The rise of money management has, for years now, brought about a considerable number of financial methods meant to boost the compounded annual returns expected of financial professionals. Pushing these methods to a greater extent has been the advent, and wide acceptance, of market index funds that, though they are accessible at no cost, continue to outperform the majority of all professionally managed funds. This has caused an escalating desire for some mathematical approach to assist in outperforming a market index, thus creating modern portfolio theory, the capital asset pricing model, weighted average cost of capital, and other widely accepted formulaic approaches.
While I am not insensible to the evidence that these methods may work for some people in some circumstances, I believe that the positive outcomes resulting from these methods are too rare for them to be accepted by the majority of investment professionals.
However, as will be discussed in this article, there does exist a unique set of principles that can, through careful use, lead to the superior returns so desired by the financial profession. While there are undoubtedly several other methods that can lead to positive investment performance, the decisions of this fund will be based on the principles laid out here. Presented in order of importance, these principles are meant to guide in bringing a rational thought process to all investment decisions, and in turn, significantly increase the likelihood of superior performance.
Principle 1: An Investor Must Understand the Difference Between Investing and Speculating
There are two requirements for a security to be considered an investment: 1) A safety of principle and 2) An adequate rate of return. If security lacks one of these requirements, it cannot be considered an investment and should instead be classified as a speculation. To be successful, an investor must restrict themselves to securities consisting of both requirements.
While often misunderstood by the general public, the definition of investment was determined in the late 1940s when Ben Graham set out two requirements an asset must have to be considered an investment:
- An investment must provide a safety of principle.
- An investment must provide an adequate rate of return.
Safety of principle can be obtained from any asset. Over time, it shows no sign of losing its value and can be resold to another party at a reasonable price concerning its value. Both non-productive assets such as gold, whose value is not derived from what it produces, but rather from its scarcity as a resource, and productive assets such as a business, whose value is based on its ability to make profits, can deliver a safety of principal.
The deciding factor determining if an asset is an investment or speculation is the presence of an adequate rate of return, something that can only be delivered through productive assets.
Because gold and other precious metals and commodity-like assets cannot reproduce anything, an increase in their value depends solely on the willingness of others to pay higher and higher prices for them.
On the other hand, producing assets such as businesses, farmland, and real estate draws their value from what they can produce. A business’ value depends on the profits it can earn, farmland’s value depends on the crop yield it can produce, and real estate’s value depends on the income it receives from tenants. As a result, these producing assets deliver both safety of principal and an adequate rate of return and can therefore be classified as an investment.
An axiom thus reveals itself that speculators aim to make their profit by gambling on the buying behaviors of others. In contrast, investors seek to make their profits by increasing the production of assets and using those profits to purchase more and more producing assets.
If one restricts themselves to investing in productive assets rather than speculating in non-productive assets, their financial results will prove far superior.
Principle 2: An Investor Must Have the Right Temperament Towards the Market
An investor must be able to stay rational throughout the volatility that’s involved with financial markets. They must not feel influenced by the trends of the market or the reaction of others, but should instead be able to think for themselves to make rational investment decisions.
The main difficulty with investment is not derived from one’s ability, or inability, to properly value businesses. Nor is it in having the proper insight into the prospects of a business. The main difficulty is derived from one’s ability to be patient with markets and not submit to the ever-increasing amount of speculation and irrational behavior in securities markets.
As discussed previously, a critical difference between an investor and speculator is their approach to price fluctuations in the market. While a speculator will try to predict price fluctuations to occur in the future, an investor will take advantage of market fluctuations after they have occurred. The problem with the speculators’ approach is that in anticipation of specific price movements, they are overcome with emotions when their predicted price movements either do not occur or go in the inverse direction to their original hypothesis.
On the other hand, an investor will have no conviction on the short-term price movements of a stock, but will instead be ready to take advantage of price movements after they have occurred. Whether this means buying at an unusually low price or selling at an exceptionally high price, an investor must do so based on a rational way of thinking rather than an emotional judgment.
As a result, a successful investor’s far more frequent behavior will be instead to do nothing during the day-to-day price fluctuations of financial markets, which presents yet another difficult feat of being an investor, which is the act of inaction.
Because stocks are so liquid, far too many people feel obligated to make frequent buy and sell decisions rather than sit idle while their stock holdings grow in value. Yet, this does not seem to be the case with owners of privately held businesses, an odd peculiarity of business ownership. While public equity and private equity exchange hands at different rates, the attitude towards owning each should in no way be different. Just as if they owned 100% of a business, an investor should focus on the operations, competitive advantage, and financial position of the company they own stock in, not the price someone is willing to pay for their equity.
Once an investor has developed a habit of ignoring the short-term market fluctuations and instead focusing on the economic fundamentals of the business, they will begin to see stocks as what they truly are, which are small pieces of businesses.
Principle 3: An Investor Must View Stocks as Businesses
To be successful with investment, an investor must see a stock for what it is, which is a small piece of a business. Therefore, an investor must take the same approach to buy stock as they would in buying an entire business.
Due to the high liquidity in financial markets, it has become widespread for people to view stocks as little more than a piece of paper whose price fluctuates on a day-to-day basis. Feeding this misconception has been the push from Wall Street firms to get people to buy and sell stocks as frequently as possible, bringing commission to stockbrokers. The reality, however, is that every stock certificate represents a small ownership interest in a business, whose price performance, over the long term, is directly correlated to the performance of the business. Due to this fact, an investor must take the same approach to purchase a stock certificate as they would in purchasing an entire business.
Fortunately, the governmental regulations existent in the United States require that publicly traded corporations release to the public all material information about the business on time. This allows investors in common stock to do a thorough analysis of the business just as they would in purchasing a privately held corporation.
Naturally, when purchasing a privately held corporation, a business owner will put his full attention on the economic fundamentals of the business, such as margins, turnover, management, and a series of other essential factors; absorbing as much information as possible about the business before moving forward with any sort of investment.
While this behavior of thorough analysis of a company may come naturally to the purchaser of an entire entity, people will often purchase common stock without doing anything close to this amount of research. Therefore, it is the investor’s responsibility to force themselves into the mindset of a business owner and approach investments in the exact same manner. Only after an investor has fully adopted this mindset can they move forward with business valuation.
Principle 4: An Investor Must Understand that Every Stock has an Underlying Value.
The level of success an investor has depends on their ability to identify securities selling for less than they are worth. To do this, however, an investor must understand that every stock has an underlying value that is based on the economics of the business. Once this is understood, an investor can go through the process of valuing companies and purchasing the stock of ones selling for far less than they are worth.
Few people will deny the fact that every stock has an underlying value, which over the long term, reflects the economics of the business. However, there is often a disconnect on how this value is calculated. So, let us start by defining the value of a company using a definition that was written by John Burr Williams in The Theory of Investment Value and later affirmed by Warren Buffett in his Economic Principles of Berkshire Hathaway: “The value of any business is the discounted value of all the cash that can be taken out of the business during its remaining life.“
This definition should be the center point on which all business valuation is done.
To understand how much cash can be taken out of a business, one must understand what the business is likely to earn over the pursuing years. Therefore, how much will be paid out to its owners, who expect an adequate return rate.
This brings us to the sole purpose behind investing. This is that the only reason for putting money into an investment now is to get more money back at a later time. The key to business valuation, then, is to estimate the future cash flows of a business and then purchase the business, or a piece of it, at a price that will provide an adequate rate of return from these cash flows.
In estimating these future cash flows, an investor must identify the key variables that determine the earnings of a business, such as the sale of iPhones for Apple or the sale of unit cases for Coca-Cola, and then estimate what the volume of sales is likely to be over the coming years.
It’s essential at this stage of the investment process that an investor not become overly optimistic in their estimation of future cash outlay, but rather base their estimates on rational thinking and a thorough analysis of the business’ past earnings, competitive advantage, and future prospects.
Parallel with the principle that all stocks have a value is the rule that over time, the price of a stock will match the business’s actual value. This concept is one people often have great difficulty with. However, a look at the history of all publicly traded corporations will reveal that regardless of any short-term price movements, no matter how volatile they may be, the price of a stock will inevitably come to match the actual value of the business. While the volatility of markets may make this hard to accept, it is essential investors realize this truth if they intend to earn superior investment returns.
Principle 5: An Investor Must Have a Wide Margin of Safety.
Due to the uncertainties involved with purchasing marketable securities, an investor will greatly increase their chances of success if they incorporate a large enough margin of safety between a security’s price and value. Even a mediocre sale will yield a favorable result.
The large number of unknowns involved with valuing a publicly traded company makes it essential for an investor to have a wide margin of safety. Put another way, when purchasing a business, an investor should aim to pay no more than 70% of the intrinsic value of what the company is worth to account for the unknown fluctuations that might occur in the business’s operations.
As an example, let us imagine that a security analyst stumbles across a company earning $20 per share and has been growing at a reasonable rate over the past few years. After further analysis of the company’s tangible assets, debt, competitive advantage, and the going rate for long-term government bonds, they value the company at roughly $350 per share. After this valuation process, the analyst references their stock manual to find the company is selling for just under $320 per share and quickly buys a block of the company’s stock with the hopes of a $30 per share profit.
Over the pursuing years, a series of unforeseen events fall upon the company, causing their earnings to fall from $20 per share to $13 per share. Shocked at these events, the analyst sells his stock out of fear the company’s earnings will continue to drop and his investment will go further south, and then spends the rest of the year in despair at the apparent mistake he has made.
Over the next five years, the company fails to reach its $20 per share earnings peak but continues to earn a great return of around $15 per share. Because this analyst could not account for any unforeseen events and purchased the security for a price far too close to what the business appeared to be valued at, they failed to have a wide enough margin of safety, which ultimately led to a poor investment result.
If, however, they had taken the proper investment approach and accounted for the “vicissitudes of time” as Ben Graham put it, they would have instead tried to purchase the security for no more than 70 cents on the dollar, compared to 90 cents on the dollar that was paid. The analyst would have continued to have a satisfactory investment despite the company’s fall in earnings.
This is a habit that all investors must develop. Without this margin of safety principle incorporated into every investment decision, one will likely fall into the habit of speculation rather than true investment and will, in turn, suffer the poor results destined to stock speculators.
Principle 6: An Investor Must Stay within their Circle of Competence.
To value a business and subsequently identify ones selling below their value, an investor must have a high level of confidence in what the company will earn over the pursing years. Because of this, an investor dramatically improves their chances of success by staying within areas of business they feel they have a superior level of knowledge.
Due to the overconfidence man often has in himself and the animal spirits John Maynard Keynes identified within us, it is extremely easy and very tempting to convince ourselves we have superior knowledge in areas where we don’t. Because of these irrational tendencies, an investor must constantly strive to restrict themselves to areas where they do indeed have a superior level of knowledge. Without the proper amount of self-restraint, an investor will drift into areas that can only offer the illusion of successful investment.
The question remains, of course, how to define one’s circle of competence and ensure that one stays within that boundary.
Defining one’s circle of competence consists not of understanding how the products or services of a company work, such as the computer science behind a technology company, but rather understanding how consumers react and adapt to a company’s products and services in their buying decisions, and from there understanding what consumer behavior is likely to be over the next 5 to 10 years. Suppose one cannot say with assurance what consumers’ attitude will be towards a company’s offerings in the future. In that case, they cannot designate the company as one within their circle of competence.
This again leads us to further restricting ourselves to investments that offer safety of principle, an adequate rate of return, a wide margin of safety, and now ones that reside within our circle of competence. Making this refinement all the more difficult is the often excessive pressure that comes from others to act on things that are seen as fashionable at the time, but are in reality, purely speculative (tulip bulbs, dot com stocks, sub-prime mortgages, bitcoin).
However, suppose an investor can stand by their convictions, not giving in to the crowd’s emotions. In that case, they can rest assured by their investment decisions, and superior returns can only be certain. These six principles, which have been developed and modified by many different investors over the years, particularly Benjamin Graham in his book The Intelligent Investor as well as Warren Buffett in his speeches and writings, have proven successful for these investors for almost 100 years. There is little doubt that they will be applied in the next 100 years.
An Investment, An Adequate Rate of Return
Endowed with these principles, any investor can find themselves prepared to take advantage of the rewarding opportunities that often present themselves in financial markets. In addition, an investor must always be striving to increase their knowledge and, through continuous reading, researching, and engagement with other professionals, expand their circle of competence, as well as their personal value, with the understanding that the greatest investment one can make is in themselves.
This article has been reprinted with permission from William Douthat´s LinkedIn page.