Three rules to find good shares at great prices

Companies analyst and Share Sleuth Richard Beddard explains his simple system for spotting equity value.

For me, investing is a continuous learning process. That is the joy of it. The world of business and finance is as complex as we choose to make it, but we don't have to be particularly clever to succeed. In my experience, we need to be thoughtful, honest with ourselves, and always remember there's more to life even than money.

Rule 1: keep your strategy simple

In his book Beating the Street, former fund manager Peter Lynch urged investors never to invest in an idea they can't illustrate with a pencil. I have tried drawing pictographs of my investments without much success, but the sentiment is noble. An investment should be simple to understand, and to explain.

What makes sense to one investor may not convince another, but all of us have a kernel of knowledge and skills that we can build our portfolios around. Warren Buffett, in one of his annual letters to shareholders in Berkshire Hathaway, the investment company he runs, wrote: "Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital."

Experience can, of course, extend those boundaries outwards, and irrespective of any industries we may have worked in, most of us have at least some idea of how manufacturers, distributors and retailers make money. What's more we come across businesses in our day-to-day lives – as customers, for example.

My goal is to keep things simple, and this is how I decide whether a company is in my circle of competence: I need to know it is profitable because profitability demonstrates that a business is viable, and cash profits give me confidence its accounting profit is real. I need to understand how a business makes money (its business model), how it will make more money (its strategy) and what could stop it making money (the risks it faces). If it treats customers, suppliers, staff and shareholders fairly, and its strategy addresses the risks, the firm is likely to prosper over the long term. It will be a good investment, as long as its shares are not too pricey. Honestly, I think that is complicated enough.

Rule 2: be honest with yourself

When writers give an opinion, they have a moral obligation to be honest and not mislead readers. The more honest the review, the more interesting it is, which is why I might read a review of a car by Jeremy Clarkson even though I have no interest in cars, and why I have read hundreds of film reviews by the late American journalist Roger Ebert.

Some years ago, Ebert explained his approach to film reviewing in an interview. He said: "I'm reluctant to tell you that I cry because it makes me look like a sap. You know, because critics are always crying and I want to be the critic that is too tough to cry. But if I did cry during that movie, then I have to tell you that happened. If I was aroused during an erotic scene, I have to tell you that happened. If I laughed, I have to tell you it's funny. I went to see Jackass, a shameful movie, and I laughed all the way through it. I have to tell you that. I'm the guy. I was in the theatre and I have to be honest."

I am the guy too. But I am not in a theatre, I am at an annual general meeting, reading an annual report, on a tour of a factory or just walking around a shop checking to see if certain merchandise really is flying off the shelves. I have never been aroused by an annual report or broken down crying at an AGM. These are not reactions an investor is likely to feel compelled to cover up. I am often confused though: uncertain and, basically, unable to fathom some aspect of a business. Nobody, least of all me, likes to look like an idiot. We all want to be the smart one who knows what is going to happen.

I have to fight the urge to pretend I know more than I do, because overconfidence is sin number one in investing. It allows us to be lazy and avoid the hard work that builds a justifiable level of confidence. It leads us to invest lots of money in shares we haven't adequately investigated.

Writing about shares is a good discipline, because it obliges me to be honest. The routine of setting out how a business makes money, what it must do to make more money and what could go wrong exposes flaws in my thinking and gaps in my knowledge, which I am sure is why many good investors document their decisions in journals and blogs, even if they are not paid to do so.

Rule 3: learn to accept the facts of life

Investing should make life better for us in the future, but it would be perverse if it spoiled the present.

It has been more than a decade since the most recent big recession and the stock market crash that accompanied it. Fears of an impending crash are heightened by the prospect of trade wars and deflation, so the stock market is febrile. This is a fact of life. It should not affect an investor's mood, but it will if they don't have a strategy for selling shares near the top of the market and buying them near the bottom, and also confidence that the companies they own will survive difficult times and prosper.

Timing the market means predicting what large numbers of traders will do, which is well outside my circle of competence, so I put my faith in companies I know well to survive challenging economic times and prosper thereafter.

I pay no attention to fluctuations in the value of shares I own, but I can't avoid worrying about the value of the Share Sleuth model portfolio, which I manage for Money Observer, because I report on its performance every five years. Coincidentally, this month is the portfolio's 10th anniversary, so I have been fretting, hoping the portfolio will end its first 10 years on a glorious run and give readers a better impression of my investing prowess. In fact, the decade is concluding with a whimper, which is deflating. This is a futile emotion, and potentially destructive if it forces us to sell good investments just because the share price has fallen temporarily.

Fidelity's Anthony Bolton described in his book how much pressure to perform fund managers are under. He concluded: "I've always thought that the best environment in which a fund manager could perform well was one in which they didn't know how they were doing. Unfortunately, the real world is the opposite of this, and every manager is only too well aware of how they are doing day to day, week to week, month to month. The pressure – when it's not going well – is intense."

Fund managers worry about losing bonuses, clients and jobs if things go wrong. The advantage for private investors is that we answer only to ourselves.

Richard Beddard has managed the Share Sleuth portfolio since he started it in 2009. He's a private investor and columnist at Money Observer.