Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 110

How to think rationally about shares

At times of buoyant markets and relatively easy gains, ask yourself whether your approach to investing in shares and building a portfolio condemns you to a lifetime of returns and emotions that rise and fall with the market. If a rising tide lifts all boats and if it’s easy to mistake a rising market for genius, then it pays to examine the approach you have adopted to investing and ask whether it is rational, repeatable and replicable.

Shares are pieces of businesses

It is cause for increasing dismay that despite the rise in popularity of shares and dividend yields, there has been no trend towards a rational approach. And perhaps surprisingly, this is true of both seasoned professionals and part time ‘investors’. For example in the professional space, fund managers, in an effort to reduce portfolio risk, build portfolios of low covariance stocks – buying even very risky companies simply because their shares move in a different direction to the others. Perhaps even more worryingly, part time investors buy shares in companies without proper due diligence and in the hope they’ll simply go up.

Indeed, John Kenneth Galbraith in his book The Great Crash, wrote that one of the key ingredients of a bubble was the replacement of considerations of an asset’s long run worth, future income and its enjoyment, with base hopes of rising prices next week and next month.

Shares need to be treated as pieces of businesses rather than bits of paper that wiggle up and down on a computer screen. But few investors do this. Witness the professional investor who buys a company loaded with debt and a manufacturer of some generic junk because its inclusion in the portfolio reduces its overall volatility. Witness the same professional who cannot buy the shares of a great business when they are truly cheap, instead having to wait until the shares have risen sufficiently to cause them to be included in the S&P/ASX200. Buying shares this way or simply buying in the hope they will rise, is not the same as buying a piece of a business.

Over time, the value of a business changes only slowly, and much less than their daily prices on the stock market. The purchase of shares without reference to the quality or value of the business is no different to betting on black or red. Similarly, the focus on daily quoted prices of shares encourages the treatment of the stock market as a casino. Gamblers and those who frequent casinos tend to lose. In contrast, treating shares as pieces of a business helps investors outperform those who don’t.

Focus on relatively few excellent businesses

Whether it is because it is seen as too difficult or produces too much volatility, few investors simply purchase at attractive prices, a portfolio of 15 to 20 excellent businesses. This is despite the fact that such an approach can produce substantial outperformance.

There are two steps investors need to adopt: first, identify superior businesses, and second, estimate their true value.

Identifying a superior business is easy. Simply look at its economic performance and earnings power.

In our previous article, Airlines and indices, I described the economics of an airline and explained how the behaviour of equity, debt, profits and return on equity, over years, provides an indisputable picture of the economics of a business as if it were owned in its entirety and how this can be used to select extraordinary businesses.

As Warren Buffett once quipped, “If you aren’t prepared to own the whole business for 10 years, don’t buy a little piece of it for 10 minutes.”

Once you embark on an examination of a business from a business owner’s perspective, using equity and return on equity, you not only create a list of candidates worthy of inclusion in a portfolio but you simultaneously simplify your investment process, by creating a benchmark.

A benchmark is a line in the sand or a corral against which you compare outsiders to those things already inside. Your investment process is simplified because nothing needs to be considered unless it is better than the things already on the inside.

Many investment professionals, and the academics who taught them, agree that you reduce your risk by diversifying broadly. I agree that if you buy shares in a lot of different companies whose share prices move in different directions, you will reduce the overall price volatility of your portfolio. But does it make sense to buy shares in an inferior company simply because its share price moves in a different direction to the others that you already have? Why on earth would you buy shares in your twentieth best thing, when you can buy more shares in your best holding? Why cut down your roses to let the weeds through? I believe you reduce real risk – the risk of permanent capital loss - by only owning superior businesses.

Great businesses have high rates of return on equity, little or no debt, bright prospects and sustainable competitive advantages. A sustainable competitive advantage is the intangible thing about a company that the competition cannot replicate or imitate. It’s the reason people will cross the street to get the product even if the guy on this side has an alternative with a lower price. It’s a barrier to entry or a barrier to imitation. Ultimately, it generates the high rates of return on equity. Over time such business should retain profits at a high rate and increase in intrinsic value at a similar rate to the rate of growth in their equity value. And if I told you that company XYZ’s intrinsic value would rise substantially over the next 5 or 10 years, would it matter if the shares fell today?

Choose quality at the right price

Take the case of a company with a low rate of return on equity and little prospect of improving dramatically in the near future. Exclude it. What about a company with bright prospects for its product or service, no debt and 10 years of stable returns on equity of 30%? Include it. Eventually you fill a corral with companies showing a demonstrated track record of superior economic performance. No longer will you be tempted to dabble in the unknown, punting on whether the market or interest rates, employment or inflation will rise or fall in the next few days. Instead, you will keep a protective eye over a short list of great businesses, any of which are candidates for your portfolio if they become available at a discount to intrinsic value.

In our next column for Cuffelinks, we’ll write about that intrinsic value, a DIY on estimating intrinsic value for popular mechanics.

 

Roger Montgomery is the Chief Investment Officer of The Montgomery Fund. This article is for general education purposes and does not address the specific circumstances of any individual.

RELATED ARTICLES

Should you be a value or growth investor?

Unwinding is warning of late stages of boom

To zig or to zag?

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Let's make this clear again ... franking credits are fair

Critics of franking credits are missing the main point. The taxable income of shareholders/taxpayers must also include the company tax previously paid to the ATO before the dividend was distributed. It is fair.

Welcome to Firstlinks Edition 424 with weekend update

Wet streets cause rain. The Gell-Mann Amnesia Effect is a name created by writer Michael Crichton after he realised that everything he read or heard in the media was wrong when he had direct personal knowledge or expertise on the subject. He surmised that everything else is probably wrong as well, and financial markets are no exception.

  • 9 September 2021

Latest Updates

Investment strategies

Joe Hockey on the big investment influences on Australia

Former Treasurer Joe Hockey became Australia's Ambassador to the US and he now runs an office in Washington, giving him a unique perspective on geopolitical issues. They have never been so important for investors.

Investment strategies

The tipping point for investing in decarbonisation

Throughout time, transformative technology has changed the course of human history, but it is easy to be lulled into believing new technology will also transform investment returns. Where's the tipping point?

Exchange traded products

The options to gain equity exposure with less risk

Equity investing pays off over long terms but comes with risks in the short term that many people cannot tolerate, especially retirees preserving capital. There are ways to invest in stocks with little downside.

Exchange traded products

8 ways LIC bonus options can benefit investors

Bonus options issued by Listed Investment Companies (LICs) deliver many advantages but there is a potential dilutionary impact if options are exercised well below the share price. This must be factored in.

Retirement

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Investment strategies

Three demographic themes shaping investments for the future

Focussing on companies that will benefit from slow moving, long duration and highly predictable demographic trends can help investors predict future opportunities. Three main themes stand out.

Fixed interest

It's not high return/risk equities versus low return/risk bonds

High-yield bonds carry more risk than investment grade but they offer higher income returns. An allocation to high-yield bonds in a portfolio - alongside equities and other bonds – is worth considering.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.