First things first: I
should explain how I go about investing in the share market. I'm afraid I can
only give a summary of the basics but I have found that this intellectual
framework is sorely lacking by many, if not most investors.
The most important idea is
to realise that stocks simply represent part ownership in a business. When
you buy shares in the Commonwealth Bank of Australia (currently the largest
Australian business), you really do own a fraction of this $113 billion
business and as an owner, are entitled to your proportionate share of its
profits - just as if you owned 20% of a family business or a farm. If CBA
flourishes financially, as an owner, you will too.
So in effect, the issue
making money on the share market comes down to buying businesses that can pay
out higher and higher profits whilst avoiding ones that are headed for a crash
landing. This is simple to understand, but not easy in practice. Even the very
best investors regularly fail in their predictions, so you must to research,
research, research about any stock that you want to buy before pulling the
trigger.
Now, you may sit back after
doing all this hard work analysing what the company sells, its competitors, its
management, its profitability, its debt levels, why you believe it will do well
in the future etc, but that is still not enough. You need to determine how much
the business is worth - this is the critical factor that separates true
investors and speculators.
'How on earth do you do
that?' you may be asking. Good question. Nobody on earth knows exactly what a
current business is worth, unless I'm mistaken and someone is sheltering a
crystal ball that can predict the future profits of a business for the next 100
years. Absent that, investors must make guesses. Some will concoct highly
sophisticated models to predict the value of a business to two decimal places,
but often these investors get so beguiled by their mathematical wizardry that
they incorporate assumptions that make no sense to rational people, resulting
in huge misjudgements. They forget John Maynard Keynes advice, 'It is better
to be roughly right than precisely wrong.'
To illustrate, imagine you
found a spare $100 million hidden in the couch one night. Making this scenario
even happier, the next day an elderly businessman proposes to sell you his sock
manufacturing business for $100 million, which just last year earned $20
million. After finding out that the business model is strong, customers are
happy, and the likelihood is that profits will increase in the years to come,
what would you say?
'No thanks, I'd rather put
my money in a 5 year term deposit at my bank and earn $4.5 million a year.'
I don't think so.
If the sock business was
earning $4.5 million, then you'd have to start thinking hard about the price,
but as you can hopefully see, it doesn't take any complex formulas to realise
that at an asking price of $100 million, this deal is a no brainer - you get a
20% return from day one (20/100 = 20%), with the expectation of future
increases in profits. Holding onto this business for many years would work out
quite well as it pays you a great return - with free socks too. Furthermore,
sooner or later someone is going to realise that the business is worth much
more than you paid, giving you the chance to sell at a higher price in a shorter period of time.
Of course, there is always
the risk that the business disappoints and produces poor results. Yet by
purchasing at a low price, you create a 'margin of safety' which mitigates your
risk in making a bad decision. For instance, instead of earning $20 million,
the sock business may experience a dramatic halving of its earnings the next
year to $10 million, but you would still be effectively earning 10% per year,
hardly what one could call a tragedy. So any way you slice it, the deal seems
too good to be true.
Indeed, in the real world,
such an offer is rare. But in the stock market, people regularly offer to
sell you a part interest in a business for a ridiculously cheap price. Aside
from how much influence you have, there really are not many differences between
buying 100% of a private business and a fraction of a business on the share
market. And fortunately, you don't need a $100 million couch to invest in the
latter, nor an elderly man to pass your way offering you his business - there
are more than 2100 businesses on the ASX for sale at the click of a
button.
This practice of finding
undervalued businesses has been called 'value investing' over the years, but I,
and many others think that the 'value' moniker should be dropped. Valuation is
essential. After all, if you don't even look at the business, instead drawing
lines on charts of the share price and whatnot to predict the future price, you're clearly not an investor, you're ignorant. Worse still, if you paid a billion dollars or a trillion
dollars for the sock manufacturing business above, you're crazy. Combine ignorance and craziness and you end up
with some pretty interesting results.
It reminds me of Bertrand
Russel's remark, 'Most people would rather die than think; many do.'
The 906 words above can be
summarised in 17 by Warren Buffett: 'Whether we're talking about socks or
stocks, I like buying quality merchandise when it is marked down.'
Even better if you can find a business that doesn't pay much out in dividends and can retain the profits and use them to grow future earnings?
ReplyDeleteOr even better than that, the top prize goes to a business that can pay out an ever increasing stream of cash with little or no requirement for the reinvestment of earnings. Unfortunately these are quite rare, identifying them is harder, and buying them at a good price is near impossible. Strong internet businesses such as Carsales come to mind.
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