Interactive Investor

Share Sleuth: five rules for the rational investor

11th November 2016 09:20

Richard Beddard from interactive investor

In recent months I've been reducing the number of criteria I use to judge an investment, and ensuring they are distinct from each other. The result is a template for what is, in my view, the perfect long-term investment. It should help me find better businesses more quickly.

The inspiration for the exercise was Daniel Kahneman's book Thinking Fast and Slow, a bestseller that, according to one less than rigorous study, most people don't finish. That would be a shame, because it contains a lot of wisdom.

Although he's a psychologist, Kahneman won the 2002 Nobel Memorial Prize for Economic Sciences. His work challenges the prevailing economic assumption that we make rational, calculated decisions.

In fact, Kahneman showed, our decisions are biased, and one of the places where those biases show up is in the stock market, as value investors have long observed.

Biased decisions

Kahneman believes a simple corrective to dodgy decision-making is to use algorithms, and the simpler they are the better.

We associate algorithms with computers; indeed, I moonlight as an algorithmic trader when I write about the Nifty Thrifty model portfolio, which buys and sells shares based on a computer-generated ranking using common financial statistics.

But an algorithm is simply a collection of rules that can be applied consistently to solve a problem. Kahneman first tried the technique out in selecting soldiers for the Israeli army.

I've boiled my algorithm down to five rules, and I plan to introduce you to one of them per month*, before explaining how they all fit together and I take the decision to trade.

The first rule is not very original, and like some of the other rules it's as much a test of me as it is of the share I'm evaluating. It is:

How well do I understand the business?

To qualify, it should be apparent to you how the company makes money. The business model should be comprehensible, and the accounting should be clear.

Variants of this rule have been championed by famous investors such as Peter Lynch, who advised investors to "buy what you know"; and Warren Buffett, who sticks to investments in his "circle of competence".

It's unlikely I'll ever find a share that meets all five criteria simultaneously without reservation, but there are lots of companies that meet individual criteria. Share Sleuth portfolio member Tristel, for example, is a business I think I understand well.

It makes disinfectants, mainly for hospitals, but also for laboratories and veterinary surgeries. It uses a formula that is safe for humans to handle and very effective at killing the superbugs that cause deadly infections.

Hospitals, particularly, are keen to use an effective method of disinfection that does not require expensive machinery. Tristel profits because they'd rather buy a constant stream of consumables.

When I heard about Tristel I knew nothing about hospital disinfection, but I had a few aces up my sleeve. I knew how to read annual reports and Tristel told me a lot. Tristel's HQ is just up the road in Newmarket, which made it easy for me to attend the AGM and ask more questions.

And my wife is a speech therapist who uses the wipes to clean endoscopes. It would have been even better to have married an infection control officer - they decide which disinfectants to buy - but that's just a decision I must live with.

Understanding how Tristel makes money doesn't tell us whether it will make a good investment (only the whole algorithm can do that), but knowing it does something useful is a good start.

Portfolio members Renishaw and Ricardo have published annual reports recently.

*I can't guarantee they will be sequential months. If I make a trade I will have to interrupt the flow to tell you about it.

This article was originally published by our sister magazine Money Observer here

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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