This is a work in progress.
We invest because we want to accumulate wealth for the future.
On a day-to-day basis, each stock’s price fluctuates in accordance with the whims of the market. Yes, there may be news, but few reflect any real impact on the underlying profitability of the company. What’s concrete is the financial data of the past, present, and future of the company. This makes short-term investing incredibly difficult, akin to a “voting machine.” You can have a thesis about what might happen in a day, but if just one more person thinks otherwise, the stock price can move in the opposite direction. This kind of back-and-forth in the short term is, in my opinion, a fool’s errand for anyone serious about building wealth. On top of that, your broker is happily encouraging you while taking a cut of every transaction you make.
It’s also true that, over time, the price will follow the underlying earnings of a company. That’s only natural. If a money machine prints more money, people will, of course, bid up the price of the machine. This is something concrete, something we can study, something predictable and within our control. It’s not subject to the whims of the market because it’s an implicit rule that a company performing well will appreciate in value. To reap the benefits of this rule, however, you need to be patient, study a company thoroughly, and watch as it grows—alongside your wealth.
I consider myself a value investor at my core.
Chris Waller, an investor whom I admire said:
We are value investors. We invest in businesses that we believe are worth substantially more than the price they are trading at. We think of risk primarily as the chance of a loss over a five-year time horizon and not the temporary drawdowns in stock prices that occur from time to time. We manage this risk by only investing in businesses trading at a subtantial discount to a conservatively calculated intrinsic value and that we would be happy to own if the market shut for five years. We welcome stock price volatility as it often presents opportunities to invest further at even better prices. When such opportunities cannot be found, we hold cash instead.
The majority of our capital is typically allocated to our six to eight best investments. We look for qualities such as attractive business economics and management teams who possess and foster a culture of high integrity, customer focus, and prudent capital allocation. Our businesses may be ‘hidden gems’ because they are small, receive little coverage, listed on under-researched exchanges, operating in unpopular industries, or offer terrific opportunities beyond short term concerns. We develop a research edge over other investors by doing extensive primary research and utilizing quantitative tools. This edge can be significant when we are competing mostly against retail investors or the small positions of larger institutions, which is why we deliberately fish in those waters.
I agree wholeheartedly with the sentiments expressed. If you can grasp the underlying rationale behind these concepts, there is little point in continuing. I strongly recommend visiting his website here.
Like Chris, I do not solely define “value” by a company’s book value. Instead, I perceive it as a function of both the book value and the anticipated future value the company is expected to generate until the end of its lifespan.
This perspective offers practical advantages. Predicting the daily fluctuations of a company’s stock price is virtually impossible (if you could find a way, please share it). If individuals claim to possess this ability, why are they not included on the Forbes 100 list? They simply require a few highly leveraged successes in succession to accumulate immense wealth. Of course, by the law of large numbers and with the assistance of the most recent technology, one can develop algorithms to engage in high-frequency arbitrage. After numerous trades, one can accumulate a substantial profit. However, the majority of us lack the intellect to create highly sophisticated algorithms or the capital to invest in such endeavors. Furthermore, those in this field must continually seek patterns to exploit, as each market inefficiency is swiftly identified and eliminated.
Therefore, what are our options?
An investor who has thoroughly researched a company and comprehends the company’s potential for compounding profits over time will be able to make highly accurate predictions about the company’s future performance. This is the essence of investing. This should be the approach we adopt if we intend to profit from facts rather than mere wishful thinking.
In the short term, the market functions as a voting machine, but in the long term, it operates as a weighing machine. - Benjamin Graham
Consequently, before making any stock purchases, you must be prepared to invest for years. That is, even if you are prohibited from accessing the markets (i.e., you lack knowledge about the stock price, cannot buy or sell), you will feel at ease (assuming the company’s narrative remains consistent or improves).
Remember
As a shareholder, you are literally owning a part of the company.
This greatly influences your approach to investing — if we are going to put our money away for a few years, it compels us to ensure the safety of our capital.
When you shift your mindset to that of a business owner, buying a stock becomes akin to acquiring the entire company and entrusting its day-to-day operations to external management whom you have hired (albeit indirectly).
Ask Yourself
1. If the company is only worth $10, would you purchase it for $15?
2. Would you let just anyone manage your company?
2.1. If not, what qualities would you look for when hiring management?
3. Would you want a business plan that ensures significant profits in the future?
Now might be a good time to stop and think about how your view of stocks has changed after looking at things like a “business owner.”
If you’ve followed along so far, you’re doing well. Let’s get back to the questions we asked earlier.
Purchasing a company for less than its assumed worth.
When we buy a stock, we’re buying a piece of a company. We want to buy it for less than it’s worth. This is the margin of safety.
It’s important to remember that the relationship between gains and losses is not symmetrical. A 100% gain is required to recover from an initial 50% loss. Purchasing a stock at an inflated price leaves little room for error, as even a subsequent increase may not yield significant returns.
Warren Buffet once said:
The first rule of an investment is don’t lose. And the second rule of an investment is don’t forget the first rule, and that’s all the rules there are. I mean if you buy things for far below what they’re worth, and you buy a group of them, you basically don’t lose money.
You’ll only lose money if you buy a company for more than it’s worth – the inflated valuation of a company often happens when other investors get too excited and bet on short-term speculative gains (aka gambling).
A good company is like a machine that makes money. Would you buy a machine that makes $10 a year for $10? Of course! But everyone else would too. That’s why stocks usually cost more than what the company earns.
Key Point
Shares in an excellent company won't yield substantial returns if purchased at an inflated price (even if it grows as expected).
Let’s do a simple thought experiment.
Consider a company, Company A. It earns $1 per share and is selling for 100 times its earnings, making it worth $100 on the market (aka market capitalisation). There are rumors that the company is doing well. You notice its stock has risen significantly in the past and hope it will continue to do so. The news suggests the company will experience substantial growth in the next 10 years, reinforcing your optimism.
However, without conducting thorough research – examining the company’s finances, management, etc. – you don’t truly know its worth.
Let’s say the company’s earnings do increase 100 times over 10 years. That’s impressive. You’re thinking your stock is now worth $10,000 – a 100-fold return. But is it really?
Over time, people realize the company isn’t worth 100 times its earnings after all, especially as more future value are being realised. By year 10, the market consensus is that it’s only worth 1 times earnings per share.
So, earnings have grown from $1 to $100, but now the stock is only valued at its earnings (1 times earnings). This means your stock is only worth $100 – the same as when you bought it.
In 10 years, you would have achieved a 0% return. This is worse than inflation and worse than safe investments like government bonds.
In hindsight, you realise that when you initially bought the company, you had already paid for all of the company’s potential growth in the next 10 years.
The takeaway is that we need to determine how much of the company’s future earnings are already factored into the stock price. We want to buy companies when that figure is low.
But valuing a company is a complex task. We’ll discuss this further later, but it’s akin to attempting to predict the future and determine what the company should be worth today.
Like any prediction, it won’t be perfect. Circumstances can change and disrupt our assumptions.
We cannot completely trust our valuations. It’s like throwing darts – hitting the board is easier than hitting the bullseye. We need a margin of safety (i.e. like extra space around the bullseye) so we’re fine (i.e. hit the board) even if we’re slightly off the bullseye.
This brings us back to the idea of a margin of safety.
Before purchasing a stock, we need to first do a quantitative valuation of the company. We then compare our valuation of each company’s stock (discussed later) to the stock price. If the stock price is significantly lower than our valuation, we have a margin of safety (this need not be the first step, but it’s a good way to start). Many well-known investors have a margin of safety threshold of 30% or more — you’ll just have to find your own.
Understanding the company you’re investing in.
Many retail investors trade stocks like lottery tickets. They buy a stock because they heard it’s going to go up. They sell a stock because they heard it’s going to go down. They don’t know what they own. Some call themselves traders. Others call themselves investors. But they’re all gamblers.
Remember
When you buy a stock, you're buying a piece of a company. You're buying a business. You're buying a machine that makes money. You need to understand how the machine works -- you need to understand how the company makes money. You need to understand the company's competitive advantage (aka moat). You need to understand the company's management. You need to understand what might bring down your thesis (aka pre-mortem analysis).
However, this is not a trivial task. In fear of competitors stealing the company’s strategies, companies often keep their operations secret. This makes it difficult for investors to understand the company’s operations.
But this is a crucial step to get through.
It will help to first study the company yourself and form your initial thoughts on the company. Then, you can compare your thoughts with others to see if you’ve missed anything. Many excellent investors publish their write-ups online, partly in hopes of getting feedback from others, and partly in hopes of getting more interest in the company (and thus, a higher stock price). So it’s a win-win for both prospective stockholders, and the authors of the investment thesis. The key here lies in deciphering between lousy, good, and great investors.
What you want to look for are companies that you can understand. This is called your circle of competence. Knowing what you own also means that if you don’t know or understand what you want to own, you should not own it. This is important because you want to have an informational advantage over other investors — you know better than anyone else where the company’s trajectory is going, and you can spot signals ahead of time when things start to go south. A deep understanding of what you own is crucial to your success as an investor.
Identifying whether a company is ran by intelligent and honest people.
When you invest in a company through an equity stake, you’re entrusting the company’s management to make your hard earned money work for you. Most of us would not even think of handing out 100 dollar bills to strangers on the street, but we’re willing to do so when it comes to investing in companies.
Key Point
We have to actively counteract herd mentality. Just because the majority thinks the company is good, the management is good, or the stock is good, doesn't mean it actually is. Maintain some skepticism and do the analysis yourself.
Some important traits to look for in good management are:
Since you’re investing for the long term, you want to find qualities in a company that will persist for the long term. In other words, your interest in a company should be due to sustainable competitive advantages instead of short-term fads.
Finding your compounding machine.
Fundamentally, a profit-making company is one that spends money to make more money. That difference between the money spent and the money made is the company’s profit.
But what do we do with this profit? Suppose you’re the owner of a company. Do you keep the profit of the company and continue with business as usual (likened to receiving dividends from your companies) or do you look for ways to expand your business such that your profit increases in the future?
Two scenarios follow:
I hope you see that the second scenario is far more lucrative than the first.
A great company is not just one that’s able to have a high profit margin, but also one that is able to find abundant reinvestment opportunities (i.e. fully utilise the earnings for that year) that are able to generate a high rate of return on the capital put into the business (i.e. the 2x in earnings per year in the previous example). This is called the Return on Invested Capital (ROIC). The idea is simple, find such businesses, and encourage them to reinvest all their earnings and not issue a dividend (i.e. because the money grows faster with the company than in your hands.) The cherry on top? Unrealised capital gains are free of tax! Dividends are not.
The lifeblood of a company.
So how do we determine what a company is worth?
When to buy?
You’ve already done the work above. You’ve found a company that you understand, with a good management team, and a margin of safety. You’ve also determined the company’s worth. Now, before you go ahead to purchase the stock, ensure that you are aware of the following points:
Maintaining a long-term perspective.
Your analysis gives you support when the stock price falls. You know what you own, you know the company’s worth, and you know the management is good. You know that the stock price is just a number on a screen, and that the company’s value is not determined by the stock price. You know that the stock price is just a reflection of the market’s mood, and that the market is often wrong.
Your analysis provides the ground truth, albeit estimated, that you fall back on when the market and your emotions are telling you to sell.
The best advice I’ve found to continue holding my companies for the long term is:
Don’t just do something, sit there!
Most of the work have already been done before you made the initial purchase. You should only sell when the story changes for the worse.
That is, new facts have emerged and the assumptions behind your prior investment thesis and valuation are no longer valid. This could be due to a change in management, a change in the company’s competitive advantage, a change in the company’s financials, or a change in the company’s industry. Either way, once the story changes and it’s intrinsic value is significantly above it’s market price, it’s time to sell.
Key Point
It is therefore extremely important to continue researching the companies that you own, after the purchase. This is to ensure that the story remains the same, and that the company is still worth owning. Make sure the management achieves what they set out to. Make sure the financial results are at least as you expected. Your work continues.
Learn to discern between noise and actual news.