How to Invest Like a Pro: The checklist
How to Invest Like a Pro: The checklist
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How to invest like a pro is not a cookie-cutter endeavor. It requires one to be studious and diligent while also being able to effectively deal with ambiguity. When it comes to learning and developing a new skill set like Investing, it's typically advisable to learn from the best. And if you can't learn directly from the best, it's at least wise to research and gain as much insight as you can indirectly via books and other info. I've studied several successful investors. In doing so, I've taken bits and pieces from each and incorporated them into my personal investment strategy to invest like a pro.
By far, I would consider the most successful investor I've studied and followed to be Warren Buffett. He approaches investing from a business perspective. In fact, Buffett's preference is to buy a company outright in its entirety rather than buy shares in a company. However, so many great companies are exceedingly large and are publicly traded with numerous owners. As such, oftentimes buying stock in a company that presents itself as a great money investment is the only viable option for ownership. Nevertheless, Buffett approaches investing money into partial ownership via stock in the same manner he would by buying the company outright.
Approach Investing from a Business Perspective
Buying a business outright has one tremendous advantage - it affords complete control and the ability to allocate capital as you see fit. In contrast, investing money in the common stock of a company has the huge disadvantage of being unable to control the business. On the other hand though, investing money in common stock has two distinct advantages: one, the stock market is a much larger business landscape and two, the stock market provides more opportunities to find bargains. And investing money in stock should be approached holistically. Below are key pillars of Buffett's investing approach. These are a set of basic principles Buffett uses to guide his investment decisions. Add these to your investment strategy to invest like a pro.
From a business perspective, the company being considered for investment should be understandable. Never invest in businesses you don't understand. An investor should understand how the business operates. Specifically, it should not be too difficult to understand the primary parts: revenues, expenses, cash flows, products, labor relations, pricing, and capital allocation needs. Buffett deliberately limits his investment selections to companies within his financial and intellectual understanding. As an investor, you should do the same. Invest in your circle of competence.
As I've detailed in previous posts, companies being considered for investment should have consistent operating history. The past is no guarantee of future results, but it is certainly a solid clue. Companies that have been producing the same high-demand product or service for several years are potentially good investment options. Such products or services should be in high-demand with no close substitutes and without being subject to regulation. Such characteristics allow a company to hold its premium pricing and occasionally raise them without fear of losing market share or unit volume.
"Severe change and exceptional returns usually don't mix," Buffett has said. A steady track record is usually a reliable indictor of future performance. The key is to determine if a strong competitive advantage exists and to assess the durability of that advantage.
In general, three characteristics of a company's management should be assessed.
- Is management rational?
- Is management candid with shareholders?
- Does management resist the institutional imperative?
According to Buffett, the most important management act is the allocation of the company's capital. Over time, capital allocation determines shareholder value. And management should act rationally when determining whether to reinvest a company's earnings, buy back shares, or pay out dividends. This practice is often linked to the company's life cycle, but rational management should manage capital to produce above-average return on equity.
Buffett is wary of management that seeks to buy growth through random acquisitions. First of all, growth usually comes at an overvalued price. Secondly, integrating large and complex acquisitions can be very challenging in terms of culture, systems, and a number of other things. Mistakes with respect to such integration can be very costly to shareholders.
Quality management exists with managers who report company financial performance fully and genuinely. They admit mistakes, share successes, and are always candid with shareholders. Failures should be discussed openly with corrective actions outlined and taken. And management should resist the need to imitate management of other companies simply for the sake of following suit. This is what Buffett calls the institutional imperative, and it typically results in a drain of resources and a decline in shareholder value.
Reviewing the annual financial performance of companies being considered for money investment are good. But to invest like a pro, one should focus more on five-year averages. Impressive year-end numbers aren't meaningful if there's no added value. Assessing performance over longer periods of time such as five-year and ten-year averages are typically going to be more telling.
- Focus on return on equity and return on invested capital.
- Are earnings steady?
- Is the balance sheet healthy?
- Look for companies with high profit margins.
Profitability: Invest Like a Pro
In evaluating companies for money investment, a focus on return on equity (ROE) ensure that the company is performing in a way that's producing effective value for shareholders. Look for above-average ROE as applies to the industry in which the company operates. But don't focus on return on equity alone. Large dividend payouts and share repurchases may shrink the equity base and inflate ROE levels. Instead, be sure to also focus on return on invested capital with an eye for above-average levels within the industry.
An investment prospect should also be profitable, with a steady history of decent earnings. While earnings may decline in a given year, a company with a strong and durable competitive advantage should be able to quickly rebound in the following year or the year after. Placing a focus on the long-term trend of earnings over the course of 5-10 years will provide decent insight on company profitability. Doing the same with respect to profit margins is also necessary. Look at both gross margin and operating margin over the course of 5-10 years, with a comparison versus key peers and the industry average. Identifying upward trends is very appealing for investment prospects.
Look for a Healthy Balance Sheet: Invest Like a Pro
The balance sheet of any company being considered for money investment should be assessed. In general, lower levels of debt is desirable and would be indicative of a company's ability to operate adequately from generation of its own cash. Cash flow and earnings should be sufficient to cover interest payments of existing debt, as well as operations. An assessment of debt levels over the long-term should also reflect lower levels as compared to key peers and industry averages.
Companies with strong balance sheets are typically those which are structured to support the entity's business goals and maximize financial performance. They should have ample cash, healthy assets, and an appropriate amount of debt. I also like to assess working capital levels of a company's balance sheet. The working capital ratio is calculated by dividing current assets by current liabilities. A good working capital ratio will depend on the industry. But in general, anything between 1.2 and 2.0 should be within a healthy range.
Financial Ratios or "multiples" are utilized heavily to do a quick & easy relative valuation of a company. Some analysts are fond of low price-to-earnings (P/E) ratios, low price-to-book values, and high dividend yields. A more robust approach is to use historical levels of net cash flow in conjunction with a current outlook to asses future levels of net cash flow. Discounting those projected cash flows to the present value at an appropriate rate will provide a decent assessment of the company's intrinsic value. No one can predict the future though, so this is all dependent on future projections and plugging in the right variables: the future stream of cash flow and the proper discount rate. Using this result in combination with financial ratios helps to truly gauge a company's value versus the price it may be trading on the stock market.
Growth and value investing are joined at the hip according to Buffett. Value is the discounted present value of an investment's future cash flow and growth is simply a calculation to determine value. Additionally, growth in sales, earnings, and assets can either increase or decrease value. Growth adds value when return on invested capital exceeds the cost of capital at above-average levels. In contrast, growth actually destroys value if a business is earning low returns that do not exceed costs of capital.
To invest like a pro, use the pillars above when deploying your investment strategy. Evaluating companies to determine if they have excellent business economics requires gauging the long-term outlook. Companies that are understandable, with durable competitive advantages and shareholder-oriented managers are the best investment prospects. This alone does not guarantee success, but it provides a great investment strategy from which to screen investment prospects. You also want to use financial ratios and DCF analyses to buy into companies at sensible prices. Doing so will help to maximize your investment returns and aid in true wealth creation.
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.