Have you ever thought about investing in stocks? It seems like a good way to grow your money if you’re planning for a comfortable retirement. We’ve heard of people who succeeded in building wealth by investing modest amounts in stocks, whether they saved it for retirement or even borrowed it to embark on an exciting journey that led to a dramatic change in their financial situation. The greatest investors in the stock market, such as Benjamin Graham, Warren Buffett, and Charlie Munger, viewed stocks differently due to their extensive experience and knowledge in finance and business. This perspective was key to their success in building vast wealth by leveraging market fluctuations to their advantage. However, some investors in this field believe they can invest in stocks without adhering to the proper rules of the game, which sometimes exposes them to losses or even bankruptcy. So, what are the rules that lead to success in stock investing?
The truth about Stock markets
Diving into stock investment is an exciting experience. When you put your money into stocks, you remain in a state of anticipation, hoping their prices will rise so you can sell them for a higher return. However, always thinking this way is a mistake, especially since financial markets are known for their volatility. Stock prices may soar at times and fall at others. The truth is that a stock's price does not necessarily reflect the company's true value. Stock prices often fluctuate due to various factors that influence the general sentiment of market participants. When sentiment towards certain companies' stocks is positive, their prices continue to climb. But once they reach a level much higher than their real value, a phenomenon known as a "bubble" can occur. This is dangerous because when the bubble bursts, stock prices plunge below their actual value, and investors' hopes are dashed. This happened in the Dot-com bubble in 2000, the real estate bubble in 2008 in the United States, which led to the collapse of major banks, and even earlier with the Tulipmania bubble in 17th-century Netherlands, where the price of a single tulip flower imported from the colonies in the East rose to the equivalent of ten years’ salary for a worker.
Inflation, Interest Rates, and Bonds
There are three things you must understand for stock investment, as they have a direct impact on stock prices and their true value: interest rates, inflation, and bonds. Interest rate refers to the profit rate agreed upon by the lender and borrower, where the borrower must repay the amount to the lender along with the agreed-upon profit. Inflation, on the other hand, is the decrease in the nominal value of money used to buy goods. So, what your grandfather could buy for a certain amount in his time would now cost you multiple times that amount. Bonds represent a loan with a promise of repayment within a specified period, where the borrowing company or government issues bonds that provide the lender with specific returns until the original loan amount is repaid. Economically, interest rates are set by governments through the central bank. When rates are raised, it means companies and individuals will borrow less from banks to fund economic activities, purchases, and stock investments. The central bank raises interest rates when the economy is strong and purchasing power is high, as a way to prevent bubbles from forming due to excessive buying of stocks and goods. Conversely, when the economy is struggling, the central bank lowers interest rates to encourage spending, leading to increased production and job creation. This usually results in lower stock prices, which can be the best time to buy. Governments gradually increase inflation by injecting more money into the markets, and they do this for several reasons. First, it encourages people to spend more before prices rise further, which drives economic growth. Second, it increases government revenue from taxes imposed on corporate and individual earnings, as taxes are levied on the nominal value of currency, not its real value.
Financial Reports Are The Key To Understanding The Value Of The Company You Are Investing in
It's essential to understand the true value of the company you’re investing in by analyzing three types of financial reports it periodically issues. These reports are required by governments to assess the company’s performance and predict its future.
The first report is the *Income Statement*, which shows the company’s profits or losses over a specific period (quarterly or annually) by detailing its revenues and expenses within that timeframe. The difference between these appears as either profit or loss, which is then distributed across the company's shares as *Earnings Per Share* (EPS), giving you insight into the return on your investment.
The second report is the *Balance Sheet*, which reflects the true value of the company (and, consequently, the shares you invested in) by showing what the company owns in assets (buildings, facilities, equipment, etc.) and the value of the liabilities used to finance these assets. The liabilities section includes both external debt (from financing companies or banks) and internal debt, like *Shareholders’ Equity*.
The third report is the *Cash Flow Statement*, which tracks the movement of cash in and out of the company. This helps to understand the company’s liquidity and to avoid situations where it cannot meet its financial obligations to creditors, employees, and shareholders.
Warren Buffett's Principles Of Value Investing: Knowing The Vigilant Leaders
Warren Buffett built a fortune estimated at around sixty billion dollars through stock investing by focusing on companies' true value. He followed four fundamental principles: understanding vigilant leadership, recognizing long-term potential, ensuring stock stability, and buying at attractive prices. For Buffett, vigilant leadership means that the management of companies he plans to invest in must always prioritize the interests of investors. He identifies successful leadership by three main traits in a company: low debt, high cash liquidity, and strong, consistent returns on shareholders’ equity. Some management teams take on debt to fund the company and accelerate growth, such as purchasing assets or new technology to maintain competitiveness and increase revenue. However, management must carefully assess risks before taking this step, as borrowing during prosperous times can be beneficial, but it poses a significant risk if product demand declines. When a company has high cash liquidity, it indicates a strong financial position, meaning its income from assets exceeds its expenses and debts. Companies with high returns on shareholders' equity are generally more attractive for investment.
Warren Buffett's Principles Of Value Investing: Long-Term Potential
For value investors, it’s important that a company's products achieve stable long-term sales and face low sales tax rates. Products like the iconic Coca-Cola drink, for instance, are not affected by technological changes, and successive generations continue to enjoy the drink as it is. This is an excellent example of a product that maintains its sales rate over a long period. In contrast, these investors tend to avoid companies whose products are constantly subject to competition, such as smartphone companies, due to the high cost of developing these products to stay competitive. Value investors also aim to minimize the taxes they pay on their investments. The tax systems in several countries favor value investors over stock speculators who aim to build wealth quickly. Value investors hold their stocks for the long term based on the companies' performance, which means they pay a lower tax rate on their stock income as long as they don’t sell. Speculators, on the other hand, pay a higher tax rate, as it includes a tax on gains from selling stocks within less than a year. As a result, speculators end up with lower actual income due to tax erosion.
Stock Stability
Warren Buffett prefers investing in stable companies whose business activities are easy to understand, which helps reduce risk. He considers two important factors: stable growth in the owner's book value and the sustainability of a competitive advantage. For the first factor, Buffett views steady growth in the book value of shareholders' equity over the long term as a sign of the company’s healthy performance. This is measured by understanding shareholders' returns, which reflect on each share's earnings, thereby increasing its value over time. The second factor is competitive advantage through brand value or purchasing power. For instance, Coca-Cola has a highly valuable brand, giving it an edge over its competitors. Similarly, Microsoft has an advantage due to its ability to purchase large quantities from suppliers at more favorable prices. This allows it to increase sales at lower prices, making it harder for customers to switch to a more costly or less capable product. This purchasing power contributes significantly to the competitive strength of Microsoft’s software.
"Be accurate, be balanced, and be cautious (ABCs) when choosing the future growth rate."
Buying At Attractive Prices
Warren Buffett operates by the principle, "A bird in the hand is worth ten in the bush." For him, there are six pillars he relies on to evaluate a stock for investment.
The first is maintaining a sufficient margin of safety when buying stocks, especially when investing in companies outside your area of expertise. This reduces the risk of misjudging the stock’s true value and provides room to exit with minimal losses if needed. The second pillar is a low price-to-earnings (P/E) ratio, which is attractive and enticing. Remember that the true value of a stock lies in the performance of the company it represents, not in the market price, which constantly fluctuates. When considering investment in a particular stock, look at its stable, sustainable earnings relative to the price you pay. The third pillar is a low book value (or shareholder equity) ratio, which aligns with the idea of a low P/E ratio for investors. Keep in mind that shareholder equity reflects funding provided to the company to boost stock returns. For example, funding a stock at $5 to earn $1 is not acceptable. The fourth pillar is setting a safe discount rate when purchasing stocks. When the risk of a particular investment is high, you want a high return on the stock by buying it at the lowest possible price to balance the risk. The fifth pillar involves determining the discount rate and intrinsic value by using formulas to assess a stock's actual worth in companies targeted for investment. The evaluation of a stock’s true value varies from one investor to another. The sixth and final pillar is knowing the right time to sell your invested stocks. In some cases, it may be better to consider selling your shares rather than holding onto them and speculating, which could cost you heavily due to taxes that erode much of your income.
Conclusion
Investing in financial markets is not difficult, but it’s a precise process that requires understanding certain aspects of the economic situation, the performance of the company you're investing in, and having the patience to let your wealth grow steadily and securely. It also involves conducting some logical calculations to produce reasonably accurate forecasts based on facts, rather than relying on speculators' guesses, which often cost more than they yield. This approach ensures a profit on the stocks you’ve invested in. It’s also essential to know the right time to sell your stocks to minimize losses and enter better investments with higher returns. After all, a stock is essentially money in the form of a share in a company, and you’re trading some of your shares for others that offer better returns with lower risks.