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The Five Rules for Successful Stock Investing
IT ALWAYS AMAZES me how few investorsâand sometimes, fund managersâcan articulate their investment philosophy. Without an investing framework, a way of thinking about the world, youâre going to have a very tough time doing well in the market.
I realized this some years ago while attending the annual meeting of Berkshire Hathaway, the firm run by billionaire superinvestor Warren Buffett. I overheard another attendee complain that he wouldnât be attending another Berkshire meeting because âBuffett says the same thing every year.â To me, thatâs the whole point of having an investment philosophy and sticking to it. If you do your homework, stay patient, and insulate yourself from popular opinion, youâre likely to do well. Itâs when you get frustrated, move outside your circle of competence, and start deviating from your personal investment philosophy that youâre likely to get into trouble.
Here are the five rules that we recommend:
1. Do your homework.
2. Find economic moats.
3. Have a margin of safety.
4. Hold for the long haul.
5. Know when to sell.
Do Your Homework
This sounds obvious, but perhaps the most common mistake that investors make is failing to thoroughly investigate the stocks they purchase. Unless you know the business inside and out, you shouldnât buy the stock.
This means that you need to develop an understanding of accounting so that you can decide for yourself what kind of financial shape a company is in. For one thing, youâre putting your own money at risk, so you should know what youâre buying. More important, investing has many gray areas, so you canât just take someone elseâs word that a company is an attractive investment. You have to be able to decide for yourself because one personâs hot growth stock is anotherâs disaster waiting to happen. In Chapters 4 through 7, Iâll show you what you need to know about accounting and how to boil the analysis process down to a manageable level.
Once you have the tools, you need to take time to put them to use. That means sitting down and reading the annual report cover to cover, checking out industry competitors, and going through past financial statements. This can be tough to do, especially if youâre pressed for time, but taking the time to thoroughly investigate a company will help you avoid many poor investments.
Think of the time you spend on research as a cooling-off period. Itâs always tempting when you hear about a great investment idea to think you have to act now, before the stock starts movingâbut discretion is almost always the better part of valor. After all, your research process might very well uncover facts that make the investment seem less attractive. But if it is a winner and if youâre truly a long-term investor, missing out on the first couple of points of upside wonât make a big difference in the overall performance of your portfolio, especially since the cooling-off period will probably lead you to avoid some investments that would have turned out poorly.
Find Economic Moats
What separates a bad company from a good one? Or a good company from a great one?
In large part, itâs the size of the economic moat a company builds around itself. The term economic moat is used to describe a firmâs competitive advantageâin the same way that a moat kept invaders of medieval castles at bay, an economic moat keeps competitors from attacking a firmâs profits.
In any competitive economy, capital invariably seeks the areas of highest expected return. As a result, the most profitable firms find themselves beset by competitors, which is why profits for most companies have a strong tendency over time to regress to the mean. This means that most highly profitable companies tend to become less profitable as other firms compete with them.
Economic moats allow a relatively small number of companies to retain above-average levels of profitability for many years, and these companies are often the most superior long-term investments. Longer periods of excess profitability lead, on average, to better long-term stock performance.
Identifying economic moats is such a critical part of the investing process that weâll devote an entire chapterâChapter 3âto learning how to analyze them. Hereâs a quick preview. The key to identifying wide economic moats can be found in the answer to a deceptively simple question: How does a company manage to keep competitors at bay and earn consistently fat profits? If you can answer this, youâve found the source of the firmâs economic moat.
Have a Margin of Safety
Finding great companies is only half of the investment processâthe other half is assessing what the company is worth. You canât just go out and pay whatever the market is asking for the stock because the market might be demanding too high a price. And if the price you pay is too high, your investment returns will likely be disappointing.
The goal of any investor should be to buy stocks for less than theyâre really worth. Unfortunately, itâs easy for estimates of a stockâs value to be too optimisticâthe future has a nasty way of turning out worse than expected. We can compensate for this all-too-human tendency by buying stocks only when theyâre trading for substantially less than our estimate of what theyâre worth. This difference between the marketâs price and our estimate of value is the margin of safety.
Take Coke, for example. Thereâs no question that Coke had a solid competitive position in the late 1990s, and you can make a strong argument that it still does. But folks who paid 50 times earnings for Cokeâs shares have had a tough time seeing a decent return on their investment because they ignored a critical part of the stock-picking process: having a margin of safety. Not only was Cokeâs stock expensive, but even if you thought Coke was worth 50 times earnings, it didnât make sense to pay full priceâafter all, the assumptions that led you to think Coke was worth such a high price might have been too optimistic. Better to have incorporated a margin of safety by paying, for example, only 40 times earnings in case things went awry.
Always include a margin of safety into the price youâre willing to pay for a stock. If you later realize you overestimated the companyâs prospects, youâll have a built-in cushion that will mitigate your investment losses. The size of your margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms with reasonably predictable earnings. For example, a 20 percent margin of safety would be appropriate for a stable firm such as Wal-Mart, but youâd want a substantially larger one for a firm such as Abercrombie & Fitch, which is driven by the whims of teen fashion.
Sticking to a valuation discipline is tough for many people because theyâre worried that if they donât buy today, they might miss the boat forever on the stock. Thatâs certainly a possibilityâbut itâs also a possibility that the company will hit a financial speed bump and send the shares tumbling. The future is an uncertain place, after all, and if you wait long enough, most stocks will sell at a decent discount to their fair value at one time or another. As for the few that just keep going straight up year after yearâwell, letâs just say that not making money is a lot less painful than losing money you already have. For every Wal-Mart, thereâs a Woolworthâs.
One simple way to get a feel for a stockâs valuation is to look at its historical price/earnings ratioâa measure of how much youâre paying for every dollar of the firmâs earningsâover the past 10 years or more. (We have 10 yearsâ worth of valuation data available free on Morningstar.com, and other research services have this information as well.) If a stock is currently selling at a price/earnings ratio of 30 and its range over the past 10 years has been between 15 and 33, youâre obviously buying in at the high end of historical norms.
To justify paying todayâs price, you have to be plenty confident that the companyâs outlook is better today than it was over the past 10 years. Occasionally, this is the case, but most of the time when a companyâs valuation is significantly higher now than in the past, watch out. The market is probably overestimating growth prospects, and youâll likely be left with a stock that underperforms the market over the coming years.
Weâll talk more about valuation in Chapters 9 and 10, so donât worry if youâre still wondering how to value a stock. The key thing to remember for now is simply that if you donât use discipline and conservatism in figuring out the prices youâre willing to pay for stocks, youâll regret it eventually. Valuation is a crucial part of the investment process.
Hold for the Long Haul
Never forget that buying a stock is a major purchase and should be treated like one. You wouldnât buy and sell your car, your refrigerator, or your DVD player 50 times a year. Investing should be a long-term commitment because short-term trading means that youâre playing a loserâs game. The costs really begin to add upâboth the taxes and the brokerage costsâand create an almost insurmountable hurdle to good performance.
If you trade frequently, youâll rack up commissions and other expenses that, over time, could have compounded. Every $1 you spend on commissions today could have been turned into $5.60 if you had invested that dollar at 9 percent for 20 years. Spend $500 today and you could be giving up more than $2,800 20 years hence.
But thatâs just the beginning of the story because frequent trading also dramatically increases the taxes you pay. And whatever amount you pay in taxes each year is money that canât compound for you next year.
Letâs look at two hypothetical investors to see what commissions, trading, and taxes can do to a portfolio. Long-Term Lucy is one of those old-fashioned fuddy-duddies who like to buy just a few stocks and hang on to them for a long time, and Trader Tim is a gunslinger who likes to get out of stocks as soon as heâs made a few bucks (see Figure 1.1).
Figure 1.1 Tim turns over his portfolio every six months, incurring a 35% short-term capital gains tax. Lucyâs gains are taxed at only 15% thanks to her buy-and-hold strategy, and more of her money compounds over a longer time. Source: Morningstar, Inc.
Lucy invests $10,000 in five stocks for 30 years at a 9 percent rate of return and then sells the investment and pays long-term capital gains of 15 percent. Tim, meanwhile, invests the same amount of money at the same rate of return but trades the entire portfolio twice per year, paying 35 percent short-term capital gains taxes on his profits and reinvesting whatâs left. Weâll give them both a break and not charge them any commissions for now.
After 30 years, Lucy has about $114,000, while Tim has less than half that amountâonly about $54,000. As you can see, letting your money compound without paying Uncle Sam every year makes a huge difference, even ignoring brokerage fees.
And since holding a single stock for 30 years may not be realistic, letâs consider what happens if Lucy sells her entire portfolio every five years, reinvesting the proceeds each time. In this case, she winds up with about $96,000âwhich is not much less than $114,000 and is still much more than Timâs $54,000 (see Figure 1.2).
These examples look at just the tax impact of frequent tradingâthings look even worse for the traders once we factor in commissions. If we assume that Tim and Lucy pay $15 per trade, Tim nets only about $31,000 after 30 years and Lucy nets $93,000, again assuming she holds her stocks for five years (see Figure 1.3).
Figure 1.2 Lucy decreases her holding period to 5 years from 30 years, but the benefit of lower taxes and a longer compounding period still nets her significantly more than Tim. Source: Morningstar, Inc.
The real-world costs of taxes and commissions can take a big bite out of your portfolio. Extending your average holding period from six months to five years yields about $62,000 in extra investment returns. Lucy gets a lavish reward for her patience, donât you think?
One final thought: To match Lucyâs $93,000 portfolio value, Tim would need to generate returns of around 14 percent each year instead of 9 percent. Thatâs the true cost of frequent trading in this exampleâabout five percentage points per year. So, if you really think that churning your portfolio will get you five extra percentage points of performance each year, then trade away. If, like the rest of us, you were taught some humility by the bear market, be patientâitâll pay off.
Know When to Sell
Ideally, weâd all hold our investments forever, but the reality is that few companies are worth holding for decades at a stretchâand few investors are savvy enough to buy only those companies. Knowing when itâs appropriate to bail out of a s...