Self-Centered Investing – Financial Assessment

A key aspect that is often missing from discussions about valuation is the investor.  Before we can get to valuing an investment, we need to consider what type of investment makes sense for us.

Experts talk about diversification, asset classes, currencies, hedging, inflation, deflation, capital structure… but they rarely talk about you — specifically, your fears, your defensive position and your desired lifestyle.

As well, we tend to have a romantic notion, supported via financial marketing, that investing is designed to make us rich so we can retire to a life a leisure.  

For me, reality is far different


Here’s the process I go through to optimize my portfolio structure.  Three types of financial information are required:

#1 – An accurate income statement // clearly lay out the money coming in and the money going out – I like to look forward 12 months and review quarterly to check against actual figures.  

#2 – An accurate balance sheet // lay out all your assets and liabilities – for each of the assets/liabilities note all benefits/costs (financial, time and hassle) in a column beside them.

#3 – Create a cash flow statement that links your income statement with your balance sheet — this will let you understand how you are financing your life. If you are living off borrowings (borrowed time) then best to make that highly visible.

You can find tools for the above with a quick google search.  With my expenses, I write them down as detailed as possible then clump them into three categories: essential, discretionary and luxury.

Ultimately, your expenses and savings goals will drive the amount that you have to work.  Therefore, expense visibility, and control, is an essential step of maintaining your personal freedom.


Now that you have a clear picture of your financial position, consider:

Your Desired Lifestyle – how do you want to live, what’s that going to take // work to convert collecting these experiences into sources of income

Black Swans – unexpected, adverse events (I like to structure my assets to protect myself, and my family) // consider how to hedge these

Macro Trends – what happens to your life if economic trends change (employment, interest rates, inflation, deflation) – focus on mitigating the changes that would impair your quality of life.

I’ll cover my take on these topics next week with a piece on Lifestyle Hedging.

The value in a portfolio comes from peace of mind and the life it enables you to lead.


Finding Winning Investments

Remember that you can have a very successful investment career with a completion rate of less than 1%.  Investing is a strange game in that most of what you work on will never actually happen.  You need a unique personality to cope with that aspect.

In the gaps between deals, your return criteria are tested and you’ll be tempted to dabble just to do something.  Remember the key five from last week and stick with the fundamentals.

When I come across a deal that fits my criteria, there are three questions that I ask myself.

#1 – Why sell?
What’s the vendor’s motivation and why am I being offered this great deal?  You can not afford to overpay and hope that leveraged asset inflation bails you out – that’s just for professional investors that use other people’s money.

The huge amount of leverage in our society is creating buying opportunities due to people’s need to repay their debts.  Other reasons to sell can be moving cities, relationship breakdown, or change of strategy.  I’ve done deals with all these types of vendors.

When I can’t figure out why I’m being offered a deal – I pause.  

Things that appear to good to be true aren’t as they appear.


#2 – Calculate your margin of safety

I’m pretty sure it’s a Warren Buffett saying, “price is what you pay, value is what you get”.  To get me to do a deal, the price needs to be less than the value.  This is mainly because you never get full disclosure and you’ll nearly always end up having to invest more than you expect.

I like to figure out what the value of the asset is an independently as possible.  I also value relative to my current, and future, situation.  When I’m 60, I suspect that I’ll have different needs than when I’m 40.  So I try to take that into consideration.  It’s also why I’m fond of Rule #4 from last week (always be able to exit).

If you don’t have the skills to properly value your deals then wait!  Acquire the skills, learn the fundamentals about valuation and be patient.  Remember that you only have to do a couple of decent deals in your entire life.  Don’t dabble.


#3 – What is required for failure?

Most of us do too good of a job convincing ourselves how we’re going to make money.  

Take time and consider what can wipe you out.  Once you have a list of those items then you can perform research to rule them out, insure against them, or accept that they might wipe you out.  Personally, I either rule them out, insure against them, or factor in the cost of mitigation.  

You don’t need to be a genius to figure out what can kill you but you will need to spend some mental effort.  The largest investments that most of us will make in our lives is real estate and a quick google search can give you a list of items to consider.  You can also keep reading my blog as I’ll be laying out the basics for you over the next few months.

On this subject, I recommend Charlie Munger’s book, lots of case studies and practical examples.  Spin the deal, and the world, on it’s head and see what that does to your situation.  

A practical example of inversion is interest rates.  

If you are borrowing significant sums of money that will reset in the next ten years – then what would happen if your cost of borrowing doubled?  What if it tripled?  Quadrupled?  Sounds unlikely?  Have a look at historical interest rates – specifically mortgage and prime rates — you need to scroll down a bit to where you can see the figures around 1980.  

Be sure to leave room for the unexpected as well as saving capital so you’ll be in a position just-in-case the buyer’s market of a lifetime heads our way.  Check out the java chart of the Living Yield Curve and imagine what is going to happen when rates rise to normal levels.

On Capital & The Key Five

When I was in school, they taught me that capital was how a firm chooses to finance itself – two main choices debt or equity.  We learned a lot of different models and theories about the nature of markets and the choices that firms make with regard to their capitalization.  I graduated in 1990; spent a decade in Private Equity; and a further decade in Real Estate investing. The real world is far less tidy than what your finance professor would have you believe.
What about us?  What are the key aspects of capital as they relate to regular folks.  I’m going to outline those and get into more detail in future articles.  I’m going to use my own terminology – like athletics, there is a fair amount of overlap and words used to define different things.  Over time, I’m sure we’ll develop a common language like we did at Endurance Corner.

What is it?
Free Capital is money that you have readily available to make investments — it is available quickly for investment.  What is an investment deserves a separate article – so I’ll save that for later.

Net Worth
Simply put your net worth is your assets less your liabilities.  Because assets are more visible than liabilities, we often make the mistake of assuming people with lots of assets have lots of net worth.  In a crisis, free capital is much more valuable than net worth (also called equity).

Acquiring Capital
You can be the best investor in the world but, if you don’t have any capital to invest… well, you won’t be particularly successful.  So, to create financial stability, the first habit you need is the ability to acquire capital.  The answer is simple, but not easy: always spend less than you earn.

The only time you want to vary that rule is when you make an investment.  

The Key Five on Investments:

  1. Limited in number across our lifetime
  2. Generate a net positive annual return
  3. Preserve capital
  4. Have an ability to sell in all market conditions
  5. Make a positive impact on our life situation

This is the first place where the reality of personal investing differs from human nature and the media.  People will try to convince you that the Key Five don’t apply.  When you hear someone talking like that look for where they make their money.

Ultimately, acquiring capital has to do with not losing capital… the Key Five are essential to remember.  The discipline they impose will rule out many schemes that can get you into trouble.

Some common schemes:

  • Second home – typically cash flow negative annually – therefore a luxury good, not an investment.
  • Cars, bikes, motorized anything – high cost of ownership, depreciating asset – treat as expenses.
  • Gold, commodities – realize that you’re gambling and any positive return is due to chance.
  • Stocks & Bonds – I lack the knowledge and confidence to make a bet large enough to have a material impact on my life.  
Many opportunities fall into the category of tinkering, they won’t make a difference in my life so fail Rule #5 and I don’t materially commit my capital.
To avoid gambling, I need to be honest with myself about what I don’t know as well as my ability to rely on historical information.