Don't Buy a Stock Just Because Everyone Hates It.
Warren Buffett recently became the third richest man alive and it’s all thanks to his strategic, long-term investment approach. Although some may think his approach is boring, evidence clearly shows that his approach is spot-on. Warren Buffett invests in companies that show sound, long-term prospects and always keeps a margin of safety. His investment strategy has popularly been referred to as Buffettology.
Buffett buys unloved stocks not because they are unloved, but because they are great value stocks. He explains it in the following quote:
"None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." - Chairman's Letter, 1990
Put On Your Thinking Cap
Value Investing is based on the principle of buying beaten down stock that most investor don’t want. However, it doesn’t mean that you should simply buy all unpopular stocks for the sake of being a contrarian.
Warren Buffett is a clever investor (find some fantastic Warren Buffett facts here). He is somewhat of a contrarian in his approach, but still bases his share purchases on an array of variables. He compares a contrarian approach with herd-mentality, citing Bertrand Russell’s observation which states that the majority of people don’t think. Picking shares solely based on the fact that the masses dislike the stock is just as effective as buying what everyone else loves. Going with the flow will only get you as far as deliberately going against it. Make decisions based on hard facts and clear thoughts.
You should base your purchasing decisions on the value and strength of a company, which is determined by fundamental analysis. By looking at a company’s balance sheets, income statements and cash flow you can determine its health and future growth prospects. Ideally you are looking for a company with low debt and a lot of cash. Remember to also factor in the way in which the company is run and the proficiency of the company’s management team. The secret to successful investing is buying good businesses.
5 Investing Tips from Warren Buffett:
1. Do Sufficient Research
Knowledge is power. The first step to becoming a great investor is doing sufficient research. According to CNBC, Buffett reads five newspapers a day. Having knowledge of different markets and sectors will automatically give you the upper hand.
A good place to start is by reading quarterly reports. For beginners it can be difficult to interpret the data correctly. It is probably for the best to first familiarise yourself with the financial jargon used in these reports. You can find very handy cheat sheets for reading financial reports online. Once you have the hang of it, you should concentrate on becoming proficient at reading financial statements. Practise makes perfect.
2. Stick To What You Know
You might be reading double the amount of newspaper that Buffett reads, but there will always be an industry or sector that you know more of than the rest. One of the basic principles of Buffett’s investment strategy is that you should invest in sectors and industries that you understand. There will always be strong, undervalued shares to buy in any sector. You just have to put your mind to it and be determined to find those bargains. If you invest in what you know, you are investing with a great margin of safety.
3. Get Your Calculator and Hit those Numbers
There are a few basic calculations you need to make to determine the health of a company and the value of its assets. Here are some of the most important formulas:
Return on equity:
It measures the profitability of a business by revealing the profit made by a company with the money invested by shareholders. ROE is expressed as a percentage and calculated as follow:
Return on Equity = Net Income / Shareholder’s Equity
By using ROE you can compare the percentage to other businesses within the same industry. Look for companies with a number higher than 15%.
Buffett prefers using this metric over earnings per share because it measures the management’s ability to create value for shareholders.
This calculation is used to identify companies that are highly leveraged, meaning companies that have a lot of debt. The more debt a business has, the higher the risk for the investors. This is why debt-to-equity ratio is also one of Buffett’s parameters. A debt-to-equity ratio is calculated by dividing the company’s total liabilities by stockholders’ equity.
Debt-to-equity ratio = Liabilities / Equity
Buffett only invests in companies with ratios below 1. If the ratio is more than one, it means that the company might be financing its growth with debt, which is certainly not a sustainable practice. It can lead to volatile earnings, high interest rates or even bankruptcy.
Buffett only buys discounted stocks. “Whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down.” He uses price-to-book ratio as one of his metrics to calculate the value of a stock. The P/B ratio is calculated as follow:
P/B Ratio = Stock Price / (Total Assets – Intangible Assets & Liabilities)
The price-to-book ratio compares the cost of a stock to the value of the business, if it was broken down and sold today. The P/B ratio is unfortunately not enough to make a wise investment decision. This is because a low P/B ratio could mean that the stock is undervalued or at the same time mean that the company is earning very poor returns on its assets. It just shows how important it is to factor in all the metrics, especially the return on equity metric.
Forward price-to-earnings ratio:
The estimated P/E of a company is often used to compare current earnings to estimated future earnings, but it’s just an estimate and should not be considered reliable data – it’s merely a forecasting exercise. When calculating the forward P/E ratio one uses forecasted earnings. The calculation is as follows:
Forward P/E = Market Price Per Share / Expected Earnings Per Share
If earnings are expected to grow in the future, the estimated forward P/E ratio will be lower than the current P/E ratio. The lower the forward P/E ratio, the better the value.
4. Start Off Small and Don’t get Over Excited
Now that you have done your necessary research and calculations, you are ready to pick your stocks. After identifying which shares you want to purchase, you have to open a brokerage account. When doing so search for the one with the least amount of trading fees and commissions.
Start your portfolio off with a few stocks until you become more self-assured in your investment abilities. In the wise words of Warren Buffett: "When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever." Let your portfolio do the job for you. If you chose good value stocks and allocated them efficiently you will earn great returns in due time. Read some more Warren Buffett facts here.
Don’t move your portfolio around too much. It might look promising in the short term, but you won’t see any result in the long term. You will only be exposing yourself to unnecessary volatility. Regular trading will also be taxed every time – you don’t want your fees and commissions to outweigh your gains. Sit back, relax and watch as your earnings rise over time.
5. Ignore the Bears and the Bulls
Ignore what the media, analysts, financial advisors or investors say about the markets. You should keep a level-headed mindset and block out all market related opinions. No one can predict the rise or fall of the market. They might have pretty good guesses but nothing is guaranteed. If the market does face a downturn, you should feel confident that the stocks you bought will survive it. Rather concentrate on the great buying opportunities the downturn will deliver. The majority of investors struggle to block out the public’s opinion and panic sell their shares at tremendous losses. That is when we capitalise on the opportunity to expand our portfolios with great value stocks. Investing for the long haul is the best way to survive a market correction.
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