If you want to be a successful stock market investor, you should think about buying pieces of "good" businesses at "bargain" prices.
Yes, that sounds simple, but if you actually could find a good business at a bargain price, wouldn't it make sense to buy it?
Doesn't that sound like an investment strategy that should work.
The only problem is figuring out what's a "good" business?
Well, a "good" business is a business that can earn a high return on capital.
What's that? It's a pretty simple concept really.
Say you own a gum store (yes, a store that sells only gum--don't ask!). Anyway, say that store costs 400,000 to build (including inventory, store displays, etc) and last year that store earned 200,000. This works out to a 50% yearly return (200,000 divided by 400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital. Without knowing much else, earning 200,000 each year from a store that costs 400,000 to build, sounds like a pretty good business.
But what if we compared that to another kind of store, say a store that sells only Broccoli (we called that store, Just Broccoli, for obvious reasons). What if it also costs 400,000 to open a Just Broccoli store? But what if that store only earned 10,000 last year? Earning 10,000 a year from a store that costs 400,000 to build works out to a one-year return of only 2.5 percent, or a 2.5 percent return on capital.
So here's the tough question. Which sounds better--a business that earns a 50% return on capital or one that earns a 2.5% return on capital? Of course, the answer is obvious. You would rather own a business that earns a high return on capital than one that earns a low return on capital.
So, now we know what "good" is--a business that earns a high return on capital.
But what's cheap? In the book, we defined cheap as a business with a high earnings yield. What's that?
Take two businesses, one earned 300,000 last year, one earned 100,000. Both are for sale for 1 million.
If we buy the first, we get an earnings yield of 30% (300,000 in earnings divided by the 1 million purchase price).
The second has an earnings yield of 10% (100,000 in earnings divided by the 1 million purchase price).
Which is cheaper? All other things being equal, the company that earns more relative to the price we're paying is cheaper than the one that earns less. In other words, getting a 30% earnings yield is better than a 10% earnings yield--a high earnings yield is better than a low one.
And that's it. Now you know the "magic formula"! What do I mean? If you just stick to buying "good" companies (those with a high return on capital) but you buy them only when they are available at bargain prices (when they have a high earnings yield), you can more than double the market's average annual return. And you can do it with very low risk.
Having trouble believing that it's that easy? Well, how about this? A study over the last 17 years shows that holding a portfolio of stocks with the best combination of a high earnings yield and a high return on capital produced over 30% annual returns vs. just 12% for the overall market during the same period
Over 17 years, earning 30% a year means 11,000 would have turned into over 1 million! Not bad.
Actually, maybe not. With me being such a blabbermouth, if everyone "knows" the "magic formula" maybe it will stop working? After all, how can any strategy keep working if everyone follows it?
Well, here's the answer.
=> The great thing about the "magic formula" is that it isn't that great! It doesn't work all the time. That's right.
=>Over long periods of time, it's true, the results are amazing.
=>But...there are still 1, 2 and even 3 years periods when the formula doesn't work at all!
=>Most people just don't have the patience or the discipline to stick it out during those tough periods.
=>After a year or two of following a strategy that underperforms the market, most people simply give up!
That means for the "magic formula" to work for you, you must "believe" that the formula makes sense and that it will continue to work over the long term--even if it hasn't worked for months or even years.
For that, you'll have to understand why the magic formula makes sense. (yes it does makes a lot of sense)
You'll have to continue to believe that it still makes sense even when friends, experts, the news media, and Mr. Market indicate otherwise. That's tough to do! Unfortunately, to really "believe", I mean really, truly "believe", you'll have to be convinced that buying above average companies at below average prices actually makes sense. I believe it does. I hope you "believe" too.
If you do, I know you'll become a more successful investor.
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Some key take aways form Prime Minister Manmohan Singh address.
Unveiled plans for
Rs 60,000 crore (Rs 600 billion) investment in the port sector.
Rs 40,000 crore (Rs 400 billion) for modernisation of airports in the country.
Rs 175,000 crore investment plan for expanding the highways programme.
Assured the industry of better tax administration.
On the issue of raising the level of 30 per cent income tax to incomes of above Rs 500,000, the prime minister said, "I promise to address these concerns over the next year."
On Labour Policy
PM said the government was committed to 'unleash a new surge of investments' by encouraging enterprise and creativity through reforming the public sector and enabling private and public partnerships.
"If it requires modifications to our labour policies to provide greater flexibility, which in turn will generate more jobs, we will work with all stake holders to generate a consensus on it," he said.
Need to pay attention to social safety nets because it was incumbent on the state to take care of the weak and vulnerable for those who cannot bear the shocks of market economy. "Social welfare legislation must go hand in hand with labour market flexibility. This will help increase employment opportunities while taking care of employees' concerns," he said.
Over the last two years the economy had moved towards lower tariffs, uniform tax rates and easier procedures.
He told the industrialists that the government would work towards improving the tax administration in the country so that "your interface with the tax system is pleasant, smooth, problem-free and conducive to easy tax compliance."
On power situation
"I hope we can initiate a speedier process in case of power sector policy reform through the mechanism of an Empowered Committee of Chief Ministers. I am going to propose to our chief ministers to forge a similar all-party consensus in the power sector," he said.
Singh said he was happy that many states, which initially kept out of VAT, have opted to join the system. He said revenues have been buoyant, setting at rest worries about its feasibility.
Need to move towards greater rationaliation of VAT and Cenvat rates, and most importantly, towards a common goods and service tax," he said. "This would enable India in to becoming a genuine common market, a dream of our founding fathers. I hope to see this happen in next three to four years, an event, which will be a landmark in our economic development," Singh said.
On investment in Railways
The feasibility studies for dedicated freight corridors on Delhi-Mumbai and Delhi-Kolkata are nearing completion.
"We will be shortly setting up a new firm to implement these corridors in addition to allowing private container trains on these routes," he said.
The prime minister said the basic institutional framework for a surge in infrastructure investment was now in place with a special purpose vehicle for the sector, viability gap funding programme, a separate approval procedure for public-private partnership projects and model concession agreements.
He said transparent competitive systems were in place and were paying off. Singh said the government was expanding the highways programme with an investment plan of Rs 175,000 crore (Rs 1,750 billion).
He said entire Golden Quadrilateral is being made six-laned and against a target Built-Operate-Transfer projects this year, the contracts have been awarded for 31 projects.
"Compared to a high of 3,500 km golden quadrilateral road contract given in 2001-02, the level has gone up to 6,000 km this year, Singh said. The prime minister said the United Progressive Alliance government had inherited golden quadrilateral being built with old contracting approach, which has now undergone changes.
Manufacturing sector should not be ignored as it created large employment opportunities. Inadequate growth in manufacturing has had its adverse impact on employment generation. "The current mismatch between distribution of workforce and value added in agriculture was one of the main reasons for large number of poor. This needs urgent correction," the prime minister said. "Manufacturing has to be like a sponge, which absorbs people who need to move out of agriculture in pursuit of higher incomes," he said.
"I do not accept the proposition that India can skip the manufacturing stage of development and go from being an agrarian society directly to become a services and knowledge based society," he said adding: "This is a mistaken view."
He said a substantial manufacturing base is essential to absorb the work force and ensure sustainable growth of the economy.
"India can target to process over 25 per cent of its agriculture produce in next five years as compared to a lowly 2.0% today. This will generate jobs, reduce wastage and enhance rural incomes," Singh said.
On textile exports
The end of Multi Fibre Agreement regime in textile must translate in to greater output and far more jobs in textiles and garments.
Stating that there were reports of mixed results in textile this year, Singh said: "We cannot miss the opportunities, which we once did in 1960s. I urge industry to have faith and take the plunge. Few will regret."
The prime minister foresaw greater competitiveness in small and medium enterprises sector in the coming years. He said large-scale industries must think global even as they act local. On forging international cooperation, he said: "I have a vision of Asia in which India has to play a key role -- a vision of a resurgent Asia; an Asia of inclusive societies and open markets."
The prime minister said he felt the emergence of a virtual Asian economic community.
On the economy
On the buoyancy in the economy, the prime minister said the state of business confidence and expectations is 'very positive.'
He said during his recent interactions with business representatives, he had been encouraged by the new sense of confidence that many now exude. "It is therefore, heartening to see the faith being reposed in the prospects for the Indian economy -- not only within India but outside," he added.
Singh said the decade ahead must be a decade of investment that should convert India into a ' first rate agricultural, industrial and service economy.'
He desired that the share of manufacturing in national income should rise in the range of 25-35 per cent for which the sector should grow at the level of 12-14 per cent in the next decade.
The prime minister assured that the government would be mindful of the interests of domestic industry even as "we enable our economy to integrate itself with the global economy." He said the industry should not only look at the threat of competition from imports but also the opportunity of accessing new markets through exports. "If we look at new opportunities, the old threats become less daunting. I urge Indian industry to adopt a forward-looking approach in preparing for a brave new world of competition."
The following brief excerpt from a legendary trader brings out the essence of trading.
"BEFORE YOU CAN SUCCESSFULLY PLAY THE MARKET, YOU MUST HAVE A CLEAR CONCISE STRATEGY AND STICK TO IT.
EVERY SPECULATOR MUST DESIGN AN INTELLIGENT BATTLE PLAN, CUSTOMIZED TO SUIT HIS EMOTIONAL MAKE UP BEFORE SPECULATING IN THE STOCK MARKET.
THE BIGGEST THING A SPECULATOR HAS TO CONTROL ARE HIS EMOTIONS. REMEMBER THE STOCK MARKET IS NOT DRIVEN BY REASON, LOGIC OR PURE ECONOMICS BUT BY HUMAN NATURE WHICH NEVER CHANGES. HOW CANT IT CHANGE? IT IS OUR NATURE"
Where there is profit, there is always risk. Greater the opportunity of profit, greater the possibility of loss:
There is a close direct relationship between the risk and the reward. Higher the reward, greater the risk. Though this is fairly simple, it is always observed in breach.
Gentlemen who prefer BONDS, don't know what they are missing. On Bonds, there is no return ON our money; there is only return OF our money:
Bonds being Debt instruments unlike equity, yield only fixed return and with inflation and income tax factored in, there is often no return at all.
Equity Investment is "risk" investment:
Investing in equity shares of companies is risk related because returns are linked to the company's profits unlike investing in bank deposits or bonds or debentures where the returns are fixed and accrue to investors regardless of the company's profits.
Stock market behaviour is unpredictable:
Stock market behaviour is dependent on human behaviour and since times immemorial, it has been established that human behaviour can never be predicted with any reasonable accuracy; and hence we have fluctuations in prices of commodities, things and stocks based on greed, emotions, hopes, fantasies, fear and dreams resulting in opportunities of making money out of such fluctuations!
ot all common stocks are common:
Though equity shares as an investment class is one, each company has a distinct identity and performs differently and therefore rewards its investors also differently.
Investing is nothing but arbitrage of ignorance:
Investing is basically profiting from pricing and difference in market perception of a given product at a given point of time. Stock market is one place where the buyer and the seller both think that they are smart in their decision.
Elephants don't gallop, zebras do:
Stock prices of big companies with large capitalizations move up or down rather slowly compared to smaller companies because there is not much of market ignorance on big companies to capitalize on. Hence smaller companies tend to reward its investors more handsomely.
Equity investment is not for everyone, nor for all times of a person's life:
One needs not only "cash" but also "courage" to be an equity investor. There has to be a positive mental temperament and willingness to absorb occasional losses. Those prone to panic at losses should remain invested in fixed deposits with banks and Government Bonds. If you don't know who you are, stock market is too expensive a place to find it out! Even for a risk loving investor, there is no single static investment strategy valid from his "cradle" to "crematorium".
Investors make mistake in buying not good stocks at high prices but in buying bad stocks at low prices.
A lay investor tends to buy unsound companies at cheap prices instead of solid companies at high prices.
Equity investment can't maximize your "income"; but it can maximize your "wealth".
Actual yield by way of dividends on equity shares with reference to their market value is often as low as 1 percent on our investment. But capital appreciation in equity values can be mind blowingly high. Ask initial investors of Infosys, Pantaloon to name only two companies.
Saving for investment is not a punishment.
Investing is making conscious choices about how you will use your money. It is not about choosing to live rich or die rich. It is about how you want you and your dear ones should live during your lifetime and thereafter.
Axiom Twelve: (On Stock Prices)
- There is no "high" price or "low" price of a stock. There is only the "market" price of the stock nor any price too "high" for you to buy or too "low" for you to sell.
- In isolation, price of a stock is not relevant. What is important is whether a share is "underpriced" or "overpriced", overvalued or undervalued.
- We do not invest in Stock Market Index; nor in Stock Market; nor in individual companies. We invest in a stock at a price at the correct "time".
- You can't control the "market" nor the individual stock prices; but you can control your "reaction" to the market.
- Intelligent investing is knowing "what" to buy; smart investing is knowing "when" to buy.
- Your profit is determined by your purchase price and not your sale price. Timing your purchase is important.
- Don't ask the price of the stock, ask what is the worth of the entire company to know whether the stock is worth investing.
- Don't expect your broker to help you to earn "for" you. He is there to earn "from" you.
- The sub-broker made money and the main broker made money and two out of three making money in a single transaction is not a bad bargain.
- Never ask a broker whether you should buy a particular stock, it is like asking a barber if you needed a haircut.