“To invest successfully, one doesn’t need a stratospheric IQ. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework” – Warren Buffet

In our piece last week, we outlined why frameworks are powerful tools for investors, and suggested that the world’s most successful investors all make decisions based on a well-established framework.

Every framework needs a foundation; we build our framework on a foundation of value. Our underlying belief is that while short-term stock prices rise or fall based on temporary factors, panics, and manias, longer term, they are the representation of the value the company will generate on behalf of its shareholders.

This week, we investigate the characteristics of a solid, value-oriented framework.

We strongly believe that some frameworks are better than others, just like some foundations are stronger than others. Our experience has shown us that value is the strongest foundation on which to build an investment framework and we agree with Nicolas Sordoni, CFA, the portfolio manager at Lazard Investments whom we cited in last week’s piece, that

Considering this, we think a good framework has three main characteristics:

  1. Transparency – The framework should allow us to illuminate the company’s business, and we should immediately be able to differentiate between what is important and what is trivial.
  2. Testability – You might remember in our post from last week that we briefly referenced hypothesis testing and the scientific method. The framework should be testable in a scientific sense – we should make predictions based on our understanding, then test those predictions against what occurs.
  3. Universality – The framework should be able to evaluate any investment by reference to first principles. The framework should not require the tweaking of rules when analyzing a company in one industry or another or one region or another.

Let’s examine each of these characteristics more carefully.

Transparency is important because it helps us to minimize the effects of bias and maximize the opportunity for insight.

If a framework is transparent, it means that the input variables (we call them “valuation drivers”) are explicit and measurable, and that the conclusions follow directly from the input variables. By insisting on transparency, we make an explicit link between information and conclusions, and we can easily see how a change in one piece of data affects our perception of a company’s value.

Using a transparent framework allows us to focus in on the most important facts about a potential investment and not get mired in the kind of superficial anecdotes that end up hurting so many investors.

Testability is vital because of its emphasis on observable facts and on intellectual honesty.

Most investors test their investment thesis for an investment by looking at whether the stock price is up or down. However, we don’t think this comparison is a valid test as long as you accept that the value of a company can differ from the price of the company’s stock.

Rejecting the idea that price equals value, we believe that a strong framework is one that focuses on the investor’s understanding of the valuation driver inputs mentioned in the previous section.

Just as a scientist makes predictions based on his or her understanding of a process, a good investor makes forecasts based on his or her understanding of a company. If the investor understands the company well, his or her forecasts for the valuation drivers will match up closely with the actual results posted by the company.

Of course, one wants to be as accurate as possible with one’s forecasts, but beyond forecasting accuracy, a major goal should be to learn about the company so that one’s next projection is better than the first.

In our work with the Brier Fund of Superforecasters, the Fund’s participants update their forecasts every couple of weeks with new data, then revise their conclusions. This practice universally sharpens their forecasts and helps them to consistently outperform the average person.

Testing is uncomfortable. It forces one to admit that one might have been wrong about something and it requires a high degree of intellectual honesty. This honesty pays big dividends though – it allows an investor to know with certainty that it is time to close a position (whether for a loss or for a gain) or to increase a position (whether one is sitting on an unrealized loss or unrealized gain).

The best professional investors in the world are those that are successful in “position sizing” and we believe skillful position sizing is impossible without having a testable framework.

Universality allows an investor to assess any opportunity and to compare it any another. Companies are faced with this issue all the time – internally. For instance, they may have the option to invest in research to develop a new product line or invest in distribution to grow into a new geography. To be successful, the framework they use to assess these two choices must allow for a direct comparison of the costs and benefits of both and compare them on an equal plane.

This quality is what we think makes a good framework for financial investors as well. Individual investors have no “mandates” forced on them regarding the instruments or ways in which they can invest. To take advantage of this freedom, an investor must have a framework that allows for such a “bottom line” comparison.

We often reference The Three Investing Fantasies – Technical, Ratio, and Fundamental Analysis. Indeed, each of these is an investing decision framework and some do better than others against the characteristics outlined above. Sadly, all of them have some challenges, blind spots, and common flaws in execution. In our next piece, we will look at each of these analytical tools and compare their characteristics to those of a sound framework.

In the meantime, Invest Intelligently.