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You the speculator

Unwittingly, you are probably a speculator rather than an investor and I’m making it the role of this series of articles for Cuffelinks to encourage you to turn your back on speculating forever and to become an investor.

Sustained sharemarket success begins with thinking like a business owner, rather than a trader of stocks. Betting on the next ‘up’ or ‘down’ is tantamount to betting on black or red at the casino. It’s not investing. Further, when someone says, “I just ‘invested’ in a tech start up,” it’s incorrect.  Speculating is not investing.

When colleagues tell you about a hot stock they own and you buy it, or a newspaper story makes a compelling case for selling a stock and you sell it, you are not acting like an investor. When a broker publishes an aggressive research note on a stock and you buy, or maybe you have a hunch that China will grow faster than expected, so you punt on quick gains in commodity and resource stocks, you aren’t investing either.

Not only are the above approaches a common way to construct a portfolio, but the one that results is a hotchpotch of ideas and beliefs that will usually amount to little. Worse, when something inevitably does go wrong, you have learned nothing from the experience because none of it was systematic, replicable or repeatable. Not only was the focus on stocks rather than businesses but it was also on price rather than value.

In fact, by listings volume, the sharemarket is far more geared towards speculation than investing. A simple search of listed Australian companies that earned more than $1 in their latest reporting period reveals that only about a third of the 2,188 ASX-listed entities made a profit and a large number of those were barely in the black. Two in every three listed companies could not cover their costs, and many will have to rely on capital raisings to stay alive. Owning such stocks requires a leap of faith that the company will eventually be profitable and while faith may prove beneficial spiritually, there is little place for it in investing.

There’s nothing wrong with experienced day-traders punting on loss-making companies, provided they understand the risks of speculation, and have enough skill to overcome the enormous odds stacked against them, including:

  • the impossibility of properly valuing loss-making companies
  • the potential for higher price volatility in such stocks
  • the huge dangers of illiquidity.

You don’t need to trade the two-thirds of loss-making companies on the ASX to boost your portfolio’s value over time. There are more than enough opportunities in the universe of profitable businesses to make double-digit returns from the sharemarket without excessive risk. My company does this successfully as a manager of other people's money.

Become an informed investor

It’s among the profitable companies where you should truly start to think like an owner of a business rather than a renter of pieces of paper that are represented by wiggles on a screen in some broker’s office. And it’s here where you’ll find extraordinary businesses at bargain prices.

Arguably, the best long-term risk adjusted returns come from buying exceptional businesses and holding them for as long as they remain exceptional, continue to have bright prospects for intrinsic value growth and share prices do not diverge too far above forecast intrinsic values.

Sustained equity investment success requires two core skills and the right temperament – the latter is up to you and your parents.  The two core skills are the ability to identify a superior business and the ability to value that business.

While myriad investment studies have shown that asset allocation is also a meaningful driver of overall investment returns, my view is that the top-down approach is fraught with errors from which little can be learned for the purposes of future exclusion. However, ability to value businesses produces a list of those that are expensive and those that are cheap. When the vast majority of companies are expensive and there are few securities worthy of investment, the only conclusion is that more funds must be allocated to cash. In one sense, a bottom up approach, such as the one contemplated here, produces the only sensible asset allocation.

Don’t be an unwitting speculator

If you don’t have an estimate for the value of a business and you buy its shares, you are, by definition, speculating and betting someone will be willing to pay more at a later date than you just did.

This is a critical point. Speculation is not just owning an unprofitable exploration or biotech company and hoping it will one day make money. It also occurs when investors buy a profitable company, perhaps even a so-called blue-chip, without having a view on its valuation, or how that valuation is changing over time. In effect, the person is unwittingly speculating rather than investing.

Imagine if a friend or colleague asked you to invest in a private company. Your first question would probably be, “What are the chances of the business going bust?” That is, is the business profitable, how much debt does it have, and can it comfortably meet its interest repayments?

Your second question might be, “Is it a good business?” Does it operate in an attractive industry, sell a good product, have an excellent reputation and client list? Does it have a long-term record of rising profits and, more importantly, a rising return on equity (ROE) or return on shareholder funds? Do you believe the ROE will continue to rise over time and lead to a higher company valuation? And will the ROE be sufficiently high to compensate for the risk in this investment?

Your third question would probably be, “How much do I have to pay to own X% of the company?”

From the answers, you determine what the company is worth, and assess that against the asking price. A view of the company’s worth (its intrinsic value) helps you make astute decisions when prices rise or fall because you understand the difference between value and price.

Don’t be swayed by market noise

So what stops us thinking like a part-owner in a business when it comes to listed companies, and instead act like part of a herd? Market noise plays a big role. We are seduced by media headlines, magazine stories on “hot stocks under $1”, television finance channels, and broker reports. We fear missing out more than we fear losing money. We latch on to supposed expert views and succumb to ever-larger waves of stock commentary, failing to realise that the entire machine has been set up to promote noise and activity.

Investors instead need a quiet, controlled detachment from the sharemarket. Step number one simply involves turning the sharemarket noise off.

Market noise amplifies those two great investing emotions: greed and fear. Market noise triggers the purchase of low-quality companies in the hope of making a quick buck, and market noise triggers the sale of high-quality companies because there was no appreciation that a sharply rising price was simply following the company’s rising intrinsic value or was all occurring well below that value. Having a clear yardstick for company value helps you know when to be greedy and fearful, usually well in advance of the herd that uses sharemarket noise as its decision-making trigger.

In the next instalment, we’ll look at how to assess a business’s quality. For now, remember the following:

  • the focus on price movement, and the expectation of profit from it rather than from business performance, is pure speculation, not investing

  • instead of renting bits of paper and hoping they will go up in price tomorrow or next week or next month, investing involves buying a slice of a business after considering the facts and applying common sense

  • buy shares in order to own businesses. Don’t buy shares merely to sell them.

 Roger Montgomery is the founder and Chief Investment Officer at The Montgomery Fund, www.montinvest.com. He is the author of Value.able, My 2 Cents Worth Publishing, 2010.

 

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