A short guide to stock investing


Get started / Sunday, August 28th, 2016

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Learning to invest in the stock market is different from say, learning maths. Whereas everyone eventually reaches the same solution in the latter, there’s no one right answer on how to invest well. Nonetheless, there are overriding similarities between learning the both, or any sorts of skills. The fastest way to learn a skill is to deconstruct it by breaking it into pieces, strip down to their essence, and examine the fundamentals.

Fundamentals provide a solid foundation, like a sturdy building holding up against shocks, so you won’t fall apart during a market panic. Investing is a slow learning process, same as everything you set out to do, like a car in first gear going uphill. And don’t worry about missing out opportunities. If the boat is not in the right direction, it doesn’t matter how fast it goes. Instead, aim for 1%, strive to improve yourself by 1% every day, it adds up over time. Build a long runway, and focus on what matters and ignore the trivial. When your knowledge compounds, your wealth follows.

In the stock market, every share you own is a slice of ownership in the business, essentially, you are the owner. You are entitled to vote, receive a dividend, if there’s one, and participate in the fortune of the business as a shareholder. You grow your wealth through the dividends received, and share price appreciation as the business makes more money.

Most investors watch their shares like a hawk, reasoned a drop in share price would impair investment capital. That is true if the shares are sold to realize the loss, but otherwise, flies in contrary to the mindset of an owner. If an asset can be acquired at a lower price, in this case, the whole business, isn’t that a positive thing? As opposed to a falling share price, the risk of an investor comes from not knowing what he is doing. If one buys a property but never take the trouble to inspect, or walk around the neighborhood, is it a surprise if the house is in a poor condition sitting in an unsafe neighborhood?

Similar to doing research before getting a fridge, a car, or a house, a big part of investing lies in preparation, doing the work before buying, and spending the time to understand the business. These knowledge create a psychological edge, and the ability to think independently, a rare and valuable trait in investing during market panic. You can assess the situation with a calm head before making the right decision rather than rushing to the exit doors like everyone else.

Your profession or things that surround your daily life are good starting points to learn more about a business and industry. If you work in the I.T industry, chances are you will be familiar with some software providers; if you are a car enthusiast, which stores do you always visit and for what reasons? Even if you’re a stay at home mom, you might have developed a good understanding where to find quality ingredients. By observing things around you, you have a good judgment on what’s selling, and what doesn’t. Look for the label, find out which company produce it and how well the business is doing.

Given the choice between a wonderful and an average business, you’ll prefer to invest in the former. But how do you distinguish the former from the latter? Is there any characteristic that defines a company as wonderful?

If one of your friends comes to you with an idea of starting a business together, you will ask questions like:
1. What kind of business is it?
2. How much investment do I have to put into the business?
3. How much money can the business make every year and how fast?

The first question focuses on having a good grasp on what the business does. If your friend is going to start something that you can’t get your head around, never ever get involved.

The subsequent two questions are the litmus test to see how attractive an investment can be, or how wonderful the business is. To start with something simple. If you decide to open a savings account, you would prefer a bank that offers a better rate, say 2% instead of 1%.

To express it in an equation:
The savings account earns you $2,000 / You have to put in $100,000 = You earn 2% return

or put it another way:
How much money can the business make / How much investment to put in = X% return

To simplify it:
Profit / Shareholders Equity = X% return (Return on equity)

Shareholders equity means the total amount of money that have been put into the business. Return on equity or ROE for short, expressed in percentage, measures how well the business is generating a return on its investment. In the savings account example, you get a 2 cents return for every dollar of investment or a ROE of 2%.

A business can report they made 1 million or 100 million in profit but that information has little value without knowing how much investment had been put in. The ROE decides how attractive a business is. In running analogy, a runner’s performance is determined by the time required to achieve an X amount of distance. In investing, it is the investment required to generate an X amount of profit that determines the share price & business performance.

Business

Wonderful

Average

Investment

$1.00

$1.00

Profit

$0.20

$0.10

Total

$1.20

$1.10

Rate

2x

1x

ROE

20%

10%

Years to reach $2

72/20% = 3.6 years

72/10% = 7.2 years

Comparison: A wonderful business generating 20% ROE and a mediocre business generating 10% ROE

As shown above using two businesses as a comparison, business wonderful can produce 20 cents of profit on every dollar of investment per year, compared to 10 cents of profit by the average. Therefore, it is producing profit at twice the speed of average.

Using the Rule of 72 (last row), which is a quick way to estimate how long an investment will double given an annual rate of return, you will reach the same conclusion. The wonderful can double the return in half of the time it takes for the average to do so, 3.6 years instead of 7.2 years, due to its ability to generate profit at twice the rate. So it makes sense to own a high ROE business than a low one, but there’s a catch. Wonderful business generally commands a higher share price (in relative to average ones) because investors are attracted to its wonderful future prospect and they are willing to pay up for it. This is an important point as share price and future return has an inverse relationship.

To understand this relationship we have to start with the concept of price and value. To put it simply, price refers to share price, the numbers that goes up and down every second, whereas value refers to the value of a business or how much it is worth. You can easily find out the price of a stock but the value of a business is obscure.

In general, the share price is a good reflection of how much the business is worth over a long time frame of 5 to 10 years. However, in the short near term, the share price is driven by the manic depressive emotions of investors. Factors from economic outlook or company specific news such as earnings release constantly affect the market sentiment. As a result, the market can be overly pessimistic or optimistic on the future prospect of a stock and from time to time, causes the share price to deviate away from its value.

A brilliant old adage describes the market as a beauty contest in the short term, and a weighing machine in the long run. In the short run, investors tend to flock to popular stocks that are flavor of the month, in disregard of the business fundamental and pushes up their share price in the process. But ultimately, it is the performance of the business that determines the share price over the long run. So when over-optimism causes the share price to increase, the future return is likely to be lower because, over the long run, price will self-adjust and return to where its value is. Hence, the inverse relationship between share price and future return.

Going back to our wonderful example above, that means yes, you’ll want to own a wonderful business but without overpaying for it.

To illustrate this further, you decided to buy a wonderful stock with a great record of generating 20% ROE per year. If you buy it:
1. At a fair price, where price equals value, the share price return will be similar to the return of the business in the long run, which is 20%.
2. At a high price, where price exceeds the value, the share price return will be less than 20% as price adjust downward to reflect where the value is.
3. At a low price, where value exceeds price, the share price return will be more than 20% as price adjust upward to reflect where the value is, followed by the 20% ROE return of the business.

Price will always revert back to where the value is over the long run. Therefore, if you overpay for a stock, you run the risk of getting a dismal return or worse, impair your capital permanently. Many thinks that a wonderful business is worth a buy regardless of the share price, that’s no different from a property agent telling you a house can worth any price because it has the best location in town. At a certain price, a wonderful business can give you an above-average return; at a higher price, the return becomes average; at an even higher price, the return will turn dismal. Price is what you pay, value is what you get.

The emphasis here is to buy wonderful stocks at a fair price or even better, at a cheap price. When do wonderful stocks usually sell at a cheap? When the market turns manic depressive and everyone is cramming at the exit door. The psychological makeup of thinking like a business owner is inherently contraries. When share price is soaring, and the crowds are jumping on board for the fear of missing out, you stay prudent; when the share price is in free fall, and the crowds are jamming through the exit door, you turn aggressive. The mindset of following the crowd is naturally wired in our brain, therefore it feels safe and natural to follow the majority. But where will the advantage be if you do the same things as others?

As the value dictates your investment return, you need a good grasp on how much a business should worth to find out if it’s expensive, fair, or cheap relatively to its share price. The value of a business is not a precise figure but an estimate of a range. Unlike share price, which is susceptible to big swing in market sentiment, the value of a business tends to be gradual, changing slowly from year to year.

The main ingredient to good estimate starts with a good understanding of the business. Using the analogy of guessing age, there’s a better chance to take a correct guess on someone’s age as compared to an animal’s. Why? Because we grow up around people, and every person acts as a reference point, which can be easily accessible by memory for cross-reference. This is why it is critical to understand the business or any estimation will be way off the mark.

While a good estimate is a must, precision is inessential. You don’t need to know the exact age to be able to tell if a person is in his/her 20s or 50s. Put it another way, wait for the market (crowd) to make a huge mistake. When the market is pricing a stock that’s worth $100 to $200 at $50, you don’t need to be precise to be right. This serves two immediate benefits. By treating the value as a range of two numbers, you are free from the stress of being precise, and in the process, reduce your losses and maximize gain. During market panic, fear overwhelmed rationality, people wants to avoid uncertainty at all cost, as a consequence most stocks get oversold. When you buy a stock selling at a dime to its true value, your entry price dilutes the risk of any bad outcome, while increase chances for above average return. The common phrase ‘High-Risk High Return’ is true, but this is something better, ‘Low-Risk High Return’.

Despite our best effort to avoid losing money, the future is never certain. We make mistakes, get a few bad apples, as long it’s not fatal. The last point brings us to the concept of Margin of Safety. Like having a spare tire at the back of the car or extra fuel in the tank for a long trip, paying a lot less for what something is worth gives you a buffer in case the unfortunate happens. Margin of safety is about being conservative in every decision you made as well. When you understand a business before investing, that’s a margin of safety against the risk and greed of buying things you can’t fathom; when you own a wonderful stock, the quality of the business is the margin of safety; by being patient, you reduce the amount of decisions you need to make (less buying decisions, less error); and so does paying a lot less for what something is worth, you guard yourself against any worse case scenario.

If we are to summarize this post into a sentence, that would be – Buy a wonderful business that’s worth a dollar selling for 50 cents.

I have presented little calculation to keep it simple, and underline an important aspect of investing. A good grasp on accounting and maths are important but you will do fine with basic arithmetic. What’s more critical to the success over the long run lies in having the right temperament, and the ability to think independently. Not having the right temperament will give you the biggest disadvantages in investing. Although learning how to think well is beyond the scope of this post but I sincerely hope that these fundamentals will serve as the bedrock for your investing journey. Something for you to anchor on, perhaps, to discard as well (think independently) should you find other fundamentals that can serve you better.

I have written the 2nd part on how to start picking stocks by applying screening criteria on a separate post, you can find it here.

Once you have done the screening. Go through this checklist before you buy anything.

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10 Replies to “A short guide to stock investing”

  1. Congrats.
    A suggestion would be to break up your text with headings or sub-headings. Or even images and charts. Too much text and readers, like me, could let lost in all the texts.

  2. A very informative article for someone like me who is just starting to invest in the stock market. Very simple, easy to understand approach in describing some of the concepts of stock investing. Thank you for writing this one, Ricky.

  3. The stock market has recently piqued my interest and this was a great guide for a newbie like me. Do you, by any chance, have a guide that explains stock market terms such as “bullish”, “bearish”, “candles”, “SMA”, etc?

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