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Focus on Long-Term Economics

Establishing core investing principles provides a solid platform for a successful investment strategy. I find that most investors tend to lean toward being short-term motivated. They respond to short-term stimuli, whether market news or the optimism or hype of making a quick return on their investment.  They tend to buy on good news and sell on bad news regardless of a prospect's long-term economics.

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Don't be short-sighted, and don't ignore the long-term economics of a company's business.  The long-term prospects are all too often ignored, with the short-term mentality grossly overvaluing a company, while at other times the market similarly grossly undervalues a company.  Those undervalued opportunities can oftentimes be leveraged for long-term wealth creation!

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By analyzing the fundamentals of a company within a meaningful investment analysis, the real long-term economic value of a business properly values the company over time. If you've invested money at a discount when an investment was out of favor with the market for whatever reason, the increase in value down the line will also translate into an increase in wealth for you!

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Because of this, I oftentimes like to buy (new or additional stock) on bad news. If the underlying fundamentals of the company haven't changed but remain solid, strong management remains in tact, and the company is poised for doing good business over long-term generating strong returns on invested capital, that's a buying opportunity in my view.

Understand Your Investment

If you buy a company's stock, your money investment is based on partial ownership in that company. As a partial owner, you may receive an annual dividend, although all companies don't pay dividends and no company is required to pay a dividend. The real appeal to investing in stock can be found in the appreciation of the stock's value over time.  This may or may not occur all depending on how well the business performs.  

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If you buy a company's bonds, your money investment is essentially an I.O.U. from the company. The investor loans a sum of money (the principal) to a company or a government for a set period of time. And in return, the investor receives a series of interest payments (the yield).  This too is contingent on the company performing well.  If the company has poor long-term economics and doesn't do well, it may default on the I.O.U., and the investor may not get anything.

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Do Your Due Diligence

As a whole, to better ensure a solid return on your investment, you need to understand your investment. It's best you do not invest money based on sheer optimism, media hype, or pure speculation.  Don't just take someone's word for it.  Oftentimes a company is perceived to be doing well because its stock price is surging in the short-term, yet the company is unprofitable, poorly managed, or poorly capitalized. Or there is some other underlying factor that ultimately works against it.  

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Look into the company. You should invest money based on how a business operates.  Understand how it makes money, how it is managing money, and the benefit to end-users of the products and/or services it provides. If you are drawn to an investment because of media hype or trivial notions rather than business fundamentals, you may be scared away at the first sign of trouble and, in all likelihood, lose money in the process.  

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You don't have to be a financial analyst, but you can and should do some level of research and analysis.  Past performance is certainly no predictor of future performance.  But having a solid understanding of the business in which you're investing is key to having an informed assessment of the company's future prospects.  Limit your selection of companies that you invest in to those that are within your financial and intellectual understanding.  If you don't know how the business works, try to learn about it.  If you still can't figure it out, move on to a business that you truly understand.  Understanding your investment will help you ensure an adequate return on your investment (ROI)!

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There will always be economic cycles (booms and recessions, ups and down), and there will always be business cycles and other external factors that may affect business performance. Such factors may include, for example, interest rate hikes, labor shortages, or supply-chain issues. But for any company in which you intend to invest, having a solid understanding of business operations will lend confidence to weathering those uncertainties and allow for confidence over the long-term.

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Look for Competitive Advantage

After establishing a firm understanding of how the business works (how it earns its money, how much financial support it needs for its operations, and how effective management is), you have to assess the company within its competitive space.

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• How much market share does it have?
• How does the company perform relative to its primary competitors?
• Does it have differentiated products/services that are difficult or near impossible for another company to replicate?
• Does it have consistent profit margins and operating history?

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A company with a durable competitive advantage typically sells a unique brand-name product or a unique service that holds a strong, leading position relative to the competition.  Or perhaps it has economies of scale. It faces little or no competition, creating a kind of monopoly in its business space.  There is no close substitute for its products or services.

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Such a market position allows the company to raise prices (to an extent; contingent on customers willingness to pay) and increase its earnings, without fear of losing market share or unit volume.  This pricing flexibility allows such a company to earn above-average returns on invested capital.  This creates great potential for long-term economic growth and long-term shareholder value for investors!

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A Key Part of Core Investing Principles

If you're evaluating a company as a potential investment, make sure it has a competitive advantage!  And make sure that competitive advantage is durable over the long-term.  Can another new or existing company with piles of cash enter the market space and replicate the company's business model to effectively compete?  Then, it probably doesn't have a durable competitive advantage.

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However, a company with a strong and durable competitive advantage will be able to use that competitive advantage to pull its company stock out of almost any kind of bad-news hit from the stock market.  Look for companies with exceptional business models and strong, durable competitive advantages.

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Consistent Operating History

Again, past performance is certainly no predictor of future performance!

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But, in my experience, the best returns (i.e., return on investment or ROI) are achieved by companies that have been producing the same product or service for several years.  They have a proven track record.  New products and new companies can also prove worthwhile investments, but they're more speculative since much remains unproven. A company undergoing major business changes also increases the likelihood of committing major business errors.

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A steady track record is a relatively reliable track record.  When a company has presented consistent results with the same type of products or services year after year, it is not unreasonable to assume that those results will continue.

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Effective Management

Assessing the quality of management is also a key part of my core investing principles. Look for companies with managers that act rational in the allocation of the company's capital.  That's what determines shareholder value over time. Deciding what to do with the company's earnings, whether to reinvest in the business or return money to shareholders, is of critical consideration depending on where a company is in its economic life cycle.

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Look for management that reports their company's financial performance fully and genuinely, admitting failures openly and sharing successes by rewarding shareholders. Be wary of management that feels the need to follow the crowd in terms of direction.  Ultimately, that leads to misallocation of capital and poor returns.  

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Some management is also focused on manipulating the financials just to meet Wall Street expectations. Taking time to evaluate management will help yield early warning signs of eventual financial performance.  Look closely at annual reports, especially as applies to the section Management's Discussion & Analysis (MD&A).  The words & actions of the management team in media reports too will help you find clues to measure the value of the team's work long before they show up in the company's financial reports.

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Investment Analysis

Quantitatively, too, we can look at management's effectiveness by analyzing certain ratios:  return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC).  I'll discuss more on these ratios in later posts.  But evaluating these ratios using the latest audited financial statements of the company will provide a static picture of how effective management is using companies assets, equity, and investment capital. Comparing these levels to other competitors in its industry, as well as how those ratios have trended over time, are also worthy of analysis.  It's also useful to analyze operating metrics such as inventory turnover and receivables turnover as well.

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Buy at Attractive Prices

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The price at which you invest will also aid in determining the level of return you experience.  

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Be wary about investing when a stock is trading at an all-time high or when the market as a whole is trending up in the midst of a bull market.

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If the real estate market is currently a "seller's market," that means sellers are hiking prices up due to competing bids and no shortage of buyers in the market. Don't pay top price and thereby minimize your return on investment!

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Margin of Safety

The famed investor, Benjamin Graham, under whom the likes of Warren Buffett studied, relied on what he called the "margin of safety."  If you're an investor who has identified an excellent business opportunity and you remain optimistic about the investment going forward, there are two tactics for adding that company's stock to your portfolio:

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1. Purchase the shares when the overall market is trading at low prices (i.e., during a recession or some bad news event).
2. Purchase the stock when it trades below its intrinsic value even though the overall market is not substantially cheap.

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In either case, a margin of safety is present in the purchase price.

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To the extent possible, you want to not only identify businesses and investment opportunities that can earn above-average returns, but you also want to purchase them at prices below their indicated value.  Investment opportunities are often presented at large discounts during recessions, bad-news events, and times of economic hardships for owners.  Take advantage of that!

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At times, the shortsighted market will grossly underprice an investment (i.e., stock or real estate) in relation to the business's future earnings' value.  That is when you want to buy!

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Conclusion

These are core investing principles that have allowed me great success.  Having core investing principles upon which to stand will afford a strong investment strategy with impenetrable focus.  The market will always generate a lot of information, misinformation, and speculation around investment opportunities.  But having core investing principles will allow an unwavering approach to investing. Additionally, if such principles have stood the test of time with other successful investors, such as Warren Buffet and Phil Fisher, then the likelihood is they'll stand to benefit you as well.

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Disclosure/Disclaimer

The information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.