share?
5. What is the worst case scenario? At what point does price = liquidation value?
6. Does the current price make sense? Is there a reasonable margin of safety at this price?

Understanding the Industry
7. How does this firm currently fit into the broader industry?
8. What is my best guess about how the industry will evolve over time?
9. What is the firm’s competitive advantage? Is that advantage durable, and does it line up with how the industry is evolving?
10. How does the company’s current cash, debt, and profit margin compare vs. competition?

Understanding Management
11. Does the company’s current management team appear to be experienced and competent?
12. Does management own the stock? Do they behave like manages or owners?

When analyzing a position I already hold for potential accumulation, particularly if the price drops:

What’s changed?
1. What caused the price to change?
2. Has the business fundamentally changed since my initial analysis?
3. Have the fundamentals of the business (cash, debt, margin) eroded significantly or unexpectedly?
4. Has management changed strategy or ownership behavior?
5. What is the prevailing market sentiment? Is it reasonable?

What’s the new valuation?
6. Based on what I now know, what is my best estimate of current value?
7. Does the current price make sense? Is there a reasonable margin of safety at this price?

How should I allocate my capital?
8. Am I currently overweight in this company, with respect to my total portfolio?
9. Is there a better opportunity for capital allocation elsewhere?
10. How much should I allocate to this company, based on this new information?

My personal investing methodology has evolved over time, and I expect it will continue to evolve as I learn more. The Personal MBA has been a tremendous help in evaluating companies and has enabled me to create this little list of questions: I know enough about how businesses work that I can form an educated opinion of a company’s prospects relatively quickly, which is a big benefit when potential opportunities present themselves.

Are you interested in applying the Personal MBA to personal investing? If so, leave a comment and I’ll look into setting up a dedicated section on the new Personal MBA forums.


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Personal MBA book

THE PERSONAL MBA
Master the Art of Business

The #1 International Bestseller, Revised & Expanded. A world-class business education in a single volume. Learn the universal principles behind every successful business, then go out into the world and make your own. More...



First 20 Hours book

THE FIRST 20 HOURS
How to Learn Anything... Fast!

A practitioner's guide to rapid skill acquisition. Accelerate your learning by deconstructing complex skills, practicing the most important elements first, and removing barriers to deliberate practice. What do you want to learn? More...