3 Steps to Stock Investing

Before we delve into the details, let's understand what we mean by a 'good' business. In the context of investing, a good business is one that consistently increases in value over time. It's like a tree that grows steadily, year after year, bearing fruits (dividends) for its shareholders.

How does a business increase in value? It's simple. A good business generates more money, indicated by higher sales, earnings (net profit/net income), and cash flow. Therefore, as an investor, you should look for businesses with consistently increasing sales revenue, net earnings, and cash flow from operations. These factors ensure long-term value growth.

Now, we must understand the correlation between the value of a business and its stock price. The stock price and dividends for shareholders are influenced by the value of the business. When a business increases in value, it leads to higher share prices and potentially more dividends for shareholders.

In the short term, stock prices are driven by factors like emotions, demand and supply, news events, and trade wars. Therefore, stock prices may fluctuate due to optimism or fear, causing the stock to become overvalued or undervalued compared to the company's true value. However, over time, the price of a stock reflects the true value of the business.

Several factors affect the value of a company. The green line on a company's stock chart represents the value of the company, which, in the long run, increases due to rising sales, profits, and cash flow. The short-term fluctuations in the stock price, represented by gyrations, are influenced by market volatility.

The growth of a business is not always a smooth ride due to the challenge of competition. Competition in the market hinders business growth by attracting competitors who offer lower prices and newer products. Some businesses, however, can raise prices, retain customers, and grow profits due to a sustainable competitive advantage. Brands like Colgate, McDonald's, and Domino's have brand monopolies in toothpaste, hamburgers, and pizza respectively.

A sustainable competitive advantage, also known as an economic moat, protects a company from losing customers to competitors. Warren Buffett emphasizes the importance of investing in companies with a sustainable competitive advantage.

A company with a strong brand can create a brand monopoly. High barriers to entry, like the ones seen with companies like Boeing and Airbus, can protect a business from new competition. High switching costs for products or services, like Adobe software or Microsoft Office, make it difficult for customers to change to alternatives. Finally, the network effect, as seen in platforms like YouTube, means that the more people use a product or service, the more others are compelled to use it.

In addition to a competitive advantage, a good business should also demonstrate resilience. It should be able to withstand legal issues, mistakes, recessions, or financial crises. Another crucial aspect is the management of debt. A conservative approach to debt and a strong cash reserve protect businesses from bankruptcy during financial hardships. A company with ample cash can survive recessions and acquire competitors, thereby strengthening its position in the market.

To be successful in investing, you must know when to enter the market. Look for opportunities to buy stocks below or near their true value. It's crucial to avoid buying when the price is above the intrinsic value and invest only when it is undervalued.

To identify the best buying opportunities, adopt a contrarian view. As suggested by Warren Buffett, be greedy when others are fearful and fearful when others are greedy. During crisis situations and bad news recessions, when people are fearful, share prices tend to temporarily decrease, presenting buying opportunities. Conversely, when people are greedy and stocks are in high demand, prices tend to become overvalued, prompting caution.

History has taught us that some of the best buying opportunities come in the middle of a crisis. Situations like the food scandal in China involving brands like KFC and McDonald's, the mad cow disease scare, the accusations against Facebook of selling data during the 2016 US election, and even a bear market triggered by an economic or financial crisis, have all created buying opportunities.

During such times, even good companies suffer due to market perceptions. However, if you understand that these crises are temporary and these companies will eventually recover, you can buy stocks of great businesses at a significant discount. Remember, this strategy involves patience, as you should wait for the downtrend to bottom out, consolidate, or reverse into an uptrend.

Although timing the market perfectly is virtually impossible, investing in good businesses with growth potential can still yield significant returns. Adopt strategies like dollar cost averaging and buying in stages to mitigate risk and potentially increase returns.

To illustrate this point, let's look at the example of investing in ExxonMobil shares during the subprime mortgage crisis, which caused panic in the financial sector. This situation led to a significant drop in stock prices, such as American Express going from $55 to $7 per share. Despite the crash, investing in ExxonMobil at or near the bottom and holding until the recovery began would have yielded a tidy profit.

While buying right is half the battle, knowing when to exit an investment is equally critical. If the business fundamentals deteriorate or the stock becomes over valued, it might be time to consider selling.

A business's fundamentals might deteriorate due to several reasons. For example, the company's competitive advantage may erode, or it might face increasing competition that impacts its earnings and growth potential. Similarly, changes in the industry, regulatory environment, or technological disruptions might adversely affect the company's future prospects. Therefore, constantly monitoring these factors is crucial to know when to exit an investment.

However, it's essential to differentiate between temporary setbacks and long-term fundamental changes. If the company's downturn is due to a short-term issue that is unlikely to impact its long-term potential, it might not be the best time to sell. In contrast, if the downturn is due to a fundamental shift in the company's business or industry, it might be time to reconsider your investment.

Additionally, if a stock becomes overvalued, it might also be time to sell. An overvalued stock is one where the current price is higher than its intrinsic value. This can happen due to excessive optimism in the market, leading to prices that are too high relative to the underlying business's actual value. In such cases, selling the stock and reinvesting the proceeds in more reasonably valued investments might be a wise move.

To gauge whether a stock is overvalued, you can use valuation metrics such as the Price to Earnings (P/E) ratio, Price to Sales (P/S) ratio, and Price to Book (P/B) ratio, among others. However, these metrics should always be used in conjunction with other fundamental analysis tools and not be the sole basis for making investment decisions.

In summary, successful investing involves a three-step process: identifying good businesses with growth potential and a sustainable competitive advantage, buying at or below the intrinsic value, and knowing when to exit. While this process might seem daunting, with the right knowledge, tools, and patience, it is a path that can lead to significant wealth creation over time.

In the following chapters, we will delve deeper into these aspects and equip you with the tools and strategies needed to become a successful investor. Whether you're a novice just starting your investment journey or an experienced investor looking to refine your strategies, the lessons in this book will be invaluable in helping you navigate the exciting world of investing.

Identifying Good Businesses

Finding businesses with potential to increase in value over time to lead to higher share prices and dividends.

Valuing a Business
Understanding the long-term value of a business and the short-term factors that affect stock prices. Knowing what drives value: sales, earnings and cash flow. Investing when stock price is near or below the value of the company.

Competition and Value of a Business
Businesses must compete to keep growing, but not all can consistently increase sales, revenue, net earnings and cash flow. Competition can cause businesses to lose market share and profits.

Sustainable Competitive Advantage
Companies like McDonald's, Nike, and Ferrari have a sustainable competitive advantage, or "economic moat", that allows them to keep raising prices and still retain customers.

Brand Monopoly and High Barriers to Entry
A brand monopoly and high barriers to entry make it difficult for competitors to enter the market, leading to an uptrend in share prices.
High Switching Cost
Products or services that require a lot of investment or time to learn make it difficult for customers to switch brands.
Network Effect
The more people that use a product or service, the more people will use it, creating a vested interest in the product.

Identifying Good Businesses

Understand the qualities of a good business, such as brand monopoly, high barriers to entry, and network effect. Monitor debt and cash position to ensure business can withstand recessions and bad news.
Undervalued Stock Prices

Invest when stock prices are undervalued or fairly valued, ideally at a support level or during a dip on an uptrend.

Fearful During Crisis: Be greedy when others are fearful and be fearful when others are greedy. People are fearful during crisis and bad news recessions, causing share prices to temporarily go lower.

Negative Perception: Investors have a negative perception of companies, causing share prices to fall even if the business is doing well.

Food Scandal in China
People sold off companies in same sector due to bad perception of one company. Yum Brands' share price dropped by 20-30% after food scandal in China, providing opportunity to buy undervalued stock.

Industry Recession
Oil prices collapse from $100 to $25 per barrel, causing oil and gas industry to enter recession. Share prices of leading companies like ExxonMobil, Shell, Chevron, ConocoPhillips dropped, creating buying opportunities.

Investing in Crisis

Opportunities to buy discounted stocks during wars and disasters, but only from market leaders. Buy when prices reverse back up.

Investing vs Trading:
Buying in stages near the bottom when it's starting to go up. Don't have to time entry exactly. Subprime mortgage crisis affected financial companies. Wait for price to reverse and get above 50 moving average for best entry. Buy great business at discount for best exit.

Exit Investment: Taking money from a declining business or an overvalued one to reinvest in a better business.

Summary:
Sell at a reasonable price to make a good profit, don't wait for the top. Redeploy cash if the business deteriorates and find another stock to invest in.