An Investment Approach That Works

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There are as many investment strategies as there are investment opportunities. Some are good; many are terrible. Here’s the one that I lean on the most when I’m looking for low risk and above average returns.

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“The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple.”

— Charlie Munger

Goal: An investment algorithm to lean on hard when it is available. Low-risk, long-duration, above-average returns.

There are many paths to investment heaven (and we’ve written on the topic before). The diversity of working approaches demonstrates that. However, fundamentally, any useful approach must do three things:

  1. It must work in all conceivable financial environments.
  2. It must be within the “circle of competence” and “circle of interestingness” of its user.
  3. It must meet the moral criteria of its user.

I believe the system below satisfies the first criterion, and allows for all three.

A 7–Element Algorithm for Equity Investing

Everyone Wins
Successful businesses have indefinitely sustainable business systems: owners, employees, customers, suppliers, all content.

Ballast for the Storm
Look for a sustainable balance sheet, given the capricious nature of the world. Past bad events do not predict future bad events. Sometimes inefficient balance sheets allow companies to survive by positioning them for all environments, not just optimizing for one.

Different and Hard to Match
Candidates must occupy a structurally profitable, indefinitely sustainable business niche, allowing for the truism that all moats are subject to being crossed eventually. There must be an element of mystery.

Operational Soundness
Reliable execution of the “blocking and tackling” of operations is a must. Getting this wrong always costs big, and can ruin a good niche.

A Few Simple Variables
Allowing for the difficulty of predicting the future, candidates should have just a few reasonably predictable economic variables that will dominate their outcomes. In the words of Warren Buffett, “There are all kinds of businesses where we have no idea what they’ll earn this year, let alone any future year.” Look for boring investments, sexy is usually complicated and full of competition. Look for what’s staying the same.

Long Runway
You should be able to foresee an indefinite period of growth ahead, through some combination of market creation, market penetration, and pricing power.

Priced Attractively
Stock should be priced so that stock returns >= business returns, always including a margin for error in forward-looking estimates.

Seemingly missing is the concept of “good management,” but I consider this redundant in light of the first four elements. Any business meeting those criteria is being managed properly, and any investment going 7/7 has a very low probability of failure.

Notice that the word indefinite is used several times. This does not mean the same thing as infinite. There are no infinities in the business world. Indefinite means “as far out as can presently be seen.”

Caution: what psychologists call the “representativeness heuristic” puts us at risk of over-fitting to this or any algorithm. Always be on guard. In the words of Richard Feynman, “Never fool yourself, and remember that you are the easiest person to fool.”