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When I first came into contact with investing over twenty years ago I had no idea where it would lead me. A chance encounter in Houston airport with a book about Warren Buffett changed my opinion on a number of things. Back then I didn’t guess that I would not just read about him, but end up meeting him. I’ve learned a lot since those early days; so to close the year I will attempt to summarise that to give you some focus for 2008.

Contrary to popular belief, fundamental analysis is not really a one-dimensional quantitative approach to the market as most believe. Over the years I have learned that identifying and qualifying companies that are suitable for a long-term investment is a multi-skilled process. At its core there are three axes of intelligent investment. Each axis represents a different key aspect of long-term investing and putting all three together should enable you to become a competent investor.

Always remember that, when we talk about ‘value’, its essence has to be what the company will return to its shareholders over time. At the end of the day, a business can only return to shareholders in value what it throws off over time, focus on that yield and never forget that price is what you pay and value is what you get.

First axis of investing: valuation

Your first task is to estimate the future value of the business. This is usually cashflow generation, but you can also use assets or earnings bought cheaply. Discount the value you have identified going forward back to its present-day value. Then judge whether this is an amount that gives you a good prospective return. Don’t forget that it pays to be pessimistic when assessing the future earnings the business will generate. The stock market does not reward over-optimism well! You may struggle to predict the future, but the great thing is that so does everybody else, keep it simple and realistic.

Second axis of investing: risk

The operational axis asks questions of survival. Can the company survive given either the competitive makeup in the market or a different economic environment? Competitive analysis tends to revolve around Porter’s five forces, but one of these – barriers to entry – I believe to be the most critical, so put more focus there.

Simple businesses with unchanging characteristics also make good targets. They tend to be well established, have a definitive need in the market and, with that, longevity. In terms of financial risk, it is a case of looking at the numbers and judging whether there is adequate and prudent management of the financial side of the business and whether this is conducive to a sustainable investment given your assumptions on other items. If it is underfunded or not generating enough free cash to grow without raising additional debt, this represents systemic risk that should be accounted for.

Third axis of investing – psychology

Adopting a long-term style requires some stern psychological traits. Coming to terms with your own psychology and those who play in the market are critical aspects of value investing.

Your objective is to buy when others sell and sell when others buy. This can be difficult, though, when your ‘wealth’ is being quoted to you on a daily basis. Don’t forget that the market is generally more geared to extracting money from you than it is earning it for you; you need to hold firm.

The method I have adopted is to look at my investments as I would a business. The main reason for this is that it takes the investor’s focus away from short-term price fluctuations and focuses you more on to a sustainable, reliable and well underpinned mindset. The market will always act like a paranoid schizophrenic – if you can keep your head while others are losing theirs you will be able pick off the opportunities that come along.

In summary, if I had to crunch my knowledge into one pseudo equation, it would have to be: -

Valuation – Margin of safety * predictability + Prospects = Recommendation

It’s pretty simple at its core but, having been privileged to work with may people who use it very effectively, I’d say it was the most effective path through the markets.

I first started writing this column three years ago and after three years of writing, weekly, about long-term investing I have pretty much covered most aspects in significant depth. Therefore, while I enjoy writing and getting much valued feedback from readers there are only so many ways I can say: ‘Buy good-quality companies that are out of favour’. So, with 2008 ahead of us, this seems an appropriate time to turn off the lights on this column.

I do hope you have got value from Long Term Investor; I have certainly enjoyed writing it. I wish you the best of luck for the future. Though I should say, as long as you stick to doing simple things well, you shouldn’t need any luck at all!