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Using 'Models' In Security Selection

As the old saying goes: "If historical data were all that was needed to select great stocks, then Librarians would all be millionaires."

Fortunately that is not the case. Historical data only supplies some 'clues' to uncovering great stocks (companies), but the rest of the work requires the creation of sound 'investment decision models.' These decision models are also known as mental models because they are not computer-derived mathematical algorithms that spit out a result; these models require the power of your analytical brain.

One renowned value investor, Philip A. Fisher, created and used a mental model comprised of fifteen (15) poignant questions covering the major facets of a business. Fisher used this check list to make sure he did a thorough evaluation of each company before making any 'BUY' decision. If a company did not pass muster on most of his requirements, he stopped wasting his time and simply moved on to the next potential opportunity.

Another renowned value investor pair, Warren Buffett and Charlie Munger, also employ 'mental models' and a 'check list' to increase the success rate of their investment 'BUY' decisions.

On this point, Charlie Munger says: "I'm a great believer of solving hard problems by using a check list. You need to get all the likely and unlikely answers before you; otherwise, it's easy to miss something important."

However, in case of Buffett & Munger, they ingeniously reduced Fisher's fifteen question check list down to a four-point (4) check list that many investors today are quite familiar with:

1. An understandable, first-class business - (Product Economics), with

2. Enduring competitive advantages - (Customers), accompanied by

3. First-class executive stewards - (Management), available at

4. A bargain price - (Margin of Safety)

To further increase their probability for success, Buffett and Munger focus primarily on businesses they feel they understand very well. Buffett calls this their "circle of competence."

Can one's circle of competence be expanded? Certainly. Charlie Munger explains how he and Buffett do this when he says: "We read a lot. I don't know anyone who's wise who doesn't read a lot. But that is not enough... You have to have temperament to grab ideas and do sensible things."

Benjamin Graham, considered by many to be the father of value investing, speaks to this in his 1946 lecture when he said:

"An investment operation is one which, on thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculators."

"The sound idea would be to measure these chances as accurately as you can, and play the game in the direction of having the odds on your side."

Charlie Munger concurs with Graham on this point: "You have to understand the odds and have the discipline to bet only when the odds are in your favor."

In his book The Intelligent Investor, Benjamin Graham further refines the concept of investing versus speculating when he adds the new concept of "intelligent speculation" into the discussion.

"There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are:

1) Speculating when you think you are investing,

2) Speculating seriously instead of as a past-time, when you lack the knowledge and skill for it; and

3) Risking more money in speculation than you can afford to lose."

Benjamin Graham, himself, had a five-point (5) mental model for "intelligent speculation" which was:

1. Understand the economics of the supply/demand of the situation

2. Advantages vs. Disadvantages (real vs. imaginary)

3. People: individual or group involved ("psychology")

4. Price vs. Value ("Margin of Safety")

5. Catalyst and conditions needed for profitable outcome


To make great investments, it is not enough to simply review the historical financial statements of a company. It is also not enough to just chart the company's historical stock performance (trend analysis). If you want to make truly great investment returns, you need to have an in depth and personal understanding of the business and its advantages over competitors. You get this by building Mental Models (check lists) that enable you to gather all the pertinent information necessary to create accurate valuations of a business and to make intelligent decisions that put the odds for success in your favor the majority of the time. The better your models, the better your decisions and greater your potential for extraordinary returns (success)! And your very best chances for success come when you can acquire that wonderful company at a bargain price!

Happy Investing!

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