Richard Beddard: what do we really need to know to invest?

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Last week, I received an email from a reader titled ‘Investing’. It has really got me thinking about what, and how much, we need to know to invest successfully. 

The answer is probably more than we know already, but less than we think.

Re: investing

The reader, Martin, says he is a passionate investor who has learned what to look for in good companies, but he feels like he needs to improve his ability to read accounts. 

Bowing to my “far greater knowledge” he asks for advice on improving his understanding, spotting ‘red flags’ (things to look out for that might warn us off bad investments) and valuing companies. 

I suspect Martin is overestimating me and underestimating himself. He sounds a lot like me, and probably many other investors, who perhaps do not come from an accounting or business background.

Any books or guides, Martin says, would be appreciated.

Best thing I ever read on accounting

The best thing I ever read on accounting was in the book that most inspired me at the beginning of my investing education. It made investing accessible to me, somebody inexperienced in business. 

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The book is Peter Lynch’s One Up on Wall Street. It taught me how to understand a  business, to work out how it makes money and how it plans to make more money, and it taught me not to invest in businesses until I understood them.

Accounting is the language of business, but Lynch floats lightly over the subject in his book.

He devotes one section of one chapter to reading the financial reports, and the first paragraph sets the tone:

“It’s no surprise why so many annual reports end up in the garbage can. The text on the glossy pages is the understandable part, and that’s generally useless, and the numbers in the back are incomprehensible, and that’s supposed to be important. But there’s a way to get something out of an annual report in a few minutes, which is all the time I spend with one.”

Then he explains how he adds cash and marketable securities together to establish how much cash a company has in round numbers. 

He compares cash to long-term debt, explaining that when cash increases relative to debt the balance sheet is improving, which is a sign of prosperity.

Concluding, almost as an afterthought, he says something remarkable:

“(You may have noticed Ford’s short-term debt of $1.8 billion (£1.33 billion). I ignore short-term debt in my calculations. The purists can fret all they want about this, but why complicate matters unnecessarily? I simply assume that the company’s other assets [inventories and so forth] are valuable enough to cover the short-term debt, and I leave it at that.)”

Readers of my articles will know that I read annual reports more enthusiastically and I do not ignore short-term borrowings. In hindsight, some of Lynch’s simplifications seem dangerous, but the thing I remember from One Up on Wall Street is not the specific advice but the general point.

The lesson I learned was that, even though Lynch was one of the most famous and successful fund managers of the last century, he made simplified assumptions. He did not burrow into every rabbit hole chasing every number bounding down it.

He did what he felt he needed to do to understand a business. Sometimes less was more because his style of investing required him to evaluate many shares, or as he described it, turn over a lot of rocks to see what was underneath. To him that meant more than scrutinising the numbers. It meant kicking the tyres: sampling the merchandise, reading the trade press, talking to management and competitors.

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My simplifying tactic when it comes to the financials has been to investigate a handful of key ratios (principally return on capital, cash flow and debt to capital, aka profitability and debt) to see if I have anything to worry about. 

If I find something, I may probe deeper into the accounts, but I do not have to investigate every number for every company.

Richard’s recommendations

In the spirit of Lynch, this is my advice to anyone, like me, whose accounting knowledge is limited. The first thing is, it does not have to be perfect. Most companies are readily understandable with a tiny subset of accounting knowledge - and we do not have to understand every company.

Second, I have not yet found the perfect accounting textbook, and would be surprised if I ever did. 

Accounting Demystified by Anthony Rice shows how accounting works. It describes the main financial statements and explains how movements in one affects the others as though they are organs in a living, breathing creature. 

Peter Frampton and Mark Robillard have recently published the optimistically titled The Joy of Accounting, which covers similar territory. Judging by the reviews (I have not read it yet) it has brought joy to readers.

Inevitably these books give an overview. If you are flummoxed by a quirk in the accounts of a company, you are unlikely to find succour in books such as these.

Accounting is governed by standards like the International Financial Reporting Standards (IFRS) and, should you have the temerity to look, these standards extend to thousands of pages that are continuously revised and superseded. I doubt there is an accountant that has read every line.

Companies refer to the IFRS by name in the notes to their accounts and it can help to chase down an explanation of a particular standard. For example, IFRS 16 covers the recent changes to the way leases are accounted for.

IFRS for Dummies by Steve Collings is a good introduction to the standards as they stood in 2012, when it was published, but things have moved on. You will not find IFRS 16 in Collings, so I tend to Google the more recent standards. You will find that most of the big accounting firms produce summaries. 

It is also worth contacting the company about befuddling accounting. The chief financial officers of smaller companies are often prepared to explain, and if they are not, that tells us something we might need to know about the company and its attitude to shareholders and potential shareholders. 

At larger companies, we have to go through the investor relations department, but ultimately we should get an answer from the finance department.

Then there is the thorny matter of valuation, which takes the numbers produced by accountants and forecasts how much profit or cashflow a business will make. The more it will make, the greater the value of the business today. 

Many investors, myself included, decide the forecasting step is too difficult and base our perception of value on a multiple of current or average earnings or cashflow. The more confident we are in the businesses’ prospects, the higher the multiple we will pay. 

I think it is important to be explicit about what we are paying for though, so I score companies to determine which are most valuable.

These are methods of company analysis, and one of my favourite books on the subject is the relatively unheralded The Economist Guide to Analysing Companies by Bob Vause. Phil Oakley’s How To Pick Quality Shares is, as the title suggests, more focused on the numbers we need to find and value good businesses.

Less is more

Phil recently wrote a series of tweets praising a new book by Steve Clapham, the founder of a training company called Behind the Balance Sheet. 

Phil says Steve’s book, The Smart Money Method, is one of the best and most enjoyable investing books he has ever read. One aspect of his review in particular caught my eye. He says:

“The book starts with a point about the 80/20 rule... Readers need to be wary of the risks of diminishing returns on time spent researching and over-analysis.”

Perhaps the idea that ‘less is more’ is not as revolutionary as I had hoped when I embarked on this column. It seems we are all singing in the same carol service.

Still, like most things in investing, ‘less is more’ is easily stated but hard to achieve in practice.

The Smart Money Method has joined the list of books I might read one day, along with The Joy of Accounting, but I will not be taking advantage of a few days off to read a book about investing this Christmas. It would not feel like a few days off if I did.

I will be finishing a book I have just started about Neanderthals. The book is Kindred, it is by Rebecca Wragg Sykes, and I am pleased to say there is a tenuous connection with investment. 

It is published by Bloomsbury (LSE:BMY), a member of the Share Sleuth portfolio and one of my own shareholdings.

It is factual, lyrical, very handsome, and evidence that Bloomsbury lives up to its promise to publish works of excellence and originality. 

Happy Christmas.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard.

Richard Beddard is a freelance contributor and not a direct employee of interactive investor.