Every Investor Needs A Sound Framework: Here’s How To Build One

Video how to invest in framework

“To invest successfully, one doesn’t need a stratospheric IQ… What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework” – Warren Buffett

When trying to become skillful at something, there comes a point where we ask ourselves, “What do I need to learn or do in order to really be good at this?” We seek out experts, watch TV, and read books. In the end, we try to gather up all the information we can and assume that we can figure out a way of organizing all that information in a way that makes us into experts.

People wanting to become skillful investors try to follow this process, but the amount of sometimes contradictory information about what constitutes skillful investing is overwhelming! We have found that only a small fraction of the information available on the web has the potential to help an individual’s investment results in a meaningful way – in contrast, most of it is actually designed to help the blog writer or analyst who published the article. Faced with huge amounts of information of dubious quality, the problem quickly becomes how to filter and organize this firehose of information in a way that makes us better investors.

That’s the power and purpose of a framework.

The Investing Salad Bar

As investing educators and institutional analyst trainers, investors come to us with all levels of engagement and experience. At all levels, we consistently see that investors are inconsistent. Information and ideas come to them from a variety of places – they pick and choose whatever seems right to them at the time! This is what we call the investing salad bar.

While everyone loves the freedom of choice at the salad bar, it’s not guaranteed that you’ll get a nutritious meal by picking a bit here and a bit there. Using an investing salad bar, there’s no organizing or prioritizing the information being selected in such a way as to generate investments where the probability of a good result is tilted in your favor.

Without a framework to organize the information we are receiving, our human biases run amok. Our X-system thinking overwhelms our more metered C-System creating a rush to judgment, or worse, to action. Our penchant for confirmation bias has us investing in great stories vs. great businesses. Anchoring biases have us looking at a company whose stock price is down 25% in the last month as a “screaming value”. All of this happens without our asking the question, “What’s really going on here?” and “Do I want to own this business?”.

Framework investing steps into this breach. Nicolas Sordoni, CFA, a Portfolio Manager and Analyst at Lazard Investments wrote a research paper entitled, Investment Frameworks: De-biased Decision Making in Equity Investing. His research led his team to this insight:

Frameworks allow for us to apply the knowledge from some of our finest human achievements to our investment decisions – the scientific method (hypothesis testing), the development of first principles and root cause analysis. Frameworks focus on the most important factors that generate durable value – operations and financial performance. Frameworks tend to minimize the impact of misleading narratives because frameworks use objective numbers rather than subjective anecdotes. In doing these things, Frameworks organize information into knowledge and over time allow users to generate unique insight. It is that knowledge and insight that are consistently monetizable because they allow the investor to observe and learn and thereby tilt the probability of a positive outcome in their favor. Price becomes what it has always been, a derivative of the business performance. Frameworks make that relationship transparent.

Better Outcomes

It comes as no surprise then, that a good framework outperforms the Salad Bar.

This can be easily seen by looking at the performance of the average investor and those investors who are passionate about frameworks and process. From Buffet to Ray Dalio (Bridgewater) to George Soros and James Simons (founder of Renaissance Technologies), frameworks play a vital if not central role in their success. You will note that these investors all invest differently from one another – they have different investing frameworks. But in all cases, the process is disciplined and repeatable and focused on organizing information into knowledge they can effectively monetize.

We’ll talk about what we believe makes a “good” framework in the next section, but for now it’s clear that investing frameworks have real power. ANY investor can do this. It just takes time and a commitment to developing your framework based on observed success, experience and expertise. Buffet was right when he said it doesn’t take a stratospheric IQ to be a good investor. It takes a consistent, repeatable framework that one uses to organize information, learn from it and turn it into monetizable knowledge.

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The Characteristics of a Sound Investing Framework

Every framework needs a foundation; we build our framework on a foundation of value. Our underlying belief is that while short-term stock prices rise or fall based on temporary factors, panics, and manias, longer term, they are the representation of the value the company will generate on behalf of its shareholders.

Based on that foundation, in this section, we investigate the characteristics of a solid, value-oriented framework.

We strongly believe that some frameworks are better than others, just like some foundations are stronger than others. Our experience has shown us that value is the strongest foundation on which to build an investment framework and we agree with the conclusions from the Lazard report mentioned above.

Considering this, we think a good framework has three main characteristics:

  1. Transparency – The framework should allow us to illuminate the company’s business, and we should immediately be able to differentiate between what is important and what is trivial
  2. Testability – You might remember in our post from last week that we briefly referenced hypothesis testing and the scientific method. The framework should be testable in a scientific sense – we should make predictions based on our understanding, then test those predictions against what occurs.
  3. Universality – The framework should be able to evaluate any investment by reference to first principles. The framework should not require the tweaking of rules when analyzing a company in one industry or another or one region or another.

Transparency is important because it helps us to minimize the effects of bias and maximize the opportunity for insight.

If a framework is transparent, it means that the input variables (we call them “valuation drivers”) are explicit and measurable, and that the conclusions follow directly from the input variables. By insisting on transparency, we make an explicit link between information and conclusions, and we can easily see how a change in one piece of data affects our perception of a company’s value.

Using a transparent framework allows us to focus in on the most important facts about a potential investment and not get mired in the kind of superficial anecdotes that end up hurting so many investors.

Testability is vital because of its emphasis on observable facts and on intellectual honesty.

Most investors test their investment thesis for an investment by looking at whether the stock price is up or down. However, we don’t think this comparison is a valid test as long as you accept that the value of a company can differ from the price of the company’s stock.

Rejecting the idea that price equals value, we believe that a strong framework is one that focuses on the investor’s understanding of the valuation driver inputs mentioned in the previous section.

Just as a scientist makes predictions based on his or her understanding of a process, a good investor makes forecasts based on his or her understanding of a company. If the investor understands the company well, his or her forecasts for the valuation drivers will match up closely with the actual results posted by the company.

Of course one wants to be as accurate as possible with one’s forecasts, but beyond forecasting accuracy, a major goal should be to learn about the company so that one’s next projection is better than the first.

In our work with the Brier Fund of Superforecasters, the Fund’s participants update their forecasts every couple of weeks with new data, then revise their conclusions. This practice universally sharpens their forecasts and helps them to consistently outperform the average person.

Testing is uncomfortable. It forces one to admit that one might have been wrong about something and it requires a high degree of intellectual honesty. This honesty pays big dividends though – it allows an investor to know with certainty that it is time to close a position (whether for a loss or for a gain) or to increase a position (whether one is sitting on an unrealized loss or unrealized gain).

The best professional investors in the world are those that are successful in “position sizing” and we believe skillful position sizing is impossible without having a testable framework.

Universality allows an investor to assess any opportunity and to compare it any another. Companies are faced with this issue all the time – internally. For instance, they may have the option to invest in research to develop a new product line or invest in distribution to grow into a new geography. To be successful, the framework they use to assess these two choices must allow for a direct comparison of the costs and benefits of both and compare them on an equal plane.

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This quality is what we think makes a good framework for financial investors as well. Individual investors have no “mandates” forced on them regarding the instruments or ways in which they can invest. To take advantage of this freedom, an investor must have a framework that allows for such a “bottom line” comparison.

We often reference The Three Investing Fantasies – Technical, Ratio, and Fundamental Analysis. Indeed, each of these is an investing decision framework and some do better than others against the characteristics outlined above. Sadly, all of them have some challenges, blind spots, and common flaws in execution. In the next section, we will look at each of these analytical tools and compare their characteristics to those of a sound framework.

The Elements of an Effective Real-World Investing Framework

We use the framework described below in our own investing, and have seen the degree to which it helps everyone from the professional analyst sitting in front of a stack of financial statements and conference call transcripts, to the individual investor listening to a friend’s hot stock tip on the golf course, to the family office manager getting pitched a new investment idea by his or her private wealth manager, to the registered investment advisor figuring out what investments to make for his or her clients.

The Framework’s Elements

As we mentioned above, our framework rests on the foundation that an investment’s value is the total cash a company generates on behalf of its owners over its economic life.

A framework that focuses in on the process of cash flow generation makes it easy to assess investment ideas because there are only a very few elements which can possibly influence cash flows.

To generate value, a company must:

  • Generate revenues
  • Convert revenues into profits
  • Invest some portion of profits to boost future profit growth

As value investors with a long time horizon, we do not concern ourselves with every quarterly blip in revenues or profits, but instead use our understanding of the company to forecast a range of likely values over the next few years. We also look at “profit” from the standpoint of a true owner using a common sense, cash-based profitability metric called Owners’ Cash Profits (OCP).

Any investment idea can be analyzed in terms of this framework, from a software company to a manufacturer to a REIT. We think of the framework in terms of a “waterfall,” an example of which, published to our members in May of last year, shows our best- and worst-case forecasts for Apple’s (AAPL) valuation drivers and our resultant valuation range:

While this waterfall diagram is the product of careful analysis, the analysis was 100% governed by the basic framework described above. We make a point to keep focused on factors that can materially affect the three fundamental drivers, and resist the temptation to be drawn into a maze of details that do not have a material impact on cash flows long term.

The cash generated by the firm over its economic life is expressed through our measure Free Cash Flow to Owners (FCFO), and ties directly to the valuation range shown at the bottom of the diagram.

So, when any new idea arrives on your desk, do this: stop, relax, and focus on the following important questions.

  1. How is this investment idea generating revenue? Are there barriers to its ability to meet demand or limits to the level of demand for its products or services? What are the risks to its ability to generate revenues? How fast can those revenues grow in the future?
  2. How efficiently and consistently does this company convert revenues to profits (i.e., how profitable is it)? In the worst and best cases, what changes about its expense profile and how does its profit margins compare to its competition? Is there something unique to the business and its offering that allows it higher profits?
  3. What investments will this company need to do to keep growing? Is the company spending enough to enable it to keep growing at a good clip far into the future? How much of the company’s stock buyback program ends up soaking up dilution from issuing stock to its employees?

The cash generated after the company receives revenues, pays costs to maintain the business as a going concern, and invests to boost future growth is our measure Free Cash Flow to Owners. The best- and worst-case estimates of those cash flows, “discounted” to their present value, constitute the company’s fair value range. The only step for us to make after estimating the fair value range is to compare that to the price at which the company’s shares are trading.

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We provide simple tools to allow investors to keep track of these numbers and derive a valuation range, but the tools are less important than the framework. If your framework is good, your tools don’t have to be fancy.

A Solid Framework in Action

A few years ago, I had the chance to hear an influential institutional investor talk about an investment that he had made. This investor, a man who was responsible for managing tens of billions of dollars, framed the investment in terms of this straightforward argument:

“This company is generating $100 in revenues right now. Out of that, it makes around $20 in profits and spends around $7 on its investments. The investments it is making right now are smart, and because of structural factor X and Y, we think profits will grow to around $100 in a few years’ time. That is worth at least $1,000 to us and right now, the company is trading for a market cap of $600. Looks like a good investment to us.”

That’s it. An example of our framework in a nutshell in five simple-to-understand sentences.

You might say that this is too simple. It is simple, but sometimes it is not easy. Fear prompted by macroeconomic news, a sharp fall in the price of the shares, an analyst’s negative comments or a dozen other things can cause even the most experienced investor to doubt their judgment. We believe that Rob Arnott’s comments at the Spring 2017 Grant’s Conference are right on target: “Bargains do not exist without fear.”

We call the psychological and social issues that cause these kinds of fears “behavioral and structural factors” and have a course to talk about how to deal with them effectively. Being able to control one’s emotions is a vital element of a successful investing framework!

In the final section of this article, we will apply our framework above to three real-world investing decision scenarios:

  • A business associate gives you a tip about a “can’t miss” stock.
  • Your advisor recommends a position change
  • Jim Cramer screams “SELL EVERYTHING!!!”

Three Examples of an Investing Framework in Action

The three situations we’ll use to show how using a strong investing framework as your touchstone can help you are:

  • Case 1: An investment manager recommends that you shift of some investment assets away from a Technology ETF to one of an Industrials ETF.
  • Case 2: Your friend gives you a hot stock tip about a single-drug biotech start-up as you’re driving in the golf cart back to the clubhouse.
  • Case 3: You turn on the TV and an on-air investment celebrity is screaming “SELL EVERYTHING!” because of the latest macro crisis.

We believe that investing well means making good decisions, and making good decisions hinges on asking the right questions. It doesn’t matter if you work with an advisor or money manager or if you are managing your investments yourself or a mix of both. A sound, cash flow based framework keeps you from investing in anecdotes and pushes you naturally toward making investments in companies you get your head around.

What are the right questions to ask? This is where having access to a solid, sensible investment framework serves you well. In the table below, we’ve offered examples of good questions you might ask, all of which reflect an intelligent investing framework which rests on a foundation of fundamental value.

In each of these cases, returning to one’s investing framework allows an investor to lean upon strong pillars of facts rather than upon flimsy piles of anecdotes.

The four-part investing framework above gives you a place to start analyzing the merits an investment idea or recommendation. One is no longer subject to just accepting a smooth-talker’s story or heading to the internet’s investing salad bar to pick at various pieces of potentially biased information.

As investors, our goal each time we commit our hard-earned capital to an investment should be understanding the idea and having a well-reasoned argument why this investment will generate a return that beats the market over our (long) investment time horizon.

The sample questions above show how to use a framework to get information you need to make intelligent decisions. Understanding how to use the answers you receive to estimate a valuation range is precisely the mission of our research reports and training courses.