A Backdoor Approach To Investing Revisited

Investing is definitely an art form, rather than a precise science. There are many investors that are highly successful, but they all have different styles.

Just like I am sure there are many profitable traders, not all of them will have the same trading style. The same can also be said with a variety of professions, from white collar jobs to blue collar jobs.

While there may be some similar fundamentals that overlap each investment style, each investor will have a slight edge in they way they approach investing.

I would dare to presume than the average investor will use a top down approach when making an investment decision. They will approach it from projecting revenue growth to the cash flow a business will likely generate in the next few years.

From there they will try to make a sensible forecast as to what the worth of the business will likely to be. This approach leads to one frame of thinking, which is how much money I as an investor will be able to make.

However, forecasting is often guesswork, with a high probability of error. Worse, we might skew projections to fit our desired share price, risking significant losses. That’s why I also favor a backdoor approach in my investment decisions.

Finding The Backdoor To Investing

I want to make enough from investing to retire comfortably, hopefully sooner rather than later. However, I also don’t want to risk all my capital in pursuit of this goal.

When I first started investing, I had my head in the clouds. The allure of making a lot of money from buying stocks drove my approach. Initially, I saw some great returns, likely due to luck rather than skill. But I also experienced significant losses on some of my early investments.

Fortunately, I learned these lessons when my capital was still small. Once I began approaching investing differently, my returns improved overall.

While forward-thinking is essential in investing, we should also think backward. Instead of asking what needs to go right for a company to succeed, we should consider what could go wrong and turn it into a bad investment.

We often create big narratives around “ifs”—if this happens, then that will happen, and I’ll make a lot of money. However, the word “if” is the biggest two-letter word in the dictionary.

So, instead of focusing solely on potential gains, it’s prudent to consider how much you could lose if your predictions don’t pan out. You never want to face a situation where you had to start back from zero, especially as you get older.

The backdoor of investing starts with thinking backward rather than projecting forward, which can help you avoid silly mistakes.

The Reverse DCF method

The most common method of valuing investments involves projecting future earnings, whether profit or cash flow. The discounted cash flow (DCF) model, favored by many, calculates a stock’s intrinsic worth by estimating the future free cash flow a business is expected to generate.

In this method, you add up the projected cash flow and discount it back using an appropriate discount rate to derive its present value. Typically, this rate is the Weighted Average Cost of Capital (WACC), but you can also use the return you expect from holding the stock.

At first glance, a DCF model may seem complicated, but it’s a valuable exercise in understanding what a business needs to achieve. However, as I’ve often mentioned, forecasts are usually wrong, and there’s a tendency to bias the numbers to fit a preferred valuation.

While DCF focuses on future projections, we should also use a backdoor approach. As the late Charlie Munger advised, “invert, always invert.”

By “invert,” I mean starting with the current share price instead of trying to determine it. Reverse DCF takes a backward approach, using the current share price to see what the market values the company at. This method helps us understand what market participants are already pricing in.

By examining the current share price, we can assess if the market’s valuation aligns with the company’s potential. If you believe the company can’t achieve the expected growth at its current valuation, you might choose not to invest.

Conversely, if the Reverse DCF indicates the market is underpricing the company’s growth, it could be a good opportunity to buy the stock.

Blinded By Investing Profits

Why do people invest in stocks? Most likely, it’s the potential for outsized returns. The stock market often gets compared to a casino because people shift from investing in businesses to trading stocks.

Many think about the money they can potentially earn from trading. This mindset leads to insane market rallies, driving valuations into bubble territory. Investors pour in cash as stock prices rise, believing the trend will continue.

However, when the bubble bursts and share prices plummet, these same investors often sell at massive losses and vow never to return.

Herd mentality is a genuine behavioral trait in finance that plays on human emotions. We don’t like seeing our friends and neighbors get richer than us. While some might be okay with it, most people deep down envy another person’s success.

Instead of considering how much they can lose, many are driven by the thought of how much they can make, overriding their sensibility.

A crucial backdoor approach to investing is thinking about how much money you can lose. Buffett calls this the margin of safety.

The margin of safety means your downside potential is much lower than your upside. It’s like making an asymmetrical risk-reward bet: heads, I lose a little; tails, I win a lot.

Once you start considering the possibility of losing more money than you can potentially make, your investment decisions will likely improve, and your success rate will increase.

Key Takeaways

• Consider potential losses, not just gains, when investing. Avoid risky bets that could wipe out capital, especially as you age.
• The DCF model projects future earnings to value investments, but it can be prone to errors and bias. Use the combination of a Reverse DCF to assess if the current market price aligns with the company’s potential.
• People invest in stocks for potential high returns, but often overlook risks. Prioritize a margin of safety to balance potential losses and gains, improving investment decisions and success rates.

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