“I have every possession I want. I have a lot of friends who have a lot more possessions. But in some cases, I feel the possession possesses them, rather than the other way around.” ~ Warren Buffett
Never allow all the things you selfishly covet or you want make you forget about all the things you have or currently possess. Put a little gratitude in your life today and be thankful for all you already possess.
Moreover, happiness doesn’t mean everything is pleasing or perfect. Instead, happiness means that you can choose to see beyond the problems and imperfections, and embrace an attitude of gratitude.
The endless pursuit of hollow amenities and fruitless assets that barely add any value to your life are often so intoxicating that people loose sight of things that truly make them happy and bring them joy such as personal relationships, joy and peace in abundance.
“Sometimes you have to stop staring at your problems and start seeing how beautiful life really is.” ~ Anonymous
Don’t wait for great. Be Great everyday! Don’t allow a little negativity keep you from feeling grateful for everything that is going right and for everything that is good and pleasing in your life.
Gratitude must become a 24 hour / 365 day mindset, so that you don’t take what you have for granted.
Research shows that gratitude can:
Help you make friends. One study found that thanking a new acquaintance makes them more likely to seek a more lasting relationship with you.
Improve your physical health. People who exhibit gratitude report fewer aches and pains, a general feeling of health, more regular exercise, and more frequent checkups with their doctor than those who don’t.
Improve your psychological health and emotional well-being. Grateful people enjoy higher wellbeing and happiness and suffer from reduced symptoms of depression.
Enhance empathy and reduces aggression. Those who show their gratitude are less likely to seek revenge against others and more likely to behave in a prosocial manner, with sensitivity and empathy.
Improve your sleep. Practicing gratitude regularly can help you sleep longer and better.
Enhance your self-esteem. People who are grateful have increased self-esteem, partly due to their ability to appreciate other peoples’ accomplishments.
Increase in mental strength. Grateful people have an advantage in overcoming trauma and enhanced resilience, helping them to bounce back from highly stressful situations.
“Don’t Fight the Fed” is an old market cliché that was very applicable during the longest bull market in US history. It is also very applicable currently as the Fed implemented policies to slow the economy by raising interest rates and selling assets from its balance sheet. ~ Chris Vermeulen, Seeking Alpha
In 1977, the US Congress officially gave the Federal Reserve a multi-part mandate to maximize employment, maintain prices near an acceptable inflation target of around 2%, and moderate long-term interest rates. In general terms, Fed policies are supposed to stimulate the economy when it’s weak and cool it when it’s too hot.
The adage highlights the strong correlation between Federal Reserve policy and the direction of the stock market.
“Don’t Fight the Fed” embodied the sentiment that if the Fed was stimulating the economy with accommodative policies, it made little sense to bet against the market’s bullish trend. Effectively, when the Federal Reserve’s monetary policy is loose, markets tend to move higher, volatility is subdued, and investors’ risk is limited, so it makes sense to stay invested and ride the wave. Why “fight the Fed” by selling stocks when it’s on your side?
The Fed held interest rates near zero and instituted a policy called quantitative easing—where it bought mortgage-backed securities and U.S. Treasuries to increase the money supply in hopes of spurring lending and capital investment.
When the Federal Reserve is on a mission to slow the economy down in order to tap down inflation, technology and growth stocks are generally hurt as the cost of capital and borrowing money increases. Thus, the old adage, “Don’t fight the Fed” becomes an important one for investors to abide.
With inflation being persistent in the U.S., Fed officials have taken a new monetary stance that is far less appealing for investors.
The Fed is in Quantitative Tightening mode and has raised interest rates and sold assets from its balance sheet. This calendar year, the Fed has raised interest rates four times and has begun shrinking its balance sheet after years of quantitative easing pushed its holdings to nearly $9 trillion. Its intent is to cool the economy and reduce inflation.
The adage, “Don’t fight the Fed”, is a warning to avoid stocks, or at least to take a more conservative approach to investing.
As a result, investors should take a more cautious approach in this tightening environment and prioritize defensive stocks with pristine balance sheets and steady revenue growth that can survive inflationary pressure.
Inflationary economies tend to punish unprofitable technology and growth companies, despite their potential. Without profits or cash flow, it’s simply too hard to improve quarter over quarter at a time when money becomes more expensive to borrow.
Historically, small-cap stocks have been shown to outperform the rest of the market because of greater growth opportunities. A massive company is limited by its existing size. ~ U.S. News and World Report
Small cap company pundits recommend that investors review several key financial metrics and ratios to properly evaluate small cap companies. Following these metrics and ratios, you will be well on your way to finding a few hidden gems in the small cap market.
Each small cap company should be evaluated on fundamental factors to identify which ones can exhibit durable long-term growth.
Growth measures include revenue growth rate;
Profitability measures include operating profit and earnings per-share; and
Capital efficiency measures include return on invested capital.
In short, investors should seek to invest in the top-tier of eligible small cap companies .
Here are seven key metrics that should be reviewed before buying any stock. These indicators should help you get most of the way in understanding a company, its operations, and its underlying business.
1. Institutional activity. Pension funds, mutual funds, hedge funds, insurance companies and corporations that buy and sell huge blocks of shares can create tremendous volatility in prices. To lessen this risk in your investments, try to buy shares in companies where institutions own less than 40% of their shares.
2. Analyst coverage . Another indication of future share volatility is the number of Wall Street analysts covering a stock. Analysts – like the big institutions – have a herd mentality. When one sells, so do the rest, resulting in great numbers of shares changing hands, and usually leading to price declines. It’s best to avoid companies with more than 10, or fewer than 2 analysts following them. (You need some analyst interest or you may be waiting a long time for price appreciation, even in the strongest and most undervalued company) .
3. Price-earnings ratio (P/E) . The price of one share of a company’s stock divided by four quarters of its earnings per share, the P/E ratio is of utmost importance in determining if a company’s shares are over- or under-valued. For the best perspective, go to Reuters , then select Ratios and compare the current P/E of the company to its average P/E for the last 3-5 years, to its estimated future P/E and to the average P/E of its industry or sector. One note: If a company’s P/E is more than 35, it might be too pricy. You may want to stick with companies that are trading at lower P/Es, particularly if you are fairly new to investing.
4. Cash flow. One of the most important parts of a financial report is its Statement of Cash Flows, which is a summary of how the company made and spent its money. The Total Cash Flow From Operating Activities represents the cash the company took in from its primary business operations.
It’s important that this number be positive, or at least trending positive over the course of a year. After all, if the business isn’t making money from its primary product – not from investing in real estate or the stock market – then you probably want to pass it by.
5. Debt/equity. This ratio is how much debt per dollar of ownership the business has incurred. Compare the firm’s historic debt/equity ratios, so you can find out if its debt level over the past few years has been rising too rapidly. Debt isn’t bad, as long as it is used as a springboard to grow sales and earnings. Next, contrast the company’s ratio with its competitors and its industry so you can further determine if your company’s debt position is reasonable.
6. Growing sales and income. One rule of thumb is to buy shares in companies whose sales and net income are growing at double-digit rates. I cannot emphasize this enough, as, appreciation in stock prices is generally precipitated by growth in earnings (which usually follows expansion of sales) . It’s certainly possible to buy stock in a company that has no earnings growth (a new business, or a tech company in the late 90’s, for example) and still make money on the shares – short-term – but it’s not a formula for serious, successful long-term investing.
7. Insider activity. Investors will also want to review the buying and selling activities of a company’s insiders – its top officers and directors. A sudden rush to sell large quantities of the firm’s shares may be a good indicator that the business is falling on rough times. Likewise, a large increase in purchases may mean good news is on the way.
No single financial metric or ratio will determine the validity or potential of your investment. It is of utmost importance that you take a complete look at a company’s financial strength and its future growth prospects, by conducting a thorough analysis – over time – usually a 3-5 year track-record.
Many small caps stay small because they have structural problems, management lacks the capability to grow the business, or their niche simply isn’t large enough to support a bigger enterprise.
In contrast, many small cap companies can graduate to greater things, earning shareholders tremendous returns along the way.
“Compounding doesn’t rely on earning big returns. Merely good returns sustained uninterrupted for the longest period of time—especially in times of chaos and havoc—will always win.” ― Morgan Housel, The Psychology of Money: Timeless lessons on wealth, greed, and happiness
More than 2,000 books are dedicated to how Warren Buffett built his fortune. Many of them are wonderful. But few pay enough attention to the simplest fact:
Buffett’s fortune isn’t due to just being a good investor, but being a good investor since he was literally a child, writes Morgan Housel in his seminal book, The Psychology of Money: Timeless lessons on wealth, greed, and happiness.
Warren Buffett’s estimated net worth is $110 billion as of November 2022. Of that, $109.2 billion was accumulated after his 50th birthday. $107.5 billion came after he qualified for Social Security, in his mid-60s. Warren Buffett is a phenomenal investor.
But you miss a key point if you attach all of his success to investing acumen. The real key to his success is that he’s been a phenomenal investor for three quarters of a century.
Had he started investing in his 30s and retired in his 60s, few people would have ever heard of him. Consider a little thought experiment. Buffett began serious investing when he was 10 years old. By the time he was 30 he had a net worth of $1 million, or $9.3 million adjusted for inflation.16
What if he was a more normal person, spending his teens and 20s exploring the world and finding his passion, and by age 30 his net worth was, say, $25,000? And let’s say he still went on to earn the extraordinary annual investment returns he’s been able to generate (22% annually), but quit investing and retired at age 60 to play golf and spend time with his grandkids. What would a rough estimate of his net worth be today? Not $110 billion. $11.9 million. 99.9% less than his actual net worth.
Effectively all of Warren Buffett’s financial success can be tied to the financial base he built in his pubescent years and the longevity he maintained in his geriatric years. If you had invested $10,000 with Warren Buffett in 1966, today you would have over $160 million! That same $10,000 invested in the S&P would be $140,000.
Buffett’s skill is investing, but his secret is time. That’s how compounding works. Think of this another way. Buffett is considered by many to be the most famous and successful investor in history. But he’s not necessarily the greatest—at least not when measured by average annual returns.
“Doing well with money isn’t necessarily about what you know. It’s about how you behave. And behavior is hard to teach, even to really smart people.” ~ Morgan Housel
References:
Morgan Housel, The Psychology of Money: Timeless lessons on wealth, greed, and happiness., Harriman House, September 8, 2020.
A focus on finding small cap companies with great fundamentals and big growth prospects.
A small-cap stock is a stock of a publicly-traded company whose market capitalization ranges from $300 million to approximately $2 billion, explains Corporate Finance Institute. The word “cap” in this term refers to a company’s market capitalization.
Savvy investors cannot afford to overlook small-cap growth companies. Although, there are several pros and cons of investing in small-cap stocks that must be considered.
Small-cap companies, in general, tend not to get the same kind of publicity as their large-cap siblings. They aren’t going to lead a segment on CNBC or the home page of the Wall Street Journal on a daily basis.
With smaller market capitalizations, small-cap companies tend to fly under the radar.
The Rise of Small-Cap Stocks
Reasons that people may invest in small-cap companies are capital appreciation — they think the stock price will go up and dividends — where the company pays you to hold it.
But some of these are solid companies and excellent small-cap stocks to buy.
Small-cap equities are more sensitive to the economy (inflation, rising interest rates and dollar strength), so a robust economic rebound would favor them.
Small-cap stocks are popular among investors because of their potential for providing better returns in the long term relative to their large-cap peers.
The advantages of investing in small-cap stocks are:
1. Growth potential – Relative to bigger companies, small-cap companies show significantly higher growth potential. For small-cap companies, it is easier to grow significantly their operational and financial base than is the case for most large-cap stocks.
Picking the right small-cap stock can turn into a profitable investment.
2. High probability of inefficiencies in the market – Information about the small-cap stocks is harder to find compared to large and mid-cap companies. Analysts typically give little attention to these companies; thus, there is a high probability of improper pricing of small-cap stocks. This situation creates vast opportunities for investors to leverage the inefficiencies in market pricing and earn a great return on their investments.
3. Financial institutions do not push prices up – Financial institutions, including mutual and hedge funds, should comply with certain regulations that do not allow them to invest heavily in small-cap stocks. For this reason, it is unlikely that the stock price will be artificially pushed up because of large investments from major financial institutions.
Nevertheless, there are some disadvantages of investing in small-cap stocks:
1. High risk – Investing in small-cap stocks involves higher risk. First, small-cap companies may have an unreliable and faulty business model which can result in company’s management not being able to adjust the business model, and can result in poor operational and financial results. And, small-cap companies usually have less access to new capital and new sources of financing. Due to this reason, it is more likely that the company will not be able to bridge gaps in its cash flows or expand the business because of the inability to undertake the necessary investments.
2. Low liquidity – Small-cap stocks are less liquid than their large counterparts. Low liquidity results in the potential unavailability of the stock at a good price to purchase or it may be difficult to sell the stocks at a favorable price. Low liquidity also adds to the overall risk of the stock.
3. Time-consuming – Investing in small-cap stocks can be a time-consuming activity. Due to the under-coverage of small-cap stocks by financial media, institutions and analysts, the amount of available research on small-cap companies is usually limited.
Moreover, small cap technology and all small cap stocks are discounted to a great degree by investors in a rising interest rate environment, purely due to the fact that they have the bulk of potential earnings and cash flow far out into the future. The higher long-term rates are, the less those future earnings and cash flow are worth. This goes for virtually all unprofitable growth tech stocks.
Essentially, small-cap stocks may provide investors with an opportunity to earn a substantial return on their investments. However, this type of investing should be approached with caution as small-cap stocks are often risky and volatile.
The tongue is like the rudder of a ship in that it steers a person’s life in the same way the rudder steers a ship. Even in the midst of fierce winds and strong currents, the rudder is powerful enough to steer the ship. In the same way, no matter the circumstances, the tongue is powerful enough to steer a person’s life.
In life, your tongue steers and determines your life. Words spoken by your tongue determine the direction and the destination of your life, just like the rudder of a ship determines the direction a ship will go.
Words may not cause you to arrive at the destination immediately, but they head you in that direction, and eventually, if you continue in that direction, you will arrive there.
Your words are very powerful. Even when it seems that circumstances are against you, your tongue holds more power than the circumstances.
If you want to change the circumstances and the direction your life is headed, then change the words you are speaking! Your words are very powerful.
But this principle can also work against you. If you are a person who says things like “I always get sick, nothing good ever happens to me, etc”, then you are likely seeing those things as reality in your life.
If you want to change your circumstances, change your thoughts and the words that are coming out of your mouth. If you want to see good days, learn to control the thoughts you are thinking and to choose carefully the words you are speaking.
People who don’t understand the power of words are constantly saying things that they don’t really mean, and they train their bodies not to believe or take their words seriously. Therefore, when it comes time to rebuke sickness or command healing, their bodies don’t respond the way they should.
Start controlling your tongue by speaking the word of positivity and victory out loud. This will train your thoughts and tongue to speak goodness and positivity, even in contrary circumstances. Start to think about the words you speak. Your life will get better and better and you will begin to see the good and positivity become a reality in your life!
Pay attention to your words and to your conversations with others understanding that what you are saying is actually directing and steering your life. The Bible says in James 3:4-5; “Look at the ships also: though they are so large and are driven by strong winds, they are guided by a very small rudder wherever the will of the pilot directs. So also the tongue is a small member, yet it boasts of great things.”
Whom you are is an expression of your inner dialogue. Your ‘inner dialogue’ is quite simply your thoughts. It is the little voice in your head that comments on your life, whether that is what is going on around you, or what you are thinking consciously or sub-consciously. All of us have an internal dialogue, and it runs all the time.
It’s essential that you observe the tone you use in your internal dialogue. Adopt the type of tone that a loved one would use if they were reassuring you. Or reflect on how you would speak to someone who was struggling with something. Work to speak calmly and compassionately to yourself, even when you hit a setback.
Speaking creates how you think, how you move, where you go. Talk to yourself or have dialogue with yourself in such a way that brings you into action, doing and being the things that you want.
The ultimate direction your life takes will be determined by how well you control your tongue. Perfectly controlling your speech is tough work, but the payoff will be immense. A warm tone helps you accept yourself just as you are. Everyone has limitations, and accepting yourself and controlling your tongue, limitations and all, leads to setting the correct course and heading in the right direction.
EBITDA, (or Earnings Before Interest, Taxes, Depreciation and Amortization), is an accounting term that is an alternative way to measure a company’s profitability.
EBITDA is simply an acronym:
To calculate EBITDA, you start with Net Income (also known as Earnings). Then you add back Interest, Taxes, Depreciation, and Amortization
EBITDA is a Non-GAAP number, meaning it doesn’t comply with “Generally Accepted Accounting Principles” For that reason, you won’t see it on many companies’ financial statements. However, some management teams do provide it and focus on it heavily.
Amortization & Depreciation are the accounting process of writing down the value of an asset over time:
Depreciation is the accounting method used to allocate the cost of a TANGIBLE asset over its useful life. A TANGIBLE asset is something you can physically touch (house, car, factory). Depreciation represents how much of a tangible asset’s value has been “used up”.
Amortization is the accounting process of writing down the value of a loan or an INTANGIBLE asset. It’s VERY similar to depreciation, but amortization happens to “Intangible” assets, which are assets that you can’t physically touch (patents, trademarks, goodwill).
Although Wall Street might love EBITDA, many investors do not. Why? EBITDA can be very misleading. Ignoring “depreciation” as an expense is a big reason why, as Buffett explained in 2017.
“A mindset that can be paranoid and optimistic at the same time is hard to maintain, because seeing things as black or white takes less effort than accepting nuance. But you need short-term paranoia to keep you alive long enough to exploit long-term optimism. Jesse Livermore figured this out the hard way.” ― Morgan Housel, The Psychology of Money
There are several mental and emotional traits that are important for being a successful long-term investor, according to the Ethical Entrepreneur. The factors are:
Being calm and unemotional. Keep away from and ignore the over-hyped financial and headline news when it comes to investing. Avoid excitement and speculation – if your personality craves these then you may not be well suited to investing. One way to combat the adrenaline cravings is to invest using a process – develop some rules and stick to them.
Not being greedy. You will never, ever sell at the top and buy at the bottom with every investment you make. It’s impossible. The sooner you accept this and move on with developing your strategy, the better off you will be. If you feel yourself starting to get greedy “just another 10%”, sell and move on.
Not being overly fearful. Listening to daily (or hourly basis) financial and headline news is only guaranteed to stoke needless anxieties and panic, neither of which are conducive towards building wealth and investing.
Being focused, patient and discipline. Have a plan and strategy. Avoid making quick and rash decisions. Have the facts to make an informed decision. If you need to rush to make an investment then you’re probably sticking your leg straight into a bear trap. Stop, calm down and think about it. If it’s really a great opportunity then it will still be here tomorrow.
Understanding your strengths and limitations. There’s a tendency today for people to act like a guru and ‘fake it until they make it’. In some ways, a bit of confidence is a good thing, but don’t fall for your own hype. What makes you so different from the thousands of other investors in the market? What are your weak spots and what have you done to guard against them? Are you playing to your advantages and how do you know they’re better than the competition? Are you in possession of all the relevant and accurate facts and if so, can you make sense of them?
Being realistic. You might read about Warren Buffet and think “I could do that” but the truth is that Warren is the outlier, not the rule. You’re not going to double your money every year and you’re not going to pick winners every week. Accept it and move on. Aim for an annual compounding rate of 10-15% and consider that an almighty challenge at the best of times. If you can compound your money at 10% a year for 20 years, that will build wealth.
Control what you can and don’t worry about the rest. You can’t do anything about what the market thinks or feels about a position hour to hour or day to day. It might feel frustrating to watch your stock sliding backward but if you’ve done your due diligence then have faith that it will be rewarded in time. Focus on your buy price, your position size, portfolio construction and how to bank profits – clear your mind of the noise.
Always seek new knowledge and how to apply them. Never stop learning! There is more knowledge and understanding about the world than anyone before us; make use of it!
Writing about and discussing the psychology of investing are much easier than actually living and following them. Enjoy your life as much as you can – you only have one! If you’re not happy with something in your life, then decide what you truly want, make a plan to achieve it and set a deadline – then make it happen. Life is far, far too short for missing daily joy, peace and abundance!
You must spend some time each day considering investing rules and tactics. Consider how you will overcome the investing challenges and focus on implementing your plan. You will inevitably slip backwards at times, but discipline, patience, persistence and perseverance will help to embed them in your behavior.
“Money’s greatest intrinsic value—and this can’t be overstated—is its ability to give you control over your time.” ~ Morgan Housel, The Psychology of Money
“Spending money to show people how much money you have is the fastest way to have less money.” ~ Morgan Housel, The Psychology of Money
“Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time.” ~ Seth Klarman
At an early age, Billionaire and Baupost Capital CEO Seth Klarman was fascinated with business and making money. By the age of ten he was investing in the stock market.
During Klarman’s time in the investing world, he’s been able to compound capital at a 20% annual return.
In 1991 Klarman wrote his book, Margin of Safety, and there have only been 5,000 copies printed. As a result of such a small supply and enormous demand, Klarman’s book is very expensive reselling for $1,500 to $2,500.
James Clear — who writes about habits, decision making, and is the author of the #1 New York Times bestseller, Atomic Habits — summarizes the book, Margin of Safety, as follows:
“Avoiding loss should be the primary goal of every investor. The way to avoid loss is by investing with a significant margin of safety. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and make mistakes.”
2010 Baupost Capital’s annual letter
Here is an excerpt from the 2010 annual letter of Baupost Capital written by Seth Klarman. He was shocked at how quickly investors have returned to the risky investing and financial behaviors that got them in trouble during the 2008 Financial Crisis;
1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected (the Black Swan) event, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can and will be far worse.
2. When excesses such as lax lending standards become widespread and persist for some time (e.g., ninja (no income, no job and no assets) loans), people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
10. Financial innovation can be highly dangerous, (think cryptocurrency) though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
15. Many leveraged buyouts (LBOs) are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
16. Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
18. When a government official says a problem has been “contained,” pay no attention.
19. The government – the ultimate short-term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.
Value investing involves determining the intrinsic value — the true, inherent worth of an asset — and buying it at a level that represents a substantial discount to that price.
The gap between a stock’s intrinsic value and the price it is currently selling for is known as the margin of safety.
The greater the margin of safety, the more an investor’s projections can be off while still profitably gaining from an investment in the shares of the company being evaluated.
It can be helpful to ensure you understand what value investing is and is not. It is not searching for stocks with low price-to-earnings ratios and blindly buying the stocks that make that first cut. Instead, value investors employ a series of metrics and ratios to help them determine a stock’s intrinsic value and a sufficient margin of safety.
Value investing in stocks often means looking for mispriced shares in out-of-the-way places. This can include looking at companies in out-of-favor sectors, businesses in frowned-upon industries, companies that are going through some type of scandal, or stocks currently enduring a bear market. Unpopular sectors and companies are often treasure troves for the successful value investor, requiring the possession of both a long-term approach and a contrarian mindset. Regardless of where the investments come from, though, value investing is the art and science of identifying stocks priced below their actual worth.
Successful value investing exercise patience and hold during lean times. Taking just one example, in early 2015, American Express shareholders learned that AmEx lost its exclusive credit-card deal with Costco Wholesale locations. In the following months, Amex lost almost 50% of its market-cap value. Yet far from being a moment to panic, savvy investors might have seen an opportunity to buy AmEx for outsized gains. Within three years of its lowest point, American Express had almost doubled and reached new all-time highs.
Selling at lows while negative sentiment is at its highest will guarantee frustration and permanent loss of capital. It can be hard to wait while your thesis plays out, but patience is absolutely necessary for value investors who want to beat the market.
Of course, value investing is more than a waiting game. Investors must remain diligent in staying up to date on a company to ensure their thesis is proceeding as planned. This means paying attention to the company’s business performance — not its stock price.
The Big 5 Numbers
Phil Town, founder and CEO of Rule #1 Investing, says there are “the big 5 numbers” in value investing.
The Big 5 numbers are:
Return on Invested Capital (ROIC)
Equity (Book Value) Growth
Earnings per Share (EPS) Growth
Sales (Revenue) Growth
Cash Growth
All the big 5 numbers will be 10% or greater if the company, and he numbers should be stable or growing over the past 10 years.
The big takeaway
Value investing is not easy. It requires time, focus, discipline, patience and dedication to the craft. It will often mean looking and feeling foolish while you wait for an investment thesis to play out. If this doesn’t sound like it’s for you, investing in passive index funds is a perfectly suitable alternative.
For investors who enjoy the hunt of looking for undervalued assets — and beating the market at its own game — value investing can be richly rewarding in more ways than one. By following this simple guide, investors can be well on their way to understanding how value investing can beat the market.
