Saturday, 11 May 2013

Socks n Stocks

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.'


  1. 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?

    1. Or 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.