There are many people who invest in stocks without understanding what is happening. The following may supply some insight.
- When you buy a stock you are buying a business. A tiny part of it, but the same rules apply to value as if you owned all of it. Value is what you can sell it for.
- In terms of value, businesses are inherently unpredictable. The price arises from an auction and the bidder may not be enthusiastic today. Warren Buffett claims the market is bi-polar. Sometimes enthusiastic and sometimes depressed.
- You have no money involved once you buy the stock. You may be able to trade it back for money, but you have no idea of that price ahead of time. Sometimes people think of stocks as money. That is a mistake. Try taking two shares of GM to the gas station for a tank of gas.
- Some stocks pay dividends. Dividends provide an immediate return on investment and impose discipline on management. The biggest risk you have as an investor is that managers develop ego and use extra money in the business to gratify that. Many acquisitions go bad. Dividends reduce the number of homeless dollars available.
- Professional management works when it is humble. Master of the Universe style does not usually work for long. Avoid these managers.
- There is more important information in existence about a company than you can know. The part you can know is usually delayed and so the thing it indicates may already have happened. The professionals talk about an event being already priced into the stock.
- Try to not data mine opinions and facts that support your beliefs. Seriously seek contrary positions before you evaluate the position.
- It is just as hard to double a $5.00 stock as a $500.00 stock. For a $5 stock to double the value of the entire company must double. Same thing for a $500 stick. Apple has had a wonderful decade, but how hard is it to add another $700 billion to the value of a company? Not hard if Mr. Market is manic but is that real value? Very difficult if you must revolutionize another industry like music and cellphones.
- Ultimately a business is worth what it will earn. Over a long time, adding predictable earnings is very difficult. If a business has success, it is not long until there is serious competition, government regulation, higher bonuses and key people who have made money with stock options and decide to retire or go elsewhere just for the fun.
- Innovation is the key but that runs out eventually too. There is no process to sustain creativity. As a business grows, reasonable management systems get in the way of novelty.
So what to do?
- Learn to recognize business value not just know gossip about a name. Businesses that produce quality products and who look after customer needs will do better than those based on hype and financial trickery. People will do well to notice the products they use and with which they are pleased. Do a little research if you find a new product you like. Early ownership of Microsoft, Apple, Google, LuLu Lemon and Tesla could have begun that way. But you could not hold them forever because Mr. Market may be too enthusiastic early on. Reevaluate early on.
- Look for companies that have a long track record. They will undoubtedly be boring, but a well managed business with a long history is not likely to change quickly. John Deere, Exxon, The Royal Bank, WalMart, will provide warning if they are going to turn down permanently.
- Know when to go away. If you would not buy a stock you own for what it sells for, you should sell it. A decision to keep and a decision to buy are logically identical.
- With any company watch for even a hint of accounting irregularities. Better to watch those unfold from the sidelines. Enron and Nortel come to mind. There is always something else to invest in. Hearing, “This time is different.” is a warning sign that it is time to sell.
Years ago I knew a person who gambled on horses almost every day. That form of investment is risky. While heading to the track one day, he said, “I hope I breakeven, I need the money.”
Try to avoid that approach with your investments.
Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. Contact: firstname.lastname@example.org