The experiences of a lifetime exert a profound and lasting influence on what you think about investment. Some seminal events in my past have had a lasting effect on my way of thinking in the present.
If you began investing near the top of the dot-com boom or shortly before the crash of 1987, you will tend to think that another disaster is always just around the corner.
Conversely, if you got rich trading technology stocks in the dot-com boom and managed to avoid the bust, you are more likely to be a natural optimist. What follows are some of my conditioning life experiences.
Equity ownership is a powerful incentive
In the early 1980s, stockbroking firms were partnerships. The partners owned the business and had unlimited liability for its debts. This imparted a sense of responsibility that was wonderful to behold.
Big Bang in 1986 was to change all that. Out went unlimited liability; in came outside cash and incorporation. This resulted in a big hike in salaries, cost-led expansion and empire building.
As a director on the stockbroking side at Henry Cooke Lumsden, based in Manchester, I watched with horror as our established business – known as ‘the Cazenove of the North’ – was hitched up to a boutique bank that had only been in existence for a couple of years.
I had learned to be very wary of acquisition-led growth and the opportunities it provides for accounting smoke and mirrors.Half the equity of the combined group was given away for fool's gold.
The recession of the early 1990s revealed just how weak the loan book had been. The bank duly went into administration and the stockbroking business was on the way to losing its independence. I had seen a franchise that took 125 years to build brought down in less than 125 weeks.
I learned that when investing in a business, it’s a good idea to check out the equity ownership of the people running it and how much they are drawing in salaries.
If they have a large amount of personal wealth tied up in the business and behave frugally, it is more likely that they will act like owners to preserve their wealth (and yours with it).
The rocky road to ruin
Long before the banking debacle, I had learned to be very wary of acquisition-led growth and the opportunities it provides for accounting smoke and mirrors. The 1980s was the era of the mini-conglomerate.
An entire genre of businesses sprung up seeking to imitate the success that Hanson Trust and BTR had achieved by bulking up with acquisitions. A handful managed to survive; most didn’t.
In my days at Henry Cooke Lumsden, I worked closely with Thomas Robinson & Son, an ancient, sleepy engineering business based in my hometown. The intention was to use it as the quoted vehicle to build a mini-conglomerate. The deals came thick and fast, and likewise, the profits shot up, fuelled by the acquisitions.
The larger deals were always done with paper, with cash alternatives fully underwritten. What began to worry me was the insatiable appetite of the business for fresh capital.
Despite the marvellous profit record, no cash ever seemed to come out. Gradually the reason became clear. It wasn't just the machinery that was being manufactured.
If you are going to invest in a business, you must master the language of businessRobinson was using fair value adjustments to write down acquired stocks and debtors, thus booking greater profits when the stock was sold, or the receivables collected.
Similarly, by writing down fixed assets, the depreciation charge taken against profits was reduced.
In an instant I had learned the distinction between profits and cash.
From 1990 onwards, Robinson faltered with repeated profits warnings and a wholesale change of management.
The component businesses were scattered to the four winds as the group was broken up piecemeal. The lesson learned stood me in good stead to predict the demise of businesses later in my career.
Acquisitions provide a wonderful opportunity for creative accounting and investors should view them warily. Some make great business sense; many don't. As long as you remember ‘Cash is King’, you won't go far wrong.
No business generating plenty of cash goes under, which cannot be said for businesses generating plenty of profit.
Another lesson is that if you are going to invest in a business, you must master the language of business, i.e. accounting.
Beware new paradigms
The most memorable experience I have lived through is the 1990s dot-com phenomenon. As with most manias, there was a seminal event associated - in this case the coming of the internet. The momentum built up by such manias is very powerful and, for many, hard to resist.
You just know something is wrong when investment bankers start devising new ways to value enterprises other than by their ability to generate cash for their owners.
Nearly always, the new valuation metric travels further up the income statement and sometimes clean off it.
As Ben Graham said: "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."
I think there are a number of lessons here. First, I agree with Sir John Templeton that "It's different this time" are the four most dangerous words in the investment lexicon.
Second - history repeats itself, but the manifestation is usually different.
Third - ignore siren voices and trust your own judgement. And lastly, often the darkest hour is just before the dawn.
In investment terms, this means the point where nearly everyone is pessimistic and can see no positive news whatsoever. As the last bull turns to bear, the market inevitably turns up.
Putting lessons into practice
In the mid-1990s, I had been working in investment analysis for over 15 years. But I did not have the anchor line of a robust investment philosophy. How do you go about finding an objective way of identifying investments that can predictably build long-term wealth?
The starting point is to identify particular types of company as investment candidates, i.e. those with the most predictable business models, then to value them.
If a business model is not predictable to a high degree of certainty, how can you value it?
And if you can't value it, how do you know if the stock market price is offering you an investment proposition or not?
Ignore siren voices and trust your own judgement.I alighted on the teachings of Warren Buffett and Charlie Munger and now set about learning with the zeal of a convert.
Buffettology, the book written by Mary Buffett and David Clark, helped to unlock the mystery. It is an accessible and very simple exposition of Buffett's methodology.
It showed me the overriding importance of concentrating on the economics of a business and discarding those companies that do not stack up against a set of predetermined criteria. This was a massive step-change in my thinking.
In a short space of time, I changed from being a securities (or investment) analyst to a business analyst practicing Business Perspective Investing.
The methodology that I use today has been synthesised from a lifetime of investment experiences.
Keith Ashworth-Lord is chief investment officer for Sanford DeLand Asset Management
