Thanks for your comments luutzu and DeepState.
DeepState - I will discuss the 10-k reports a bit later. At the moment I'm going through the 900 pgs of BRK shareholder letters from 1965-2013 (which will take me a few weeks to read and digest).
To expand on my Investment approach, here goes:
My Investment Philosophy:
Risk comes from not knowing what you're doing." - Warren Buffett.
I truly believe in it. If I cannot value a business, I have no business investing in it. If I cannot know about it, or understand it - I simply forget it and move on.
The only other important thing is understanding my own Psychology, (mental frame of mind, or temperament). My short-term trading experience in the past has helped me over-come this barrier. I fully accept market volatility and am very comfortable sitting on a large paper loss as long as the underlying business fundamentals haven't deteriorated. I believe in Ben Graham's concept of 'Mr. Market' who is here to serve me, not instruct me.
My approach to Valuation:
Value investing is not a paint-by-numbers exercise. Scepticism and judgement are always required. - Seth Klarman (Security Analysis: Sixth Edition, Foreword by Warren Buffett)
Valuation as I think of it is a 'Range' rather than a precise number. For the most part I do very rough and loose calculations in my head which can easily be 15-20% off on either side.
No one formula, or number can be used for valuing a business. Here are few broad techniques I use:
Multiple of Earnings : 2 to 5 x average earnings (e.g. a business earning 50k pre-tax could be worth around 250k if Debt:Equity is well below < 0.5). A good business is only worth what it will throw off in earnings over time.
Book Value : though less than perfect, it is a simple, easy, and close proxy to the net worth of a business. (some investors use Enterprise Value but I am less inclined. I NEVER use Market Cap.)
Net Tangible Assets (+ resale value of Brand, Patents, or intangibles if applicable) : This helps me answer the question: If the business ceased to be a going concern and was liquidated what would it be worth?
Capitalization Structure : though it many not directly help in valuation, it helps me understand if the business can service its financial obligations (especially if heavily leveraged).
I then overlay business specific characteristics (e.g. for Retail I focus on Inventory management and Working capital; for Manufacturing I focus on Depreciation, Interest expense, and Commodity prices; for Utilities I focus on Regulation and Pricing Power; for Pharma I focus on Patent Life, R&D expenses, and pending lawsuits; for Insurance I focus on adequate Reserves, and Combined ratio; for Business Services I focus on hidden financial disclosers).
Side Note: Even though I learn and read about various industries & businesses I rarely invest in most of them. They're merely a learning exercise for me, they don't get any of my capital.
My idea of a 'Good' business:
A cynic is a man who knows the price of everything, and the value of nothing. ― Oscar Wilde
I maintain a watch list of 'good businesses' at all times. 'Good' meaning they have favorable qualities like above average Operating
Margin, much better Operational Efficiency than competitors, lowest cost producer with big distribution power, high Free CashFlow, value in intangibles like patents or brands, monopoly-like characteristics, can price itself ahead of inflation, operates in a regulation industry with uncapped pricing power, excellent people that are self-drive, honest and diligent (though I admit I not good at judging people).
Some characteristics are quantitative, but quite a few are qualitative, and these are the ones that will not show up in financial statements but are the sort of 'good business characteristics' I try to find out for myself. For e.g. I think of Brand as Reputation, it doesn't come over night, it takes time to build. Reputation can't be liquidated or redeemed for cash, but if used wisely under the right circumstances can be used to increase earnings potential (by raising prices, or gaining favorable contracts).
All of these business will have met my 'Quality', and quite possibly 'Growth' requirement.
My Purchase Criteria:
It goes without saying that Return on Investment is a direct factor of Purchase Price. The cheaper I buy the better my returns will be, and also the better my loss cushion will be.
Of all the businesses in my watchlist that have met my 'Quality', and possibly 'Growth' pre-requisite, the last hurdle is the 'Value' requirement. Value simply is some discount to my valuation criteria outlined above.
A 'good business' is not necissarily a 'good investment' when bought at the wrong price. I find it very easy to walk away from a 'good business' if it doesn't not accept my offered price.
My Capital Allocation Guideline:
Of all the business that make it in my watchlist of 'good businesses' and meet my purchase criteria make it into the 'best businesses at bargains' watchlist. I only allow the top 5 ideas to compete for my capital. My 5th best idea looses to the top 4, and 4th competes with top 3. Capital is only given to the best 3 or 4 deserving ideas.
This approach works for me because I'm dealing with very small sums of capital, and until the sums step into double digit million I won't change my capital allocation approach.
I don't subscribe to the 10% here and 10% there approach. I understand what I'm doing and I do it with confidence. Few bets, big bets, infrequent bets.
My understanding of Stock Prices:
Stock prices in the long run (not days, but years) are driven by 2 factors; Earnings Growth (EPS without stock dilution), and Changes in Valuation (P/E multiple).
The first factor, Earnings power, is the most stable element in the true reflection of business and hence in its stock price.
The second factor, Change in Valuation (or P/E multiple), for the most part is sentimentally driven and void of clear rational thought process to business valuation. This in turn creates Volatility in stock prices. This in turn favors the rational investor.
The stock price can also be easily manipulated by issuing additional stock (diluting value), or by stock-splits (creating the perception of "cheap" price), or by stock buybacks (which can be favoralbe if done at discount). All of these can distort stock price without any change in the underlying fundamentals of the business.
My Habits and Beliefs:
Reading and continually learning about businesses is what keeps me honest toward my investments. And the more I do with frequency the more of a daily habit it becomes. Investing to me is a skill, and practising it correctly a necessity. The best part is that it's all cumulative, and can only lead to an improvement in my thought process with each passing time.