Buying stocks is not easy. It requires a great amount of leg work. And the entire exercise is complicated by emotion. But it is possible to benefit from specific equities in your investment portfolio. Here are some cautionary moves before you sink your money into stocks.
1) Don’t ignore moats
Successful long-term investing involves more than just identifying solid businesses, or finding businesses that are growing rapidly, or buying cheap stocks. It entails evaluating whether a business will stand the test of time.
An economic moat is a long-term competitive advantage that allows a company to earn oversized profits over time. Companies with a wide moat will create value for themselves and their shareholders over the long haul. They have long-term structural advantages versus competitors, predictable earnings, returns on capital higher than the cost of capital, and long-term staying power.
The beauty of a wide-moat company is that the odds are pretty high that the company would be able to deliver higher shareholder value over a longer period of time. In other words, time is on your side with these companies.
By contrast, companies with no economic moat generally destroy shareholder value over time--when you buy a no-moat company, you're making a speculative bet that the stock will bounce up just long enough for you to sell it. That's a very tough game to play, and generally only seasoned pros should attempt it.
2) Don’t buy without a margin of safety
Fair value is what the stock is worth. Fair value estimates aren't meant to be automatic buy or sell indicators. To determine reasonable buy and sell prices, one has to look at a stock's margin of safety. It is wise to buy when a stock's fair value estimate is considerably more than its market price. This is important because buying when the stock is trading at a discount protects the investor just in case the fair value estimate is too optimistic. In other words, a margin of safety gives you some error cushion in case your estimate is too high.
On the other hand, when the market price has climbed far above the fair value estimate, this may be an indication that the stock is overvalued and potentially vulnerable to any hiccups that might come along.
So instead of buying shares based on what everyone else is doing, buy a stock only when it's selling at a decent margin of safety to your estimate of its fair value. Don't even think about the overall direction of the stock market, because that's impossible to predict with any consistency. Patience is indeed a virtue when using this approach, because often it may take many months, or longer, before a suitable opportunity presents itself.
Obviously, to determine whether a particular stock is trading with a sufficient margin of safety, you must have some sort of an estimate of what you think the stock is worth. Also, you must determine how much of a margin of safety you'll require before buying a stock. If the firm is not very risky, you could be content with a 15-20% discount to its fair value. If the firm is riskier than average, you may demand a 30-40% discount. Ultimately, it's your decision and varies depending on the company in question.
3) Don’t think like a trader
Stocks represent ownership stakes in businesses and are not just pieces of paper to enable trading. Think like a business owner. If stocks are ownership slices of a business, we should value stocks like we value businesses. A business is worth the discounted value of all future cash flow that it can generate.
Morningstar’s chief equity strategist Paul Larson believes that there are two ways to make money in the stock market:
1) Own businesses that will grow in value over time.
2) Buy below intrinsic value, and wait for the market to come around to recognise that value.
He advises investors to try and do both.
4) Don’t be afraid to hold relatively few stocks
There are very few good ideas in any given year--Warren Buffett has said he's happy to have even one. For the rest of us (ie. those without the need to invest several billion dollars to make a difference in their portfolios), there may around half a dozen good ideas a year.
Larson says that there is a dosage effect regarding portfolio diversity. Diversity is important to have, but too much can also dilute best ideas and excess returns. It can actually be safer to have fewer baskets if it affords a much-closer watching of the eggs. He says that the greater the payoff odds (lower price/fair value ratio), the greater the weight a position should be in a portfolio, all else equal. Likewise, the greater the confidence in one’s projections, the greater the position size should be, all else equal.
Just ensure that your positions qualify on these fronts:
- Companies with moats - wide and narrow, which will increase in intrinsic value over time;
- Bought at a significant discount to fair value (a margin of safety);
- A time horizon of at least 3-5 years on each pick. It may take this long (or longer) for the market to recognise the value of a company.
5) Don’t make hasty sell decisions
Many investors come unstuck by making decisions to sell a stock based purely on historical share price movements. While it is worth monitoring, it's the fundamental outlook for a company that usually determines its share price performance and record of paying dividends over long periods of time.
If you've held a poor performer for a long period, you'll need to be absolutely confident that your analysis isn't off-beam or that you haven't missed an important change.
If a stock in your portfolio has done badly, there can only be one of two reasons for it:
1. The market is wrong, or
2. You were wrong about the company when you bought it.
Anyone who believes they are always right will never win in markets. But plenty of investors believe that holding on to stocks that have fallen in value is a smart move because "everything goes up eventually".
Again, revisit the reasons why you bought the company in the first place. Stick to basics and ask yourself: How healthy are the earnings? What are the growth forecasts? How likely is the company to achieve those forecasts? Did you miss something in your analysis? And even if you conclude that the market is definitely wrong, how long will it take to get it right? Can you identify any key trigger events for that to happen? And can you afford to wait?
Stock prices venture far away from reality in both directions and if you paid a fair price for the company and the earnings are coming through, or are likely to, there's every chance its performance will pick up.
The risk is that the company may be overtaken by subsequent events before the share price has time to recover - so obviously you'll need to watch closely any stock that's going backwards.
Selling stocks that have fallen in value often means that you buy high and sell low - no way to make a profit. However, just as it's unwise to sell stocks solely because they have fallen in value, it's even more common for investors to get it wrong in the other direction altogether.
