The Mindset of a Value Investor
Investing vs. Speculating:
As many great investors say, any intelligent investment is a value investment. But what do we mean by a smart investment? Essentially, there are two distinct approaches to stocks: investing and speculating.
First, you need to decide what you aim to achieve with stocks. You can speculate in the market and potentially make money, or you can invest in stocks and grow your wealth. Among the younger generation, speculation is much more popular. Speculation is exciting and offers the thrill of quick gains, whereas investment is often seen as boring. Not everyone loves the slower, more methodical approach of investing.
Investor vs Speculator:
However, let’s look at some research data to highlight the differences. Over 10 years, 95% of speculators lose their capital, while 95% of intelligent investors grow their capital over the same period. While you can make some profit in the short term through speculation, in the long run, it often leads to losing money.
Investing, on the other hand, requires a lot of mental strength, continuous learning, and mental disciplines such as extreme patience. While it might be less exciting, it is ultimately more rewarding. So, let’s continue our discussion assuming you are an intelligent investor focused on value investing.
How to Value a Stock
Once you identify yourself as an intelligent investor, you need to understand the attitude of an intelligent investor toward stocks. The main difference between value investors and others is that value investors primarily focus on valuing the business. They always try to determine the right value of the company, seeing stocks as portions of businesses rather than lottery tickets. To value a stock, you need to understand some basic fundamental knowledge about business.
Identify How the Business Makes Money:
- Understand the business operations of the company.
- Know the products and services they sell.
Analyze Financial Performance:
- Revenue: Determine the revenue generated each year.
- Revenue Growth: Look at the revenue growth over the last 10-20 years.
- Gross Profit Margin: Examine the gross profit margin of the company.
- Net Profit: Review the net profit of the company and its growth over the decade.
Assess Financial Position:
- Assets, Liabilities, and Equity: Analyze the financial position of the company by looking at its assets, liabilities, and equity.
Calculate Key Financial Ratios:
- Debt to Equity Ratio: Measures the company’s leverage.
- Current Ratio: Assesses the company’s ability to pay short-term obligations.
- Earnings Per Share (EPS): Indicates the company’s profitability per share.
- Price to Earnings (P/E) Ratio: Helps compare stock prices to earnings.
Evaluate Dividend Information:
- Dividend Payments: Check if the company pays a dividend.
- Dividend Consistency: Determine if the company pays dividends consistently.
- Dividend Yield and Payout Ratio: Look at the dividend yield and dividend payout ratio.
By thoroughly analyzing these aspects, you can gain a comprehensive understanding of a stock’s value and make informed investment decisions.
The Right Time to Buy, Sell, & Hold
Once you identify the intrinsic value of a stock, always aim to buy the stock below its intrinsic value. No matter how good the product, service, or business, always keep in mind to buy under its value.
Key Concepts:
- Intrinsic Value: The true worth of a company based on its fundamentals.
- Margin of Safety: The difference between the intrinsic value and the price you pay for the stock. This margin protects you from losing your capital.
Investment Rules:
- First Rule: Don’t lose money.
- Second Rule: Never forget the first rule.
Importance of Margin of Safety:
- Even the best analysts, as John Templeton says, will be wrong at least one out of three times.
- Always maintain a margin of safety to protect against errors and market volatility.
Benefits of Buying at a Discount:
- Holding the Stock: Once you buy the stock with a margin of safety, you can benefit by holding it.
-
- As a stockholder, you become an owner of the company.
- Most companies share a portion of their profits with shareholders through dividends.
- Price Appreciation: Over time, the stock price would likely increase.
- You would collect dividends over the holding period.
- Eventually, the stock price might surpass the intrinsic value of the company.
Selling for Profit:
- When the stock price exceeds the intrinsic value, you can sell your stock position and realize a profit.
By following these principles, you can make informed decisions about when to buy, sell, and hold stocks, maximizing your chances of long-term success.
