Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

The Nitty-Gritty of Prudent Investing

This week we’ll take a bit of a break from discussion of the week-to-week in hard assets. Instead, we’ll take a deep dive into the idea generation process. That process takes place long before the fundamental research process even begins.

The truth is, we never quite know where the next great idea is going to come from. There is no formula, no magic recipe. The process requires inspiration, and therefore constant reading of all sorts of industry publications, both primary and secondary, in our areas of coverage. That’s how we typically begin our day. It is sometimes here that a seed is planted for follow-up due diligence. Sometimes it can come in the form of a friendly and casual conversation with a contact within a given industry of interest. Of course, we take nothing at face value, and we’ll roll up our sleeves and begin to learn more about the merit of any given idea. We’ll pull all of the recent financial filings and get to know the assets, as well as the track record of the people involved.

Sometimes an idea that made no sense to us in the past can have significant merit today. While it can be a mental challenge to revisit something that has undergone a transformation, a company can pivot, turn over its asset base, replace management, and repair a broken balance sheet. It is often here that the best opportunities occur because substantive overhauls are often overlooked by the entire investment community, and may therefore represent value. Keeping an open mind is crucial to good research and due diligence.

Here is something we do notdo when we generate ideas: We don’t run quantitative screens that sift through scores of historical data. It is exactly that – history – and inherently backward-looking. Many investors take past performance and extrapolate it into the future. On the bottom of every investment presentation you’ll find the words “past performance is not indicative of future results.” Ironically, there are more and more professional investors who do exactly that, despite knowing that the past is not necessarily predictive of the future prospects of a company. These “investors” are often chasing metrics such as earnings momentum, which can turn on a dime. Such trades are often crowded, and in downturns the race to the exit can become a stampede. “Quants” are managing more and more institutional money. We think this presents an exceptional opportunity for investments in companies that do not “screen well,” but may do so in the future as they undergo multi-year transformations.

Practice makes perfect, and we have been practicing the idea generation process for decades. In addition to giving us valuable insights into how companies create value over the long term, practice also cultivates another very valuable skill – intuition. This is a skill that cannot be replicated via any sort of computer algorithm, as it allows us to see what has possibly been overlooked. Fundamental analysis as practiced by many is quite quantitative, and often gives the illusion of precision. Intuition helps the investor incorporate ideas that do not show up “in the numbers.” It can even be a creative process as one puts things together – “this thing goes with that thing” – and develops a mosaic. Many investors steeped in quantitative thinking will discount and overlook this skill. However, it is valuable in developing an outlook for future returns because, as mentioned earlier, we do not look backwards; we forecast and develop an outlook for the future.

The process of idea generation can require enormous patience. There are many times when we will have something that sounds interesting on the surface, but, after rolling up our sleeves and doing more detailed due diligence, we find a deal breaker of some sort. This can be anything: The key asset of a natural resources company is being depleted more quickly than the historical data might indicate; we’ve had a bad experience with management of the company in a prior investment scenario; the balance sheet can be of lower quality than it appeared at first blush. While it’s an exercise in discipline and intellectual curiosity, the process can often and frustratingly lead to a dead end. But the work is not all for naught, as we continue to cultivate experience, wisdom, and intuition – for which there are no substitutes.

Best Regards,

David McAlvany
Chief Executive Officer