10 tips to be a successful equity investor

By Larissa Fernand |  20-06-17 | 

Paul Larson is a portfolio manager at OppenheimerFunds. Prior to this position, he was the chief equity strategist at Morningstar. During that period, he penned down some thoughts on what it would take to be a successful equity investor. We build on those.

Think like an owner.

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.

Joe Mansueto, founder of Morningstar, explains it: An investor should think like a business owner, not a renter. Most business people don't get up in the morning and ask whether they should sell their business that day. If they own a pizza shop, they don't think about whether what they really should own is a shoe store instead. They show patience and persistence and try to understand their underlying business better so they can earn the greatest return for the longest period of time.

Warren Buffett subscribes to the similar sentiment. "If you own your stocks as an investment—just like you'd own an apartment, house or a farm—look at them as a business. If you're going to try to buy and sell them based on news or something your neighbour tells you, you're not going to do well. Find a good bunch of businesses and hold them," he says.

Stay within your circle of competence.

An investor needs the ability to correctly evaluate selected businesses. You only have to be able to evaluate companies within your circle of competence.

Do not be afraid to admit, “I don’t know” and/or that something is “too hard.” As Charlie Munger famously said: You'll do better if you have passion for something in which you have aptitude. If Warren had gone into ballet, no one would have heard of him.

Having said that, remember that investing is a multidisciplinary exercise. Read widely. Look for wisdom in unconventional places, and always keep an eye out for opportunities. It was Benjamin Franklin who noted that “an investment in knowledge pays the best interest.”

Keep an eye on value and price.

According to Howard Marks, the "awareness of the relationship between price and value —whether for a single security or an entire market — is an essential component of dealing successfully with risk."

Focus on the value of the securities just as much as the price. If we know the price but do not know the value, we know nothing. One becomes a better athlete by practicing, not watching the scoreboard.

Valuation matters. Paying too high a price for a stock can lead to disappointing returns, even if the underlying company subsequently performs wonder­fully. Look for situations where a company has to meet or exceed a low set of expectations priced in by the market.

Don't ignore Margin of Safety. 

There are two ways to make money in the stock market:

  • Own businesses that will grow in value over time.
  • Buy things below intrinsic value, and wait for the market to come around to recognize that value.

Try to do both.

The future is inherently uncertain, and one should always demand a margin of safety. The more uncertain a situation, the greater the margin of safety should be.

To understand Margin of Safety, read How to buy stocks and cut your risk.

According to Seth Klarman, a margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. 

Look at Moats.

Businesses that have strong and sustainable competitive advantages—a wide a economic moat—will increase in value at a greater rate than those that do not. Wide-moat firms are also best suited for survival, possessing the high ground that will flood last, if at all, when a downturn hits. Focus on these firms.

As Mohnish Pabrai explains:

Moats are critically important. They are usually critical to the ability to generate future cash flows. Even if one invests with a time horizon of 2-3 years, the moat is quite important. The value of the business after 2-3 years is a function of the future cash it is expected to generate beyond that point. All I'm trying to do is buy a business for half (or less) than its intrinsic value 2-3 years out. In some cases intrinsic value grows dramatically over time. That's ideal. But even if intrinsic value does not change much over time, if you buy at 50 cents and sell at 90 cents in 2-3 years, the return on invested capital is very acceptable.

If you're buying and holding forever, you need very durable moats. In that case you must have increasing intrinsic values over time. Regardless of your initial intrinsic value discount, eventually your return will mirror the annualized increase/decrease in intrinsic value.

Look at reputation of the management.

This works both ways. Look at the reputation of the management of the business you are investing in. And, also keep a tab on yourself. Warren Buffett advises investors to maintain a sterling reputation for honesty by “never doing something you wouldn't want to see reported on the front page of your local newspaper.” 

Buffett, when chairman of Salomon Inc, famously told a Congressional panel that he had a simple message for employees in the wake of a scandal in 1991: "Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm and I will be ruthless." 

Patience is a virtue in investing.

Activity for activity’s sake is harmful since frictional trading costs can greatly harm returns. Aim to minimize commissions, brokerage, taxes, and fees.

As Paul Samuelson says, “investing should be like watching paint dry or watching grass grow. If you want excitement…go to Las Vegas.”

Don’t go overboard with diversification.

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. Buffett believes that wide diversification is only required when investors do not understand what they are doing.

"Know what you own, and know why you own it." is how Peter Lynch puts it.

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.

Always consider opportunity costs.

We should not be afraid to sell a good opportunity to take advantage of a great opportunity. We can generate value by selling dollar bills trading for $0.90 to buy other dollar bills trading for $0.60.

Don’t be afraid to go against the crowd.

As Benjamin Graham wrote, in the short term, the market is a voting machine. Popularity rules the day. In the long term, the market is a weighing machine, gravitating toward a company’s true intrinsic value. Buy on the cannons (when stocks are unpopular), sell on the trumpets (when euphoria reigns).

John Templeton wisely says, “If you want to have a better performance than the crowd, you must do things differently from the crowd.” Which means, invest at the point of maximum pessimism.

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AshaKanta Sharma
Jun 26 2017 07:30 PM
An Excellent article indeed...

Thanks
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