The beauty of simplicity 5 comments

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In investing, as in life, I believe that simple things are the best.

Perhaps it is due to my training as an engineer. The phenomena of nature are diverse and complex, but the beauty of science lies in systematically categorising these phenomena and building simple models to explain the system behaviour, whether it is the flow of air over an aerofoil, or how heat spreads from a point source, or how spring-damper-mass systems can be used to model the dynamics of a wide variety of mechanical systems. Or how about the concept behind the I-Ching, the oldest of the Chinese classics --- that simplicity is the root of the substance, that fundamentals govern complexity.

Below are three instances in investing where I feel simplicity rocks.

Firstly, in stock selection, I always go for the stocks where it is easy to see how the business operates, what its competitive strengths are, what the key risks are as well as where growth is likely to come from. It should preferably be backed by a theme, or a "story" that will excite investors. Ok it is a cliche because Peter Lynch has said a similar thing in a different way: that if you can't summarise the reasons you should buy a stock in one or two sentences, then it is not worth buying. But hey, it's true. Not for me the complex investment undertakings of Ipco, or the circuitous financing arrangements of Unifiber in its attempted Kiani Kertas acquisition, or even recovery stocks like Yongnam where the theme (construction recovery) can be obscured by a dubious set of financials that complicate any growth story. In short, the search for simplicity often leads me to well-financed companies which are typically market leaders in the niche/sector that I target. The monitoring part post-purchase is also easier, because one just monitors the "story" to make sure that it doesn't turn sour. The more complex the "story", the more monitoring effort one has to expend and the greater the risk that he will get things wrong.

Secondly, given the myriad of events and breaking news that pervade our senses every day, it is necessary to find a structure to the chaos. It is often simpler to understand the spirit behind the corporate moves or new government regulations or whatever --- that is the crux of the issue. It is more important to read the intentions and general shareholder orientation of a company's directors/management from their various corporate moves (a good example would be the Lim Seck Yeow-linked companies) with which further corporate developments can be corroborated. It is more important to understand the spirit behind a government's regulations in the long-term than to keep track constantly of new rules (eg. China's new medium-term goal of "sustainable development" under Hu Jintao is giving rise to reform in the healthcare sector, its push for energy security, and its development of inland regions). Without simplifying things and developing a coherent world-view, it is very easy to be overwhelmed if one attempts to keep track of everyday news.

Thirdly, my search for simplicity leads me to eschew quantitativeness in favour of qualitativeness. Quantitative strategies are necessarily complex --- they involve things like arbitrage where one typically plays off one investment instrument against another related instrument (eg. mother stock and warrant) in the hope that their divergent prices will converge. Or some might buy a stock about to undergo merger to capture the small difference in current price and acquisition price --- known as risk arbitrage. These quantitative strategies can work but are typically practised by professionals using leverage and advanced quantitative modelling tools. So I'd prefer to assume that the market is generally efficient on such pricing (ie. it has smoothed out any big potential gains from quantitative-based trades) and instead focus on qualitative aspects like figuring out a business's medium to long-term prospects. The historical and forward financial metrics can be worked out and projected in a straightforward way mathematically, nothing complicated, because the difficult part is in understanding the business dynamics. Here, therefore, I practise quantitative simplicity.

To end, a quote from Albert Einstein: "Everything should be made as simple as possible, but not one bit simpler."