Saturday, January 3, 2009

Investment Principles That Have Stood the Test of Time. Professional Investment and Trading Education and Learning.

Investing Lessons & Stock Trading Education

a) Investment Principles That Have Stood the Test of Time

Don’t lose faith in value investing and jump ship to something else simply because your portfolio is lagging over a period of time. You might start reading articles or hearing financial gurus talk about whether stock investors should favor “value” stocks or “growth” stocks. This argument always strikes me as silly. Isn’t every investment about value—buying something below its intrinsic value? Should we classify someone who buys an item at a price that is greatly above its intrinsic value a growth investor?

The goal of investing is to buy great businesses at prices that, over time, will produce above-average returns. A stock market investor should look at the profit margins, operating incomes, and the return on equity of a business, regardless of whether it is labeled a “value” or a “growth” stock, and then factor in future earnings growth to determine whether the stock is undervalued or overvalued.

Warren Buffett wrote:
The two approaches are joined at the hip: growth is always a component in the calculation of value. As long as you are buying great companies for less than their real worth, don’t give a darn as to what investing style it is called, just watch your account balance rise over time.

1. Think of a Stock as Part of a Business
As simple as this sounds, this is the last thing that many investors do. Look at a stock the same way you would look to invest in a private company. Ask yourself:
A. What is the long-term outlook of the business?
B. How good are the people running the business?
C. Is the business attractively priced?

2. Deal with Stock Market Fluctuations
Ben Graham provided a framework for dealing with the stock market that will keep you sane while others are going crazy. Mr. Market is your partner who appears every day and offers to buy or sell your holdings. Some days he is totally depressed and will offer you very low prices. Other days he becomes euphoric and will bid up prices to the sky. He also doesn’t mind if you ignore him. Mr. Market is a terrible arbiter of value, so don’t allow him to tell you what a company is worth. Take advantage of him when it is to your benefit and ignore him the rest of the time.

3. Keep Three Words in Mind
Warren Buffett said that three words, margin of safety, are the most important words on investing. Don’t buy $1 worth of assets for 95 cents; wait until the discrepancy between price and value is very wide. Then, and only then, should you make a purchase. The wider the discrepancy between the stock price and the underlying value, the greater the margin of safety.

b) Invest in Companies with Consistent and Predictable Earnings
After you have read about the company, and have some understanding about it, stick to those companies that have consistent earnings and revenues. You can’t put a good spin on inconsistent results, and it just makes good sense to invest in companies that make money—at a good rate and consistently over time. As a general guideline: Invest in companies with consistent earnings.

On the surface this seems a pretty bland guideline. By following it, investors would have avoided most if not all of the dot-com stocks and companies that stole headlines only to fizzle out and disappear. In order to establish a valuation for a company, it needs to show some kind of earnings. During the heyday of the dot-com boom, many companies were not making money, so Wall Street invented new measures of valuation. One of them was “eyeball count.” Internet companies were valued based on how many people went to the site. How this translated to profits, no one ever really figured out.

By looking at companies that have a history of consistent earnings (at least 10 years), you are knocking out a good percentage of companies that are still in their infancy and have no earnings. This then becomes a small universe of stocks to choose from, a very important factor. You will then limit your focus to companies that over periods of time are able to generate earnings above their industry average. Sure, there will be good years and not-so-good years. The main point to keep in mind is consistency. If a company’s earnings are very erratic, it is extremely hard to project what future earnings will be and what price to pay for them.

c) Stick with Quality
Quality companies are easy to spot: Their financial statements are strong. It’s impossible for a company to report strong earnings and capitalization each and every year without underlying strength. The success of good management leads to strong competition as well; the better a company’s success, the more competitors it will have.

The companies on the list of exceptional results had two important attributes that will surprise many people. First, they tended to use very little debt capital, showing that well-run businesses do not need to borrow. Second, the list consisted of some rather mundane companies (all but one of them were hightech companies or drug manufacturers), selling products or offering services that did not change much over the reported decade.

Return on Equity (ROE)
Where you find a company that is able to produce a high ROE year after year, you will surely find a great business. The business world is highly competitive; Charles Darwin could have been speaking about it when he lectured on survival of the fittest. If a company is selling a product or service that has customers beating a path to their door, it won’t be long until that company faces a host of competitors.

A company that is able to consistently increase the worth of the business (shareholder equity) and at the same time increase profits (net income) is rare indeed. A business that is able to produce an ROE (while using little debt) greater than 15 percent are the ones that should garner most of your attention.

When your third grade teacher told you to “watch the margins” when you are writing a composition, she was giving you excellent investment advice. The ability to expand margins, operating and net profit, is a hallmark of a quality company.

Businesses that have rising operating margins are making more money on every dollar of sales. As time goes on, quality businesses are able to boost operating margins as they become more efficient as they grow. If a retailer with 10 stores has one warehouse, they will spread the expense over each one of their stores, or 1/10 of the cost per store. But when that same retailer grows to 50 stores (assuming that they won’t need another warehouse), they will now be able to spread the expense of the warehouse over 50 stores, or 1/50 of the cost per store. The same goes for advertising, labor, trucking, and so on. The bigger they get, the more they should be able to earn due to economies of scale.

At the end of the day, they should see a rise in their net profit margin, or the profits that fall to the bottom line. A business that is able to expand their net profit margin on a consistent basis is keeping a tight watch on expenses, is not sacrificing profit for sales and most likely is a leader in their industry.

Investing in quality companies allows you to sleep better at night. There will be times when the stock of a quality company will sell off sharply. During these sell-offs you should discern if the drop in stock price is a function of Mr. Market or the fundamentals of the company. Those are the times you will be able to get your biggest bargains.

For more Information:
Investing Principles Guide
Modern Investment Management, Commodity Investing Fundamentals, Income Investing, Value Investing


1 comment:

  1. This is an excellent post. Recently there have been a lot of mathematical modeling based mutual funds that have come into the market. I wonder what kind of advice they follow in tracking the markets. Is it still the basics that you have mentioned here that are important or is it just history driven in the case of mathematical modeling based investment?


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