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Notes from John Train’s The Art of Investing
April 22, 2007, 3:21 am
Filed under: investments/finance/economics

Excerpts from John Train’s The Craft of Investing

 

An Investment Credo

 

  1. The basic purpose of investment is to buy a stream of earnings and dividends that will rise substantially faster than inflation: that is, to preserve capital in real terms and provide an income to live on.
  2. Within this broad objective, active investment management seeks to buy undervalued securities that should rise faster than the market, and can then be sold in whole or in part to buy new undervalued securities.
  3. We have a number of specific techniques that we follow when making an investment. Some of them are:
    1. Normally, we want to know more about a company whose stock we buy than almost anybody else outside of management.
    2. The stock should be misunderstood by the market at the time we buy it, for reasons that we also understand.
    3. The imputed rate of return, assuming that one could buy the whole company at the market capitalization implied by the price per share, should be much higher than either inflation or the nominal return on bonds.
    4. We only buy the stocks of outstanding companies that we would be willing to hold for a long time in the absence of any market… the way one buys a house. We do not buy unseasoned, mediocre or troubled companies that seem underpriced: that is a more profitable strategy if it works, but increases risk if things go wrong.
  4. Here are some of the characteristics of an outstanding company:
    1. By nature it can float on the surface of inflation. This usually means that it dominates some particular area of a growing market, and it is able to pass on price increases to its customers.
    2. Management is superb, and dedicated to the shareholders’ interest, with substantial ownership position.
    3. It is not a natural target of government regulation, consumerism, or intense competition (e.g., Japanese).
    4. It has a high profit margin, and makes a high return on capital: in cash, not just in taxable accounting profits. In practice this usually mean that I has very low debt, and also that it is the low-cost producer in its industry.
    5. Typically, an outstanding company that is big enough so that we can feel confident we understand, and still small enough to have a lock on something with dynamic growth, will have sales in the middle to high hundreds of millions of dollars, and will not be significantly unionized.
    6. Often such a company will be a “productivity play”; that is, it enables other companies to make more money, rather than competing in the consumer market.
  5. We do not employ margin. In a severe market decline, good stocks can be cut in half in a few months. If one is employing meaningful margin, one risks a wipeout, even though everything recovers in due course. That is even truer of short sales.
  6. We maintain reasonable liquid reserves at all times, increasing them when we believe the market to be dangerous. Our cardinal objective is to avoid a major impairment of our clients’ assets.
  7. We do not regard bonds as a desirable long-term investment, unless one reinvests most of the income. If one spends bond interest during a period of inflation, one is to some extent really consuming capital, since because of inflation the value of a bond in real terms often declines at a rate comparable to the after-tax interest received. And above all, during hyperinflation bonds can lose most of their value in real terms.
  8. One is, on the contrary, increasing capital in real terms if, for example, one owns shares in businesses whose value is building at the rate of 15 percent a year before inflation (or, let us say, 10 percent after inflation) and one spends 5 percent of one’s capital a year, even though the actual dividend income is only 3 percent.
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