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Stock Market Course: How to Choose Winning Stocks – Rewriting Formula

How to Choose Winning Stocks_ Rewriting Formula

Introduction

Investments in stock markets have attracted the mighty and the low equally well. It is not the level of intelligence but the ability to spot trends and apply common sense that has made many individuals rich in their own rights. Fortunes fluctuate and there is no decisive science to this subject.

This book is an attempt to develop a methodology and systematize the effort involved in the art of investing in a scientific fashion based on the experiences of the author and the approach practiced by him. This book aims at generating a supplementary income for the investor who pursues this as a part-time activity in addition to his main professional interest.

Therefore, full-time investors are advised to adopt more rigorous tools taught in business schools; however, the layman and the part-time investor can make decent gains by adopting this approach of systematically evaluating options and picking the right one to place bets on.

The readers are advised to keep booking profits once they practice this approach because of the uncertainty of markets. There is no real target price to book profit—it depends on the market conditions and profitability of the company in question and various other economic conditions as well as the herd mentality found in stock markets these days.

Some of the basic definitions of terms are given subsequently to refresh the naïve reader and to facilitate a better appreciation of the concepts.

The driving forces of stock markets of today and yesteryears have been the same underlying factors as put forth by many. They are:

  • Fear
  • Greed
  • Mass psychology
  • Mania making
  • Now, in today’s technology world, media coverage of the
    events
  • Last, the most neglected fundamentals of investments:
    ° Expected growth rate of economy
    ° Expected growth rate of company’s profits

There are many advocates of various driving forces, and the foremost are Benjamin Graham and Warren Buffett who have advocated the last of the above driving forces, such as the fundamentals of company and investing based on value-based philosophy.

While it is possible to make money with other driving forces if you are on the right side of the coin, what is not realized is that underlying forces of the market are the fundamentals that drive the market. For example, the mania witnessed for Japanese stocks in the 1980s and the technology stocks later on are classic examples of how markets go crazy with investor behavior and how reputed opinion gets formed about the stocks with everyone agreeing on the themes and creating a buying pressure for the theme stocks.

This book covers only the driving force of fundamentals of a company and prescribes an approach based on analyzing the fundamentals of the investment principles by examining the relationship between various entities in valuation, thus deriving a common sense approach to investments based on value principle as advocated by Benjamin Graham and Warren Buffett.

While it should be remembered that this prescribes evidence- based systematic analysis of factors that influence a stock price movement based on fundamentals of a company, various approaches described in the book are tools of analysis to arrive at an investment plan. It can go haywire in the short term due to disturbances in the market and imperfections in market on the basis of news and other criteria. However, in the long term, the theory advocated by many pundits in this field is that the price will move towards its value.

Buffett had held on to his stocks for a considerably long time to realize the value and profits—if the fundamentals of the company are improving over a period of time it is better to hold on to the stock rather than selling them. It all depends on the staying power of the investor and also his objective while setting up the investment plan.

For example, different investors may have different objectives, like:
1. I want to generate supplementary income in addition to my professional/business income.
2. I want a quick buck and get out as soon as possible with quick gains.
3. I want value-based investment for long term; say a period of 10 to 30 years.

Let us understand what is value-based investment and its approach to investing conceptually.

 

VALUE INVESTMENT PHILOSOPHY

Wikipedia gives the definition of value investing as an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text, Security Analysis. Although value investing has taken many forms since its inception, it generally involves buying securities whose shares appear underpriced by some form(s) of fundamental analysis. Such securities may be stocks in public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price- to-earning multiples or have low price-to-book ratios (definitions of these ratios are given subsequently for the understanding of the reader).

Investments based on these principles have stood the test of time over the past 80 years and therefore nothing can be deceitful with this approach. However, one needs to develop a judgment as to which company’s share price is at a discount and if there is a margin of safety (which can be defined as ratio of intrinsic value to market price of share). If the margin of safety is more than 1, then one can safely invest in the stock, provided there is no adverse trend developing in the stock.

As mentioned above, value investing is a technique pioneered by Benjamin Graham and perfected and practiced successfully by Warren Buffett. This approach requires that you must master the self discipline to avoid the advice of stock brokers, agents and the plethora of middlemen who promise sky-high returns and such. In addition, you must have a working knowledge of accounts to read the financial statements of companies so that you can interpret them correctly and identify positive and negative points of a company. Just remember you are investing not in the company but in its business and its prospects.

Moreover, you should avoid going with the crowd in the stock market so that your analysis and foresight on the business of the company can fetch you gains and you should have the discipline and the wherewithal to avoid shuffling the portfolio at the drop of a hat. These are the basic conditions you must master if you want to be a value investor. Many studies have proven that value investing scores over even the growth investing style and other new fads that have come into the market.

Some of the advices given by Buffett in the great book, How Buffett Does It: 24 Simple Investing Strategies from the World’s Greatest Value Investor by James Pardoe are summarized here for those who want to practice value investing:

  • Be patient and invest for the long term for a period of more than 10 years.
  • If you have found a great business, stay with it till you reap the rewards and do not exit from the stock on the basis of day-to-day price movements and other short-term trends developing out of the stock. Keep reading a lot about the business and keep adding on to more quantity if the price comes down below the value due to market imperfections.
  • Keep the big picture in mind, do not be swayed by short-term adverse developments and avoid losing confidence in the stock. For example, it is often quoted that Buffett had turned an investment of $10 million into a $1 billion investment by holding on to these shares for life. He did not lose his cool and did not get out of the stock when the stock plummeted by 50 percent within 2 years of his initial purchase. The underlying logic of Buffett was that it was not a volatile business, so he held on and was rewarded for his judgment in collecting an annual dividend check of $10 million every year, which was his initial investment into the company.
  • Business analysis and performance is the key to investment. It is always good to study the long-term track record of the company. One should learn to buy into those companies whose business one can understand—this is the thumb rule that one should use. It is a well known fact that Buffett did not buy into any of the fancy technology stocks when there was so much clamor for them in the Internet boom era.Buffett did not buy into them as he did not understand their business model. For example, companies like Coca Cola are investment worthy as they have predictable cash flows and are stable companies that will exist even 50 years from now.
  • Earnings and cash flows are two foundation stones based on which a company can build its safe future. Look for companies that have sustainable competitive advantage. Here it is advantageous to determine those companies that stand out from their competitors. Remember, though Buffett bought into Berkshire Hathway in 1965, textile operations of the company had to be closed down 20 years later as it was not making money. Similarly, Buffett bought into PetroChina as it was the fourth most profitable oil company in the world and had an assured market in China. After a company is identified, one needs to wait for its price to become attractive.
  • It should be borne in mind that businesses wherein change is ubiquitous should be avoided as any technological innova- tion is likely to make these investments obsolete. Using this criterion it is always preferable to invest in old economy stocks as these are more sustainable.
  • Once you are convinced of a company to invest in using this approach, then do not spread your risks by investing less in the company. Focus your attention by putting your big money into that league. The distinguishing style of Buffett is the concentration of portfolio rather than the usual theory of diversification of stocks as practiced by many in the world. For example, Buffett took huge positions in the following companies after his analysis and they are worth billions now: (a) Coca Cola: 200 million shares, (b) American Express: 151 million shares, and (c) PetroChina: 2 billion shares. What is demonstrated by Buffett is that concentration of portfolio rather than diversification is the essence of the game. For example, Berkshire Hathaway, in 2004, had investments only in 10 companies; at times it had invested only in 5 companies. Therefore, buying into the companies with the right businesses and the right price is the essence of value investments as practiced by Buffett.
  • If the company you invested in and its business are strong, it will automatically reflect in the operating results and the market price will adjust accordingly in the long term. If your goal is the long-term success of your investments, avoid looking at the prices daily and subjecting yourself to emotions that can make you take a wrong decision. Remember that the stock market is much more than you and your company and reflects the collective opinion and prospects of the company. Remember the popular words of Benjamin Graham who said, ‘Markets in the short run is a voting machine and in long run it is like a weighing machine.’ If you want to invest like Buffett, practice performance analysis for the company like him and innovate. This book is about new criteria for investments that have been developed out of fundamental concepts that have been practiced for long and thus prescribes a unique approach to value investing.
  • Successful investments of Buffett were made during the market downturns when the usual investor gets out of the falling market by typically cutting his losses. For example, Buffett bought into Washington post at $6 a share when the marked was down in 1973 and more than 30 years later the share reached a price of $900, the second most expensive share in the New York Stock Exchange (NYSE). It is important that one does not run out of cash, particularly during periods of market crisis and should have adequate resources like Buffett to buy into the stock at the bottom of the market.
  • Even the great Buffett had his share of misjudgments as admitted by him in the case of Walmart. He admitted that he did not like the share price and missed the opportunity which could have earned him $10 billion later on.

It is crucial that one develops a judgment about the market and companies and their fundamentals so that one who is keen to invest is ready to exercise his/her judgment and reap the rewards later on.

 

HOW THE STOCK MARKET WORKS IN THE LONG RUN

A study by Barclays bank reproduced from the book, How the Stock Market Works: A Beginners Guide to Investment by Micheal Becket is given next to reinforce Buffett’s observations. Tables 1.1 and 1.2 show how various types of securities have appreciated if one has invested £100 in 1945 and 1990. This gives an indication of how different classes of securities behave and whether they can beat the inflationary trends in economy and give you real appreciation of your money.

How to Choose Winning Stocks_ Rewriting Formula

It can be clearly seen that Warren Buffett’s observation to invest long term in equities is upheld by this study by Barclays over a period of last 50 years. As can be seen, equity as a class of security has outperformed both in nominal and real terms over other types of securities available in the market.

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