1. Good at calculation

A successful investor must be familiar with numbers. There are rarely complex calculations in the world of investment, but familiarity with numbers, percentages, and probabilities is essential.

Financial statement analysis is one of the main ways to apply calculation skills. Accounting is one of the main languages ​​of business. Excellent investors are good at financial statement analysis, which allows them to understand the past operating conditions of a company and have an understanding of its future operating conditions.

The purpose of financial statement analysis has two parts. The first is to convert financial statements into free cash flow, which is the lifeblood of corporate value.

The method of calculating free cash flow starts from cash income and subtracts the investments made by the company to generate future income. It is also the total amount that the company can return to shareholders in the form of interest payments, dividends, and share buybacks without harming the company's value creation prospects.

Profit is the most widely used indicator for measuring corporate performance. However, profit growth and value growth are completely different. If the company's investments do not achieve adequate returns, the company may increase profits while also destroying its value. By focusing on the present value of future free cash flow, a thoughtful investor will transform financial statements into factors that determine value.

The second purpose of financial statement analysis is to establish a link between a company's strategy and how it creates value. A simple approach is to compare two companies in the same industry on a line-by-line basis. Are their expenses comparable? Are their ways of using capital similar? Noting the differences in how companies spend money and allocate investment resources helps gain insight into their competitive position.

A simpler analysis can be performed by looking at the path of return on invested capital (ROIC). ROIC can be divided into two parts: profitability (after-tax net operating profit/sales) and capital turnover rate (sales/investment capital).

Companies with high operating profit margins and low capital turnover rates usually pursue the 'differentiation' strategy advocated by Michael Porter, a business analysis creator of Porter's Five Forces.

Companies with low operating profit margins and high capital turnover rates follow a 'cost leadership' strategy.

Analyzing how a company makes money directly affects how long it can maintain its advantages (if ROIC is attractive) or evaluate what the company must do to increase its profits.

Understanding business requires understanding numbers. As more and more investments are made in intangible assets and less in tangible assets, this task becomes more challenging.

2. Understand enterprise value

It's interesting to consider what is mutable and what is immutable in investing. In fact, many things are mutable. The average half-life of a listed company is about 10 years, which means that the investable field is constantly changing. The situation is always changing due to unknown factors such as technological change, consumer preferences, and competition.

However, for investors, there is an almost immutable concept that the present value of future free cash flow determines the value of financial assets. This is true for stocks, bonds, and real estate.

Valuation is a challenge for stock investors because each driving factor of value: cash flow, time, and risk, is based on expectations. For bond investors, two of the three driving factors are based on contracts.

Great investors focus on understanding the scale and sustainability of free cash flow in the future. Factors that investors must consider include which stage the industry is in its life cycle, the company's competitive position in the industry, entry barriers, the company's economic condition, and the management's skills in allocating capital.

The inevitable result of this attribute is that great investors understand the limitations of valuation methods such as P/E and enterprise value/EBITDA multiples. In fact, valuation multiples are not the result of valuation but shorthand for the valuation process. Any thoughtful investor will not forget this. Shortcuts are useful because they save you time, but they also have blind spots. As Al Rappaport said, cash is the fact, and profit is the view.

3. Evaluate enterprise strategy correctly

There are two dimensions to this attribute. First is a basic understanding of how the company makes money. Its idea is to extract business as the basic unit of analysis. For example, the basic analysis unit for a retailer is store economics.

How much does it cost to establish a store and fill it with inventory? What revenue does it generate? What is the profit margin? Answers to these and other questions should enable investors to assess the economic profitability of a store, which can then be summed up to understand the entire company.

Great investors can explain clearly how a company makes money and grasp the changes in drivers of profitability. If they do not understand how a company makes money, they will never hold the stock of that company.

The second aspect is to master the company's sustainable competitive advantage. When a company's investment return is higher than the opportunity cost of capital and earns higher returns than its competitors, it has a competitive advantage. The classic method is to analyze the industry and how the company adapts. Common methods include the 'five forces' that shape industry attractiveness, value chain analysis, assessments of disruptive innovation threats, and company-specific sources of advantage.

The key to strategy is understanding trade-offs. Strategy refers to making difficult choices about which activities to do and which not to do that distinguish it from its competitors. Operational effectiveness is related to all the activities that any business needs to do, so no choice is necessary.

Great investors appreciate the unique aspects of a company, which allows it to build an economic moat around its franchise, protecting its business from competitors. The size and duration of the moat are important factors in any thoughtful valuation. As Michael Porter emphasized years ago, strategy and valuation need to go hand in hand. This is the macro dimension of understanding strategy.

4. Effective comparison

Comparison is a key factor in investment. Investors have always been comparing: stocks and bonds, active and passive, value and growth, stock A and stock B, now and in the future. People are quick to make comparisons but not good at it.

Perhaps the most important comparison investors must make, and the most important comparison that distinguishes ordinary investors from great investors, is the comparison between fundamentals and expectations. Fundamentals reflect the future financial performance of a company.

Value drivers, including sales growth, operating margin, investment demand, and investment return, constitute the fundamentals. Expectations reflect the financial performance implied in the stock price.

Making money in the market requires a view different from the current price. Most investors cannot distinguish between fundamentals and expectations. When fundamentals are good, they want to buy; when fundamentals are bad, they want to sell. But great investors can always distinguish between the two.

An interesting analogy to investment is gambling. Horse racing is a good example.

The amount bet on a horse is reflected in the odds or probability of that horse winning the race. Our goal is not to figure out which horse will win, but which horse's odds are mispriced relative to how it is likely to run in the race. Fundamentals are how fast the horse can run, while expectations are the odds. Investors need to consider these elements separately.

Humans tend to think by analogy, which can cause some cognitive problems. One problem is that one or even a few analogies may not fully reflect the relevant reference class of the case at hand.

For example, instead of asking if this reversal is similar to previous ones, it is better to ask what the basic success rate of all reversals is. Psychologists have shown that properly integrating results from relevant reference classes can improve the quality of forecasts.

Another challenge of using analogy is that when we focus on similarities, we see similarities; when we focus on differences, we see differences. The focus of comparison affects the results.

The final challenge is to consider causality from the perspective of traits and environments. Traits are characteristics that allow grouping. We usually limit comparisons to the characteristics to be compared, which misses important insights. Great investors are less likely to fall into common traps.

5. Think from a probabilistic perspective

Investing is an activity in which you must constantly consider the possibility of various outcomes. This requires a certain mentality. First, you must constantly seek advantages, under which the price of an asset distorts either the probability or the outcome.

From the general manager of the franchise to the professional gambler, all successful operators in the probability field focus on finding advantages.

When probability plays an important role in the outcome, it is important to focus on the decision-making process, not just the significance of the outcome. This is because a particular outcome may not indicate the quality of the decision.

Good decisions sometimes result in bad outcomes, while bad decisions sometimes result in good outcomes. However, in the long term, good decisions portend favorable outcomes, even if you occasionally make mistakes.

Time frame and sample size are also important considerations. It is important to learn to focus on the process, accept periodic and inevitable bad outcomes.

Great investors recognize another reality about probabilities: the correct frequency is not important (batting average); what is important is how much money you make when you are right and how much you lose when you are wrong (slugging percentage).

Due to loss aversion, this concept can be difficult to implement because our pain from losses is roughly twice the pleasure we derive from gains of equal magnitude. In other words, we prefer to be right rather than wrong. But if the goal is to increase the value of the investment portfolio, slugging percentage is the most important.

There are three methods for calculating probabilities. The first is subjective probability, a number that corresponds to a state of knowledge or belief. For example, you can assign a subjective probability to the likelihood of war between two countries.

The second is propensity, which is usually based on the physical properties of the system. For example, you can estimate the probability of throwing a four based on the fact that the die is a perfect cube and that the throws are unbiased at 1/6.

The last method is frequency, which considers the results of the class appropriately cited in the consideration.

You can use the frequency method to predict company performance indicators, such as sales and profit growth rates. Subjective probabilities that need to be updated frequently are also very useful. But in some areas, linking probability to investment results can be unreliable, as probability and investment results are largely unknown.

This is the realm of "black swans," where results that are beyond the expected range can have huge impacts and can only be explained afterwards. If you plan to participate in this area, your goal is to come into contact with positive black swans.

Buffett summed up this property well: "Multiply the probability of profit times the amount of possible profit and subtract the probability of loss times the amount of possible loss to get the result. That's what we're trying to do. It's imperfect, but that's the point."

6. Update your views effectively

Most people tend to hold on to their beliefs for a long time, even if the facts show that their beliefs are wrong. We all have our own worldview that we think is correct. Only when you are faced with the reality that contradicts your beliefs will you be forced to change your mind.

The easiest way to avoid feeling wrong is to fall into the confirmation bias. In confirmation bias, you look for information that confirms your point of view and interpret unclear information in a way that is favorable to your belief. Consistency can stop you from thinking about a problem, avoiding change because of rationality.

But great investors do two things that most of us don't do. (1) They seek different information or perspectives from their own; (2) They change their beliefs when the evidence shows they should. Both of these tasks are not easy.

The trait of seeking different perspectives is called "positively open-minded." Studies have shown that positively open-minded people perform well in tasks that predict the need for information collection. A positively open mindset can counteract confirmation bias.

Great investors also change their views as new information becomes available. The idea is that you can use probability to represent your degree of belief about something. When new information arrives, you change that probability. The formal method is to use Bayesian theorem, which tells you the probability that a theory or belief is true given the occurrence of certain events.

The actual challenge is to avoid overreacting to information that appears to explain causal relationships but does not actually do so and to find information that is truly important but does not seem to have a causal relationship. In addition, the magnitude of change is also important when the degree of belief increases or decreases noticeably.

The best investors recognize that the world is constantly changing and that all our views are fragile. They actively seek different perspectives and change their beliefs based on new information.

The result of updating your views may be action: changing the position or weight of an investment in the portfolio. Others, including your clients, may find this psychological flexibility unsettling. But good thinking requires keeping as accurate a perception of the world as possible.

7. Beware of behavioral biases

Psychology professor Keith Stanovich likes to distinguish between intelligence quotient (IQ) and rationality quotient (RQ). IQ measures the truly useful cognitive skills in cognitive tasks, while RQ measures the ability to make correct decisions. His point is that the overlap between these abilities is much lower than most people think. What is important is that you can cultivate your rationality quotient.

Warren Buffett, in distinguishing between engine horsepower (IQ) and output (RQ), grasped this point:

"I always thought of IQ and talent as horsepower. But output, engine efficiency depends on rationality." Many people start with a 400 horsepower engine, but output power is only 100 horsepower. If there is a 200-horsepower engine that outputs all power, it is a far better choice.

Humans tend to use heuristic rules, which are often correct and save us a lot of time. But these heuristics have related biases that can lead to thinking deviating from logic or probability.

Examples of heuristics include availability (depending on available information rather than relevant information), representativeness (placing people or objects in inaccurate categories), and anchoring (placing too much weight on anchoring numbers). Great investors not only understand these concepts, but also take measures to manage or mitigate behavioral biases during the investment process.

Prospect theory suggests that in risky situations, individual decisions deviate from normative economic methods. Loss aversion is a good example, which suggests that individuals weigh losses more heavily than comparable gains. Although loss aversion could be persuasively explained by evolutionary theory, it is detrimental to investment management.

Cognitive rationality, or the degree to which your beliefs correspond to the world, is an important component of rationality quotient. People who score high on rationality quotient are well calibrated, meaning that the probabilities they assign to specific outcomes are often accurate in a large sample of judgments. One way to improve calibration is to keep score. You can track your predictions and rate them based on the outcome.

The ability to avoid behavioral biases may be partially personality, partially training, and partially environmental. Excellent investors are generally less affected by cognitive biases than the average person. They understand biases and how to deal with them, and they place themselves in a work environment that allows them to think well.

9. Understand the difference between information and influence

In capital markets, prices also provide useful information. Their main value is as an indication of future financial performance expectations. Great investors are good at interpreting the relationship between expectations and fundamentals and separating them when making decisions.

However, investment is essentially a social activity. Therefore, prices can change from being information sources to being sources of influence. This has happened many times in market history.

The threshold model proposed by Stanford sociology professor Mark Granovetter is one of the best models for studying such behavior.

Imagine 100 potential rioters in a public square. Each person has a "riot threshold," which is the number of rioters that must be seen to join the riot. Assume that one person's threshold is 0 (instigator), another's is 1, another's is 2, and so on until 99.

This uniform distribution of thresholds creates a domino effect and ensures that the riot occurs. The instigator smashes a window with a stone, one person joins in, and then when the scale of the riot reaches his or her limit, everyone joins in. Substitute "buy meme stocks" for "join the riot," and you'll understand the meaning in the stock market.

Except for the instigator, few people think that riots are a good idea. Most people would probably avoid rioting. But once a certain amount of other people involved in the riot, they will join in. This is why the information value of stocks is put aside, and the influence element takes its place.

Great investors will not be swept up by the whirlpool of influence. This requires a trait of not caring about how others see you, which is not innate to humans. In fact, many successful investors have a skill that is very valuable in investing but not so much in life: openly ignoring the views of others.

Success requires consideration of different viewpoints, but ultimately forming a thoughtful, consensus-avoiding argument. The masses are often right, but when they are wrong, you need a psychological toughness to oppose them.

9. Position size.

9. Position size.

Pag Pearson is a legendary gambler who smokes cigars, won the World Series of Poker, and is one of the best billiards players in the world.

When asked about the reasons for his success, Pearson said, "There are three things to do good gambling: know the outcome of a 60-40 probability series, money management, and understanding yourself." Great investors will keep all three things in mind, but in investment practice, capital management is the least attention paid.

Bringing Down The House, written by Ben Mezrich, tells the story of six MIT students who implemented a counting card system in Las Vegas and made a lot of money. Their system has two parts.

The first is the method of counting cards. Here, team members are dispersed to different tables and develop a signal to indicate when the odds look good. But the second part of the system is often overlooked, which is to consider the odds at the gambling table and their own capital size, and team members need to know exactly how much to bet.

Similarly, successful investment has two parts: finding symbols with advantages and maximizing those advantages through appropriate position sizes. Almost all investment companies focus on advantages, while position size is usually less attention paid.

Proper investment portfolio construction requires identifying a goal (maximizing money over a period of time or investing in batches), identifying an opportunity set (many small advantages or a large advantage) and considering constraints (liquidity, payback, leverage). The answers to these questions suggest an appropriate strategy for position sizing and portfolio structure.

What method is easiest for investors depends largely on how you answer questions about goals, opportunities, and limitations. But overall, most investors do poorly in position size management, while excellent investors are more efficient in this area.

Smart investors understand that finding advantages and making appropriate bets is crucial for long-term success.

10. Read, and keep an open mind.

Charlie Munger says he loves Einstein's view that "success comes from curiosity, focus, perseverance and self-criticism." Self-criticism refers to the ability to change your mind and break your favorite ideas. Reading is an activity that cultivates all of these qualities.

Munger also said, "In my life, I have not known smart people (in a wide range of subject areas) who do not always read." This may be exaggerated, but it seems to be the case in the investment field as well.

Great investors usually have some habits in reading. First, they allocate reading time. Warren Buffett has said that he spends 80% of his working time reading. If you spend time reading, you are not doing other things. This is a cost. But many successful people are willing to put reading first.

Second, excellent readers tend to read materials from various disciplines, not just business or finance books. Expand the scope to new domains or fields. Follow your curiosity. It's hard to know when an idea from a seemingly different field will come in handy.

Finally, clearly identify the reading materials you do not necessarily agree with. Find a thoughtful person who disagrees with your point of view and read his or her case carefully. This helps maintain positive and open-minded thinking.

Studies have shown that successful people read a lot of books, and more importantly, for learning rather than entertainment. Reading is their main means of continuing education. This habit is especially important for investors, because they must input a large amount of reading information into actionable ideas.

In conclusion,

There are various reasons for failure, but successful people have many similar traits.

Familiar with numbers, understanding free cash flow, accurately evaluating global strategy, effectively comparing expectations with fundamentals, thinking from a probabilistic perspective, effectively changing your own perspective, being wary of behavioral biases, understanding the difference between information and influence, doing position management well, reading and being open-minded.

These excellent qualities are reflected in various great investors. These excellent qualities are also worth our long-term learning and persistence.

Edited by Jeffrey