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Tutorial 6 - Developing an investment strategy

Tutorial 6 - Developing an investment strategy

Executive Summary

After completing this tutorial, you will have understood the importance of having a macro view of the markets, how to develop a daily routine of analysis and how to evaluate a business based on quality, price and value. Furthermore, we discuss useful research steps and how to develop an investment strategy; touching on value and growth investing and ending with Warren Buffet's and Peter Lynch's investment principles.

Market capitalisation

Introduction

By this stage you should have accumulated considerable knowledge on a multitude of share market-related subjects covering the full range of fundamental analysis. It is obviously impossible to cover everything that there is to know about share market investment in a training course of this nature, and so your financial education must be ongoing. Everything that you learn about the financial markets will help you to make well-informed decisions; so make financial and investment education a life-time habit.

In this tutorial, we will remind you of certain key principles covered elsewhere in the course and try to draw the threads together into a well-rounded approach the share market. The purpose of setting out these key principles in this tutorial is to give you an example of the type of thinking that you need to develop a framework for your share market decision making.

The 80/20 Rule

To be a successful investor on the share market, you need to grasp, as early as possible, what it is that causes a share price to move. Of course, it is often very difficult, even with the advantage of hindsight, to understand exactly what happened to make the share price move in a particular direction on a part

icular day, and often the explanation remains a mystery forever. A plethora of factors both perceived and real, interact to produce the final pattern of the share's price. Daily or minor share price fluctuations, corrections, rallies, the underlying bull or bear trend, investment fashions and market sentiment all exert an influence on the final share price.

In this mass of apparently unrelated data there are certain clear understandings which can greatly assist the investor. The most important of these is that 80% of a share's move is dictated by the underlying direction of the market, while only 20% of its move is caused by factors relating to the specific company. For example, when gold shares move, they all move together and while you certainly benefit by taking care over exactly which share you buy, your biggest gains will come from the primary market trend. For this reason, you should spend 80% of your time devoted to establishing the trend of the sector and the market as a whole. Only 20% of your time should be spent on the "unsystematic" factors relating to the company.

Indeed, many novices in the market fail precisely because they become too involved in the micro-analysis of specific shares and lose sight of the larger picture. In a strong, over-priced market, the study of specific shares can be likened to haggling over the deck chairs on the Titanic. One of the greatest threats to our share market is undoubtedly the threat of a melt-down on Wall Street. Pre-occupation with micro-analysis is really a form of investor escapism. It is simply easier to focus on the detailed workings of a single company or the chart patterns of a single price chart than to digest the algebraic sum of diverse and complex forces and relationships which make up the direction of the primary market trend.

Forming a macro view of the market

It is impossible to separate the local share market (i.e. the JSE) from the progress of other world markets and it is impossible to separate the South African economy from the economies of our major trading partners. Successful investment requires a macro view of the markets, which encompasses the entire world economy. This approach means having a view of the future of the level of US interest rates, the growth of Chinese capitalism, the impact of AIDS in Africa, the prospects for the Dow Jones, the Japanese Nikkei, and the FT 100 industrial indices, the oil price, the future of the Rand, and many more factors. These factors are all inter-connected in a dynamic and fascinating matrix of strengthening and weakening, direct and inverse relationships. Each factor, taken in isolation, is a study of considerable complexity in itself. No wonder it is easier for investors to ignore all this and concentrate on individual companies! Unfortunately, this "provincial" approach is also far less profitable and such investors are often bemused when an apparently "good quality" share fails to perform as ex

pected.

The secret to a forming a macro view is to read widely with the idea of building a "good general business knowledge". Although it is often difficult to make time to read everything thoroughly, we suggest that you start small with careful reading of the daily Business Day newspaper. Try to develop an eye for articles which have significance for your "macro" world view and focus on these, quickly passing over other, less important material. You could then gradually expand your horizon to include Internet websites such as Reuters and Bloomberg.

The problem with subscribing to many other publications is two-fold – time and money. One solution to this problem is to work with a group of other investors, like in an investment club, where each member then takes on one publication, or focuses on one specific market. When an article of significance is found it should then be photocopied or the website link sent via email for the others in the group. This approach also helps to reduce expenses. Important articles should be filed away for later reference, especially articles which contain useful factual information.

Developing a daily routine of analysis

It is important to plan the time that you spend on share market analysis carefully so that it is as effective as possible. This planning must take place within a sound overall investment strategy. Creating a watch list was discussed in the second tutorial at the start of this investment training course, but it is important to revisit the idea as it is very important. Study the diagram below. The outer circle shows the universe of JSE-listed shares available. From this list you should then create your own "watch list" of interesting-looking shares (about 25% or 25 companies) to follow, which you think may be potential buys at some point in the future.

Once you have created your watch list, you should then look at the share prices and volume traded of each share every day. Better still, you will notice which shares have the most activity and moving higher by looking for shares that are "green" or trading positive compared to the previous day's trade.

Valuable company research is automatically linked to the shares in your watch list, which is a big time-saver. Familiarise yourself with the fundamentals of each company, i.e. the nature of their business, what sector they operate in, their financial ratios and valuation, etc. The more you know a

bout the company, the better. Out of this watch list you will select those shares which you are actually going to buy and hold in your trading or investment portfolio. In general, a balanced portfolio should have no more than 12 shares and no fewer than 8 shares. Obviously, this is idealistic, but more than 12 shares will tend to spread your time too thinly, while fewer than 8 shares will expose you unduly to market risk. When you are just beginning in the market, you only buy one share and spend no more than R3000 on the outside, even if you have far more money than that, because the lessons that can be learned with R3000 are the same as the lessons that can be learned with R50 000, but there is just less pain!

This means that the shares that you hold should be about the top two- to -three percent of opportunities on the market. If you do not think that the share you are considering fits into this category then scrap it and look elsewhere. Your watch list should be comprised of shares which you feel have the potential to be in the top performers on the JSE. Do not waste your precious time with mediocre shares.

Part of your whole investment strategy should be a process of having shares moving in and out of your watch list and into and out of your portfolio. In general, you should try not to buy a share that has not been on your watch list for at least one month. In creating a watch list, the process of prospecting for shares should be fine-tuned with knowledge and experience. We have borrowed the word "prospecting" from the mining profession and it simply refers to the fact that you should be continuously looking for interesting shares that may have the potential to be a winner.

There are four different prospecting methods (Refer to "Getting Started - Choosing your first shares"), which include:

  • The Top-Down Approach,
  • Using Financial Journalism,
  • Using Fundamental Analysis, and
  • Using Technical Analysis.

These prospecting activities should result in a continuous stream of "prospects", which you should then subject to a series of fundamental and technical sifting criteria.

Fundamental sifting criteria

From the Watchlist, select the button called "View as Investor."

This will change the Watchlist from price movements to a valuation model.

  1. The first fundamental criteria could perhaps be that you are looking for undervalued shares. For example, the PEG ratio is below 75% or the Price/NAV as close to 1 as possible.
  2. The second fundamental criteria could be profitability. For example:
    • Is the ROE% greater than 15%?
    • Is the operating profit margin above 5%?
  3. The third fundamental criteria could be that you want shares that are financially sound and have no risk of going into bankruptcy. For example:
    • Is the debt/equity ratio less than 100%?
    • Is the interest cover greater than 3-times?

Technical sifting criteria

  1. The first technical sifting criteria you could use is that the share price must be in a bullish trend. For example, you would establish this by using cycle analysis, multiple moving averages (e.g. 21 & 40-day moving averages) and trend lines. As long as the share price is in a bullish trend, there is potential to make money.
  2. As a second sifting criteria you would want the share price to be in a little "dip," having retraced from a previous cyclical high. Ideally, the share price should be technically "oversold". For example, the OB/OS and Momentum indicators are both in oversold territory (i.e. below the "zero" line).
  3. The final sifting criteria, is that the share price should be outperforming relative to the whole market. For example, the Relative Strength indicator and a 10-day simple moving average (SMA) based to the JSE Overall Index, as well as the industry and sector would help to find shares that are outperforming the market.
  4. You would also want to see that share volume is confirming price action (i.e. volume accumulation).

Some of your selections will be right and some will be wrong. As you get better at evaluating companies, your "hit-rate" will improve. A mistake is defined as any trade where you are forced to sell out at your stop loss level. From this you can see your "in-the-money" mistakes and "out-of-the-money" mistakes. Obviously, it is the "out-of-the-money" mistakes that really matter, because they show you that there is something wrong with the share selection process. In the next few pages, we will review the share selection process from a fundamental point of view because a good company with good prospects, over the long-term will give you good results.

Evaluating a business

In evaluating a business, your goal is to get to know the company very well inside and out. Evaluating a business and not evaluating a share is written intentionally like that because too many people think of their investments merely as shares. They pay too much attention to the share price and too little to the underlying business. Each share is more than an intangible price that goes up and down each day. Each share represents for its owner a claim on a small percentage of an actual business.

If you own one share of PicknPay, you, along with members of founder Raymond Ackerman's family, own the company. True, they own a lot more of the company than you do but your share still counts. When important decisions are to be made like approving members of the board of directors, the company will send you a ballot and solicit your vote. And every time a shopper buys groceries, a set of towels or even a television, a tiny fraction of the profit from that sale generated is yours. The fate of each share is tied inextricably with the fortune of its underlying business. Successful investors need to get and stay familiar with the companies they own.

Quality, price and value

As you have learnt in this investment training course about how to study various companies, you will have run across many different measures and tools that investors use in their share evaluation. These might include P/E ratios, return on equity (ROE), profit margins, and so on. At first, you will probably keep them all in your mind. You will do well to try and sort them into two categories, namely: quality and price. Here is why:

There are two main questions you need to answer before you decide whether to invest in a company:

  • Is this a strong and growing high-quality company?
  • Is the company's share priced attractively right now?

If you do not make a point of addressing both of these questions, you might end up buying grossly overvalued shares of a wonderful company or you might snap up shares of a hapless, doomed business at what seems like a bargain price.

Quality - There are a number of ways that you can zero in on a company's quality.

  • Is it debt-free, or up to its ears in interest payments? Remember that debt is not necessary a bad thing, but a lot of it can sometimes spell trouble. Look at interest cover to see whether the debt is manageable. Below three times cover would set off alarm bells.
  • Is the company generating a lot of cash and spending that money efficiently?
  • Are sales and earnings growing at an admirable rate?
  • Are gross, operating, and net profit margins growing as well?
  • Is the management smart and executing well?
  • Is the company generating a lot of value for shareholders?
  • Is the company well positioned to beat competitors?

Price - When evaluating a company's share price, investors typically take a number of measures and relate them back to the company's earnings.

  • The price-to-earnings (P/E) ratio, for example, compares the share price to earnings per share (EPS).
  • The price-to-sales ratio compares the company's market capitalisation to its sales or turnover.
  • The PEG ratio compares the P/E ratio to the company's expected earnings growth rate.

Discounted Cash Flow (DCF) is another way to evaluate a share price to estimate the company's earnings for the years ahead and then discount them back to their present value. Remember, a company's share price is essentially a reflection of all its expected future earnings, in today's money. If your calculations suggest that the total discounted earnings will amount to R50 per share and the share is currently trading at R30 per share, you are probably looking at a real bargain. If this sounds a little complicated, it is. But it still is not rocket science. And anyone who likes playing with numbers and solving puzzles may actually find it fun!

A share's price is meaningful only when you compare it to earnings and other measures like that. It is pretty much meaningless, though, when examined in a vacuum. People often mistakenly think that a R10 share is more attractive than a R150 share. The R10 share may be overvalued, while the R150 share might be a great bargain. Another common misconception is that penny shares, those trading for less than 200c per share, are great buys. People think that a 150c share is likely to double quickly. Well, penny shares are usually trading that low for a reason. They are more likely to drop to zero than to double. Do not think that just because you can afford to buy 10 000 shares, that you are bound to make a bundle.

People often think that they have to buy shares in "round lots" of 100 shares. Not true. You can buy as many shares as you want. If the company that you are interested in trades for R75 per share and you only have R2 000, you can buy 27 shares (i.e.R2 000/ R75 = 27 shares). Just be aware that you must still make allowance for brokerage costs. Brokerage costs as a percentage of the transaction will be much higher and therefore you will have to make a much bigger profit in percentage terms just to break even. For example a minimum brokerage fee of R98 would translate into 4.90% cost (R98/R2000).

Value - Once you have a better understanding of the company's quality and its share price, you can make a judgement on whether it is offers good value. Before we go any further, you must know that there are many different investing styles. Some investors focus primarily on finding undervalued companies, paying close attention to a share's price. Other investors do consider price, but they focus more on the quality of the business. Both of these are wise approaches. What is foolish is simply to look for rapidly growing companies, regardless of price or quality. Or only to use technical analysis and examine charts of a share's price movements and its volume in trading.

"Price is what you pay, value is what you get." - Warren Buffett

Useful research steps and questions

Imagine that you are in an investment club and you are explaining to your fellow members why the club should invest in a particular company. Here are some steps and questions that you could take that would help in the process.

  1. If possible, try out the company's product/s or service/s. See how impressed you are with them.
  2. Read up on the company. Find magazine or newspaper articles about it.
  3. Visit online message boards for the company where you can ask questions of fellow investors and get opinions. See what other investors are saying about the company.
  4. If possible, send away for more investor information from the company and then study it.
  5. Figure out the company's business model. How does it make money? How might the model change in the years ahead? On what assumptions is the model based?
  6. Examine the company's competitive environment. What are its competitors up to? Is the company likely to fend off attacks? What advantages does the company have over the competition? Is it at any disadvantage? How is the industry changing and what challenges does it face? What does the future hold?
  7. Think about the company's risks. Is the company's main product a pill to treat cholera? What would happen if cholera is cured? Does the company earn half of its income from just one customer? If so and that customer cancels orders, what then?
  8. Crunch a bunch of numbers. See just how quickly sales are growing. See what the company's debt-to-equity ratio is. Determine what its gross profit margins are. Talk to people in the business, such as company employees, suppliers and people in stores that sell the company's products, customers of the company, people familiar with competitors, and so on. See how they perceive the industry and where it is headed. See what they think of the company you are studying and its future prospects.

Sure, you can follow all the above research steps and questions and be more prepared to invest in today's hurly-burly markets than 9 out of 10 people. But how can you become better able to handle the twists and turns of individual shares than 99 out of 100 investors? To really take advantage of your relationship with us and this course, you need to discover our extensive online offerings by visiting our Internet websites. There you will find dozens of additional educational features, and much, much more. The PSG Securities Ltd website is designed to be a place for investors to turn to when it comes to any aspect of investor education and investing on the share market, respectively. Online you will have everything you need at your fingertips.

Developing an investment strategy

Do you have clear investment strategy? For instance, do you know when to sell, or do you rely on a wait-and-see approach? A better approach would be to make sure you are invested right in the first place.

  • Have you given your shares a financial check-up recently?
  • Do you still believe in them?
  • Did you pay off your credit cards before investing?
  • Did you put your emergency fund into a money market account?
  • Did you invest only money that you would not need for at least five years?

If you have done all the above, then a depressing bear market will be much easier to live through. If you do not … well, those are the steps you can take to get through a mess. It is much easier to think long term when your financial matters are in order.

In the book, "How to Make Money in Stocks", author William J O'Neil argues that the share market is really no different from any other business, and should, therefore, be operated just like a business.

"Assume you own a small retail woman's clothing store. You have bought and stocked dresses in three colours - yellow, green and red. The red dresses are quickly sold out, the green ones are half sold, and the yellow ones have not sold at all. What do you do? Do you say: The red dresses are sold out. There is no demand for the yellow ones, but I still think they are good and besides, yellow is my favourite colour, so let us buy some more?

"Certainly not! A professional merchandiser would look at the situation objectively and say: 'We sure made a mistake. We'd better eliminate the yellow dresses. Mark them down 10%. If they do not sell at that price, we will mark them down another 10%. Then buy more of the red dresses." This is common sense, but do you do this with your investments?

"Everyone will make buying errors," says O'Neil. "When you do slip up, sell and go on to the next thing. You do not have to be correct on all your investment decisions to make a profit. Any time a commitment in a share is made, define the potential profit and the possible loss. This is only logical; you would not buy a share if there were a potential profit of 20% and a potential loss of 80%. But how do you know that is not the case when you buy a share if you do not attempt to define these factors and operate according to well-thought-out selling rules?"

Developing your own investment strategy

Investment strategy refers to the choice of shares in one's portfolio, timing of purchases and sales and one's overall investment stance (e.g. whether one is investing in shares for the short, medium or long-term, what level of liquidity is desirable, etc.). As far as the choice of shares in a portfolio is concerned, one basic approach is the "top-down" approach as mentioned in the TFS Learner Guide at the beginning of this training course. As a quick reminder, the process starts where one gets an overview of industries to identify those with good potential and then try to find those companies within these industries which offer the best prospects of earnings growth.

It is important to assess how sound a company is, what its track record of earnings and dividend growth are, and its prospects. Stockbroker research reports can be very useful in this regard as they generally provide an analysis of particular shares and an assessment of likely future earnings growth. One should be alert of special opportunities, e.g. dynamic new management taking over a company which could boost its earnings, or a takeover possibility. When a company becomes a target for a takeover, its share price generally rises. Once one has decided on the basis of fundamental analysis that a share is a good investment, the next question is when to buy i.e. the timing of one's investment decision. In this regard, one must clearly be alert to what range the share price has been moving in and also have a general idea of what is happening to the share market. Where possible, one should try and buy shares after the market has taken a dip (i.e. retraced or corrected) so as to get in at the best price and to improve one's chances of making a profit.

Technical analysis is widely used to improve one's timing decisions and the various techniques discussed in lessons 7, 8 and 9 of this training course can all be applied to the timing of one's purchases or sales. One's overall investment stance is clearly dictated by how one reads the market. What is the outlook for gold, interest rates or share prices? If the market has been in a downward phase for some time, has this ended and is it worthwhile investing again? Obviously, one has to watch world markets closely, particularly Wall Street. If things go wrong there, then markets around the world react. By the same token, any sign of a recovery in the South African economy will be positively interpreted by investors on the JSE.

Once you have gained sufficient knowledge and experience through 'playing' on the Trading Simulator, one of your main objectives is to search for better solutions through successful investment strategies on the real market. We encourage you to develop your own personal preferred strategy or style of investing. Here are two investment strategies that you may consider, namely the aggressive and conservative strategies.

The Aggressive (Small-cap) Investment Strategy

Some companies succeed by breaking all the rules. Here we are talking about the small capitalisation and penny stock companies that provide investors with the most dynamically high returns achievable on the share market. They provide inspiration and guidance to all business people; be they managers, planners, or executors. These companies are capitalism's special sauce, its tastiest and most necessary condiment.

Small capitalisation or penny stock companies are only for the more experienced, aggressive, brash and daring of investors. Those who invest in these small cap companies consciously take on lots of risk, believing that for the experienced and wiser investor, high risk will lead to high reward. Small cap shares should make up only a part of any portfolio and investors are warned that they should be prepared to lose the money they invest in these companies. Not too encouraging, is it?

Here are some useful tips on how to find these outperforming small cap companies and their characteristics:

  • The company should be a "top dog and a first mover" in an important, emerging field. In other words, being top dog in the left-handed scissors industry is not enough.
  • The company needs to demonstrate sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors. Aspen would be an example.
  • Strong price appreciation is vital to a group of companies. A good indication of this is a relative strength rating of 90 or above.
  • Look for good management.
  • Look for a company that has a strong consumer brand.
  • Finally, consider it as a good sign when the financial media, not seeing the big picture, rates a company as overvalued.

The advantages of investing in small cap companies

Whether or not you decide to look for emerging companies the "Aggressive Investment Strategy' way, you should give serious consideration to including a number of small-cap companies in your portfolio. The beauty of investing in small-cap companies is that they sometimes give the individual investor a chance to beat the unit trust fund managers to the punch.

Due to the size of most unit trust funds and financial regulations and legislation, as well as the way they are set up, fund managers often have a hard time establishing any kind of meaningful position in small-caps. In order to buy a position large enough to make a difference to their fund's performance, they would have to pick up at least 10% or 20% of small-cap shares. In fact, fund managers are frequently restricted from doing this by their own guidelines or mandate. Secondly, if they have not already tipped their hand to the market, the previously attractive price will be now inflated by them buying the first 5% of the company.

The fact that the unit trust fund managers cannot buy these small-cap companies is a great advantage to the individual investor who has the ability to spot promising companies and get in before the institutions do. That is because when institutions, like unit trust and pension funds, get in, they will do so in a big way, buying many shares and pushing up the share price with their demand. Also, many of these small-cap companies are "closely-held", that is, the management owns a sizable percentage of the company. Since most of their potential for wealth is tied to the share price, you can bet that they will be working very hard to get the share price to move up.

The final and probably the best reason to buy these small-cap growth companies is because they grow, sometimes rather quickly. Small companies are in a much better position than their larger counterparts to expand their businesses, and rapidly multiplying earnings often translate into quick growth in the share price.

If you are thinking of buying small capitalisation or penny stock companies for your portfolio, we recommend that you only make it a small part of your overall investment strategy. A better approach might be the 'balanced' approach, which includes a few blue chip or large capitalisation companies, a bunch of green chip (i.e. growth) mid-capitalisation companies, and a few small capitalisation or penny stock companies thrown in for fun and to spice things up a bit.

The disadvantages of investing in small-cap companies

Investing in small-cap companies is not for everyone, though. You should know your way around a set of financial statements, and a few laps around the investing block does not hurt, either. Novice investors should steer clear for a while. You would not go up in the Space Shuttle without prior training, nor would you try investing in small-cap companies until you have cut your teeth on some large- and mid-cap issues.

The lack of time is another dissuading factor as finding good small-cap companies is a lot of work, and it takes even more attention after you have made your purchase. If you do not have the available time, energy, or inclination to keep up with the news on your portfolio, you are better off using the "Conservative (i.e. Large-and Mid cap) Investment Strategy" or an index fund such as the SATRIX 40.

The last reason to stay away from investing in small-cap growth companies is if you have a natural aversion to risk. Small-caps are more volatile than large-caps. If the mere thought of a 5% downward movement in the share price gives you an ulcer, then you are better off saving your stomach. Everyone has his or her own risk tolerance, and there is no reason why you should make any investment that makes you feel uncomfortable.

If you have got some experience under your belt and are not averse to volatility, then investing in small-cap growth companies will make a nice addition to your portfolio.

The Conservative (i.e. Large-and Mid cap) investment strategy

Some small-cap companies grow up to become dominant in their industry, able to call the shots and generate great value for shareholders. These companies serve most investors well. This particular investment strategy suggests buying companies that are stalwarts (i.e. financially strong and well managed). They are generally big large-cap companies. Not all big companies will meet the criteria listed below, though, and many non-blue chip companies will be worthy of your consideration.

This investment strategy relies only on simple numeric calculations, common-sense logic, and your patience. This investment strategy is as convenient as a unit trust fund, but which offers above-average performance and lower expense.

To identify these companies, you may want to:

  • Look for the number one brand name in an industry.
  • Look for repeat mass-market purchases. Most people do not buy many motor vehicles or washing machines each year, so Consolidated Motor Holdings (CMH) and Amalgamated Appliances (AMAPS) are examples. Think instead of things you routinely use, either because you like to or you have to.
  • When crunching financial numbers, you can check several measures. Look to see that gross profit margins (gross profits divided by turnover) is above 60%, net profit margins (net income divided by turnover) are topping 10% and that turnover is growing faster than 10% per year.
  • Cash is king with these types of companies. You want to see plenty of it, as well as little debt as possible on the balance sheet. You want companies that manage cash flow effectively by demanding payment quickly and paying their obligations slowly.
  • Just as important as how the company fares on the above measures is the direction it is moving in. For example, you want to see margins rising and that the company buys back its own shares. Compared with industry peers, this company should be clearly ahead of the class.

The time horizon with this investment strategy is meant to be a long-term one. The idea is that once you identify and invest in these powerful companies, you should, for the most part, be able to leave your money invested for a decade or longer.

There is more involved in identifying and investing in these types of companies, and we suggest that you develop more of your own criteria but these are some of the core principles. They will help you to zero in on companies worth a closer look. Whether you have blue chip companies or other companies in your share portfolio, you will do well to make sure that you have got a few heavyweights in it. That is because large companies are generally more stable than smaller ones. They are not going out of business overnight and they usually have a broader range of products and/ or services than smaller capitalisation companies.

Value Investing

Value investing is an investment model that derives from the ideas on investment and speculation that two professors at Columbia Business School called Benjamin Graham and David Dodd began teaching in 1928 and subsequently developed in their 1934 text "Security Analysis." Although value investing has taken many forms since its inception, it generally involves buying companies whose shares appear underpriced by some forms of fundamental analysis. Graham always took the position that value investment was the only real form of investment; anything else was speculation.

As examples, such shares may be shares in companies that trade at discounts to Net Asset Value (NAV) or Tangible Net Asset Value (TNAV), have high dividend yields, have low price-to-earning (P/E) multiples or have low Price-to-NAV (P/NAV) ratios. In terms of picking shares, it was recommended defensive investment in shares trading below their Tangible Net Asset Value (TNAV), as a safeguard to adverse future developments often encountered in the stock market.

Net Asset Value (NAV) is most useful in industries where most assets are tangible. Intangible assets such as patents, software, brands, or goodwill are difficult to quantify, and may not survive the break-up of a company. When an industry is going through fast technological advancements, the value of its assets is not easily estimated. Sometimes, the production power of an asset can be significantly reduced due to competitive disruptive innovation and therefore its value can suffer permanent impairment. One good example of decreasing asset value is a personal computer. An example of where book value does not mean much is the service and retail sectors. One modern model of calculating value is the discounted cash flow model (DCF). The value of an asset is the sum of its future cash flows, discounted back to the present.

Value investing is the strategy of selecting shares that trade for less than their intrinsic values. Value investors actively seek shares of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company's long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated. Typically, value investors select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.

The big problem for value investing is determining a share's intrinsic value. Remember, there is no "correct" intrinsic value. Two investors can be given the exact same information and place a different value on a company. For this reason, another central concept to value investing is that of "margin of safety". This just means that you buy at a big enough discount to allow some room for error in your estimation of value. Also keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and do not place any value on future growth. Other value investors base strategies completely around the estimation of future growth and cash flows. Despite the different methodologies, it all comes back to trying to buy something for less than it is worth.

High profile proponents of value investing, including Warren Buffett, have argued that the essence of value investing is buying shares at less than their intrinsic value. The discount of the market price to the intrinsic value is what Benjamin Graham called the "margin of safety", which called for a cautious approach to investing. The intrinsic value is the discounted value of all future distributions.

However, the future distributions and the appropriate discount rate can only be assumptions. Warren Buffett has taken the value investing concept even further as his thinking has evolved to where for the last 25 years or so his focus has been on "finding an outstanding company at a sensible price" rather than generic companies at a bargain price.

Value investing has proven to be a successful investment strategy. There are several ways to evaluate its success. One way is to examine the performance of simple value strategies, such as buying low PE ratio shares, low price-to-cash-flow ratio shares, or low Price-to-Net Asset Value ratio shares. Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value shares outperform growth shares and the market as a whole in the long run.

Intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of a company in the hope of finding investments where the true value of the investment exceeds its current market value. For example, value investors that follow fundamental analysis look at both qualitative (business model, governance, target market factors etc.) and quantitative (financial ratios, financial statement analysis, etc.) aspects of a business to see if the business is currently out of favour with the market and is really worth much more than its current valuation.

Value investing principles

Below are ten principles which will provide you with the essential information you will need when deciding which shares to invest in. Companies which stand out after applying these rules, should depending on the timing, produce above average returns. In addition, by sticking to this maxim the probability of not losing any money when investing, rises considerably.

  1. Focus on following the progress of individual companies, not the share market. When buying shares, make sure you know everything there is to know about the company. Regular analysis of business reports is key to making an informed investment.
  2. Make sure you can clearly picture the future of the company. A long-term earnings outlook is essential to any investment decision. The only reason to invest money in shares is the expected cash flow.
  3. Choose shares in the best companies. Only consider companies which have proven that they are excellent in their field of business and have achieved an increase in profits over a number of years.
  4. Stick to what you know. Those who know their branch and business inside out can avoid false estimations.
  5. Identify the actual value of a share. According to Benjamin Graham every company has an intrinsic value. This is calculated by taking into account not only the book value of a company but also its earning power.
  6. Only buy when the price is right. Even when investing in the best companies, you can end up paying too much for shares. The long-term return on invested capital is calculated by looking at the relation between the purchase price and the earnings trend of the company. If the former is too high, the return can be slim.
  7. Do not feel the need to cover all your bases. This does not mean abandoning your conservative and safe approach and throwing caution to the wind, but rather that just a few investments in companies with excellent prospects will be your path to success.
  8. Hold on to your shares. Selling your shares should only ever be an option when the basic estimation of the earnings trend changes, or if an investment that promises even higher returns presents itself. A higher stock market price should never be a reason for selling.
  9. Avoid additional costs. Try and avoid making non-essential transactions as this results in paying extra brokerage commission and often taxes. Bank surcharges, management and consultant fees are all drains on your earning power.
  10. Ignore the experts. Trust your instincts and not the opinions of others- least of all the stock market.

The Warren Buffet strategy

Warren Buffet is one of the world's richest individuals through investing, with his personal net worth well over $30-billion dollars. Not only has he become one of the leading investment authorities, his performance record, which goes back more than forty years, is unmatched. Warren Buffet is truly an amazing man in that he still drives his own car and does his own taxes. He is very intelligent, quick and intuitive, whilst also being a man of warmth and genuine charm. While investment markets appear more confusing than rational, it is no surprise that investors all over the world have become keenly interested in Mr. Buffet's investment approach and ideas. The buy-and-hold investment strategy that is the core of Mr. Buffet's investment approach appeals intuitively to people. Mr. Buffet does not practice portfolio management, at least not in the traditional sense. Modern-day portfolio managers are mindful of the share weightings, industry diversification, and performance relative to a major index. Mr. Buffet approaches portfolio management differently. If he were restricted to selecting only companies that were based in his home town of Omaha, he would first ascertain the long-term prospects of the various businesses. He would then judge the quality of management and finally, he would purchase a few of the very best businesses at reasonable prices. He says that he would not be interested in purchasing shares in each business in town (i.e. spread the investment risk). Now, since the universe of companies that he can select from extends much further than Omaha, why should he behave any differently?

However, the idea of buying a good business and holding this investment for several years, thus achieving returns matching with the financial matters of the business, is simple and straightforward. Investors can easily understand and appreciate the workings of this approach. Warren Buffet's method is attractive to people for two reasons:

  • He is the designated representative of the buy-and-hold strategy; and
  • He also happened to become a billionaire by using this method of investing.

Here are some of those investment principles for you to take note of and apply:

Look at "owner earnings" - This is the net income, plus depreciation, depletion and amortisation, less capital expenditure (CAPEX) and any additional working capital required. This figure gives the true reflection of any business in whose shares you are considering investing. Earnings as normally reported is only useful to your analysis if they approximate the expected cash flow of the company. But even cash flow is not a perfect tool for measuring value, as it ignores CAPEX, which is critically important on an ongoing basis for manufacturing companies.

Look for high profit margins – These figures reflect not only a strong business, but also the company management's tenacious spirit for controlling costs. Buffet says: "Managers of high cost operations tend to find ways to continually add to overhead costs, whereas managers of low-cost operations are always finding ways to cut expenses." And every Rand spent unwisely deprives the owners of the business of a Rand of profit.

Look at retained earnings - For every Rand retained out of earnings and ploughed back into the company, there should be an equivalent improvement in the market value.

Combine both the 'value' and 'growth' approaches to investing - Mr. Buffet says that the debate between the two ways of selecting shares, the 'value' or the 'growth' approaches, is nonsense as they are "joined at the hip." The value of any business in which you are thinking of investing should be determined by estimating the net cash flows expected over the life of the business, discounted at the current yield obtainable on long-dated fixed income investments (i.e. bonds). The share price increase should at least match the growth of retained earnings over time.

Mr. Buffet says: "Value is the discounted present value of an investment's future cash flow; growth is simply a calculation used to determine value. Irrespective of whether a business grows or does not, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted cash flow calculation to be the cheapest is the one the investor should purchase."

Focus on four-or five-year averages – When studying the figures, do not take yearly results too seriously. Only invest in a business when its share price is significantly below its true value. Buffet believes in buying stakes in great businesses when they are having a temporary problem, or when the share market declines and creates bargain prices for outstanding businesses.

Stick with the simple and stable – To avoid mistakes in valuation arising out of wrongly estimating future cash flow, stick with businesses that are simple and stable, and insist on a substantial margin of safety between the share price and your determined value.

Ignore the stock market trends - This is one of Mr. Buffett's most controversial principles. Buffet has gained the reputation as a savvy investor because of his ability to buy a good business when most of Wall Street either hates or is indifferent to that business. He does not care what the market has done recently or is expected to do in future because he buys shares that offer value. Buffet also does not care if a share has already risen greatly. He bought Coca-Cola after it had already risen fivefold in six years and then made four times his initial investment over the next three years.

Be extremely selective - Normally only five companies' shares account for more than 75% of Mr. Buffett's main investment share portfolio.

Making a few correct decisions is what matters most - Mr. Buffett says that in his 40-year career, it is just 12 investment decisions that have made all the difference. "An investor should act as though he had a lifetime decision card with just 20 punches on it. With every investment decision his card is punched, and he has one fewer available for the rest of his life."

Do not buy a share unless all the facts are in its favour – Buffet puts no confidence in the prospects of market timing (i.e. the use of technical analysis), nor does he commit any resources to judging economic cycles. Buffet suggests that an investor should ignore the environment and focus on the company. "Stop trying to predict the direction of the share market, the economy, interest rates, unemployment figures, currency exchanges or elections, and stop wasting money on individuals who do this for a living." Buffet is more interested in focusing on business fundamentals, management, and prices. He says, "Study the facts and the financial condition, value the company's future outlook, and purchase when everything is in your favour."

Have cash ready to snap up bargains - Mr. Buffett's company Berkshire Hathaway has not declared a cash dividend since 1976. Shareholders get their reward through the rising value of their shares. The money that would otherwise be paid out to shareholders in the form of dividends is retained in the company to make it grow faster and make the price of its shares grow faster. Buffet says that it is even OK to borrow money to snap up a bargain on one of those rare occasions when one comes on offer. But more usually, you should have a pile of cash waiting in the bank to use when you need it.

Private investors can do as well as professionals - Buffet does not believe that individual investors are at a disadvantage relative to professional fund managers. "Because of the erratic and illogical behaviour of institutional investors, individuals can easily profit, as long as they stick to simple business fundamentals." However, they must be able, financially and psychologically, to handle market volatility. Mr. Buffett believes that "unless you can watch your share holdings decline by 50% without becoming panic-stricken, you should not be in the share market". The Mr. Buffett way to share market success does not require computer programs, complex mathematics or expert knowledge of a company or its industry. It boils down to valuing a business according to particular principles, then buying a piece of it when the shares are seriously undervalued. However, you have to do your own thinking and be prepared to ignore what the share market is doing. "If you plan on owning shares in an outstanding business for a number of years, what happens in the market on a day-to-day basis is inconsequential. "Ultimately, the best investment ideas will come from the doing your own homework".

Before you think about buying shares, you ought to have made some basic decisions about the share market, about whether you need to invest in shares and what you expect to get out of them, and about whether you are a short-term trader or a long-term investor. More importantly, you need to decide beforehand how you will react to sudden, unexpected, and severe drops in price. It is best to define your objectives and clarify your attitudes beforehand, because if you are undecided and lack conviction, then you are a potential market victim, who abandons all hope and reason at the worst moment and sells out at a loss. It is personal preparation, as much as knowledge and research, that will distinguish the successful share picker from the chronic loser. Ultimately it is neither the share market nor even the companies themselves that will determine an investor's fate. It is the investor.

Buffet does not like mining or farm-related shares. He would rather own the output (i.e. gold bullion) than the shares of a mining company. "It spends a billion to extract some commodity," he says, "then it has to reinvest much of its profits in more and more development and facilities. Eventually the consumers have gotten the metal and the company is left with a hole." He does not like farm-related businesses either. "You have to finance the farmer until the harvest is in the barn. You may show a book-keeping profit, pay taxes on it, and end up with receivables (i.e. debtors) that you have trouble collecting." Warren Buffet has a list of six qualities that he believes are necessary for investment success:

  1. You must be animated by controlled greed and fascinated by the investment process. Mr. Buffet believes that too much greed will control you but that too little will fail to motivate you.
  2. You must have patience. Although Mr. Buffet's time frame is much longer that the average investor, he believes that you should buy into a company because you want to own it permanently, not because you think its share will go up in price. His belief is that if you are right about the company and buy it at a sensible price, you will eventually see your share appreciate.
  3. Think independently. Mr. Buffet believes that if you do not know enough to make your own decisions, you should not make any decisions at all. He also quotes Benjamin Graham (the father of fundamental analysis) "The fact that other people disagree with you makes you neither right nor wrong. You will be right if your facts and reasoning are correct".
  4. You must have the security and self-confidence that comes from knowledge, without being rash or headstrong. In effect, Mr. Buffet is telling us that if we do not have confidence in our decisions because they have been poorly thought out, we are likely to be spooked as soon as the price goes against us.
  5. Accept it when you do not know something.
  6. Be flexible as to the types of business you buy, but never pay more than they are worth.

The Peter Lynch strategy

Peter Lynch is the Vice-Chairman of Fidelity Management and Research Company and a member of the Board of Trustees of the Fidelity Group of Funds. For the thirteen years, from May 1977 to May 1990, he was the portfolio manager of Fidelity's Magellan Fund. The Fidelity Magellan Fund was initially only $20-million in size and by the time that Mr. Lynch retired in 1990, it was over $14-billion with over a million shareholders, making it the largest fund in the world.

If you had invested $10 000 in this fund when he became manager, ten years later you would have had $190 000. This fund rose 28-fold per share for the best performing fund in the world. Peter Lynch knows how to make money.

Here are some of Peter Lynch's other ideas for identifying superior companies. He believes that in the end, superior companies will succeed and mediocre companies will fail, and investors in each will be rewarded accordingly.

  • Stop listening to professional fund managers – This is one of the secrets of his success and it is his number one rule. The key to making money in the share market is sticking with what you know. Instead of investing in a high-tech organisation you read about in the financial press, look around you. You will see many clues that will lead you to find the "ten-bagger", in Wall Street parlance a share whose value increases ten-fold, before the professionals.

However a share has grabbed your attention, whether via the office, the shopping mall, something you bought, something you ate, or something you heard from your stock broker, your mother-in-law, the discovery is not a buy signal or that you own the share. Not yet. What you have got so far is simply a lead to a story that still has to be developed. Treat this initial information as if it were an anonymous and intriguing tip. Developing the story is really not difficult; at most it will take a couple of hours of research.

  • Elephants do not gallop - The size of the company has a great deal to do with what you can expect to get out of the share. Shares on the JSE are categorised by size. For example, the Top 40 index represents the top 40 shares by market capitalisation, and these shares are usually household names such as Anglos, Barworld, etc. The next 60 companies represent the Mid Cap Index and any share that is not in the top 100 shares is classified as a small cap share.

How big is this company in which you have taken an interest? Specific products aside, big companies do not have big price moves. You do not buy shares in Anglo American expecting to quadruple your money in two years. If you buy Anglos at the right price, you may expect to triple your money in six years, but you are not going to hit the jackpot in two years. Lynch adds, "In certain markets, these companies perform well, but you will get your biggest moves in smaller companies." Sometimes a series of misfortunes will push a big company into desperate straits, and as it recovers, the share will make a big move.

  • Categorise the share – Once Mr. Lynch has established the size of the company relative to others in a particular industry, he would then place the share into one of six general categories, namely slow growing, stalwarts, fast growing, cyclical, asset plays, and turnaround companies. There are almost as many ways to classify shares as there are stock brokers, but Mr. Lynch found that the six categories will cover all of the useful distinctions that any investor has to make.

Slow growing companies are usually the large and aging companies that are expected to grow slightly faster than the gross national product (GNP) or between two and four percent growth in earnings. Slow growers did not start out that way. They started out as fast growers and eventually tired out, either because they had gone as far as they could, or else they got too tired to make the most of their chances. When an industry at large slows down, most companies within that industry lose momentum as well.

You can usually spot a slow grower by looking at technical charts, where you will notice that they are not very cyclical and bounce along slowly. Another sure sign of a slow grower is that it pays a generous and regular dividend. This is usually because the company cannot dream up new ways to expand the business. This does not mean that the management is doing anything wrong and in many cases it may be the best use to which the company's earnings can be put.

If the company is not going anywhere fast, neither will the price of the share. If growth in earnings is what enriches a company, then what is the sense of wasting time on these slow-moving companies?

  • The Stalwart companies – These are the large-cap companies such as Barworld and Bidvest. These multi-million Rand conglomerates are not exactly agile climbers, but they are faster than slow growers, usually grow between 10 and 12 percent annual earnings. Depending on when you buy them and at what price, you can still make a sizeable profit in stalwarts. But when someone brags that they have doubled or tripled their money, your next question should be: "And over what period was that?"
  • The fast growing companies – These are among Mr. Lynch's favourite investments: small, aggressive new companies that grow at 20% to 25% a year. If you choose wisely, this is where you will find the 10-to-40-baggers. With a small portfolio, one or two of these shares can make a career. A fast growing company does not necessarily have to belong to a fast-growing industry. All these companies usually need is room to expand within a slow-growing industry.

There is plenty of risk in fast growers, especially in the younger companies that tend to be overzealous and underfinanced. When an underfinanced company has headaches, it usually ends up bankrupt. Also, the market does not look too kindly on fast growers that run out of steam and turn into slow growers, and when that happens, the shares are beaten down accordingly. But as long as the management can keep it up, fast growers are the big winners on the share market. Mr. Lynch looks for companies that have good balance sheets, and are making substantial profits. The trick is figuring out when these companies will stop growing, and how much to pay for the growth.

  • The Cyclical Companies – A cyclical company is a company whose turnover and profits rise and fall in regular if not completely predictable fashion. In a growth industry, business just keeps expanding, but in a cyclical industry it expands and contracts, then expands and contracts again. The automobile companies as well as the resource companies (i.e. steel, paper, chemical and gas and oil) are all examples of cyclical companies. These cyclical companies flourish when they have come out of a recession and into a strong economy. Their share prices also tend to rise faster than the share prices of the stalwarts. This is understandable, since people buy new cars in a strong economy, and there is a greater demand for steel, chemicals, etc.

The disadvantage with cyclical companies is when the economy is not flourishing and going into recession (i.e. the opposite direction). Cyclical companies are the most misunderstood of all the types of shares. It is here that the unwary stock picker is most easily parted from his money, and in shares that he considers safe. You can lose more than 50% of your investment very quickly if you buy cyclical companies in the wrong part of the cycle, and it may take years before you can recover your losses. Because the major cyclical companies are large and well-known companies, they are naturally lumped together with the trusty stalwarts. Timing is everything with cyclical companies, and you have to be able to detect early signs that business is falling off or picking up. If you work in some profession that is connected to steel, aluminium, automobiles, etc., then you have an edge, and nowhere is it more important than in this kind of investment.

  • Turnaround companies – These companies have been battered, depressed, and often can barely drag themselves out of insolvency. Yet there is an opportunity in a crisis situation sometimes. These are not the slow growing companies; these are no growers. These are not the cyclical companies that rebound; these are potential fatalities. A poorly managed cyclical company is always a potential candidate to fall into this category of shares.

Turnaround companies can make up lost ground very quickly and the best thing about investing in successful turnarounds is that of all the categories of shares, their ups and downs are least related to the general market.

Peter Lynch talks about there being several different types of turnaround companies. For example:

  1. The "bail-us-out-or-else" kind of turnaround-company.
  2. The "little-problem-we-did-not-anticipate" kind of turnaround-company.
  3. The "perfectly-good-company-inside-a-bankrupt-company" kind of turnaround-company.
  4. The "restructuring-to-maximise-shareholder-vales" kind of turnaround-company.

Restructuring is a company's way of ridding itself of certain unprofitable subsidiaries it should never have acquired in the first place. The earlier buying of these ill-fated companies is called diversification. Peter Lynch calls this "deworsification".

  • The Asset-play companies – An asset play is any company that is sitting on something valuable that the market has overlooked. The asset may be as simple as a pile of cash. Sometimes it is property.

Asset opportunities are everywhere. Although they require a working knowledge of the company that owns the asset and once again, if you work in some profession that is connected, you have an edge. But once you understand what is happening in the company, all you need then is patience.

Finding the perfect company

You never find the perfect company, but if you could imagine it, you will know how to recognise favourable attributes. Like Warren Buffet, Peter Lynch also believes that getting the story on a company is a lot easier if you understand the basic business. He would rather invest in a panty hose company than in communication satellites, or in motel chains than in fibre optics. The simpler the business, the better he likes it because it is easier to follow.

Here are more attributes of a perfect company:

The perfect share would be attached to the perfect company, and the perfect company has to be engaged in a perfectly simple business, and the perfectly simple business ought to have a perfectly boring name. The more boring it is the better.

  • It is even more exciting when a company with a boring name also does something boring and there is something depressing about it. An example would be a burial company.
  • Better than boring alone is a company that is boring and disgusting at the same time. An example would be a waste disposal company.
  • The company is a spin-off. It was once a division or part of a company and is now a separate, free-standing entity.
  • The institutions do not own it and the analysts do not follow it. Similarly, you can get excited about companies that were once-popular with the professionals but have since been abandoned.
  • The company is in a niche market. Peter Lynch would rather own a local rock pit than a movie company because a movie company has much more competition. If you own the only gravel pit in Gauteng province, for example, you have got a virtual monopoly, plus the added protection of the unpopularity of rock pits.
  • The company has products that people have to keep buying. For example, companies that make drugs, soft drinks, razor blades or cigarettes.
  • The company is a user of technology. Instead of in a company that makes automatic barcode scanners, why not invest in a retail chain that installs the scanner? If the scanner can help the retail chain cut costs (i.e. pilferage, better stock control) by just 3%, that alone might double the company's profit.
  • The management (i.e. company directors) are buyers of the companies' shares. There is no better tip-off to the probable success of a company than that the people in the company are putting their own money into it. In general, company insiders are usually net sellers, and they normally sell 2.3 times as many shares to every one share that they buy.
  • The company is buying back its shares in the market. Buying back shares is the simplest and best way a company can reward its investors. If a company has faith in its own future, then why should they not invest in themselves, just as shareholders do? When a company buys back its shares, those shares are taken out of circulation and the number of shares in issue shrink. This has a magical effect on the earnings per share calculation, which in turn has a magical effect on the share price. For example, if a company buys back half its shares and its overall earnings stay the same, the earnings per share figure will have doubled. Few companies could get that kind of result by cutting costs or selling more of their products.

The kind of company to avoid has the following attributes:

  • Avoid the hottest company in the hottest industry, the one that gets the most favourable media publicity, the one that every investor hears about on the car radio in peak traffic driving time, and succumbing to the social pressure, often buys. Hot shares can go up fast, usually out of sight of any fundamental value, but since there is nothing but hope and thin air to support them, they fall just as quickly. If you are not clever at selling hot shares (and the fact that you have bought them is a clue that you would not be), you will soon see your profits turn into losses, because when the share price falls, it is not going to fall slowly, nor is it likely to stop at the level where you first purchased it at.
  • Avoid shares in a company that has been touted as the "next best thing" such as the next Didata, or the next Arcmittal. In fact, when people tout a share as the next of something, it often marks the end of prosperity not only for the imitator but also for the original to which it is being compared.
  • Avoid companies that prefer to blow money on foolish acquisitions (i.e. deworsification), instead of buying back their shares or paying a special dividend to shareholders. If the company seeks out merchandise that is overpriced and completely beyond his or her realm of understanding (i.e. not their core business), then you have a dedicated deworsifier.
  • Avoid buying shares on tips. These companies are often the long-shots, also known as whisper shares and whiz-bang stories. Often these companies are on the brink of solving the latest national problem: the oil shortage, drug addiction, AIDS. The solution is either very imaginative, or impressively complicated.
  • Beware of the company that sells 25% to 50% of its products to a single customer. You never know when that single customer would cancel its contract, start producing their own products, or decide that they can do without the product. Short of cancellation, a big customer has incredible leverage in extracting price cuts and other concessions that will reduce the supplier's profits. It is rare that a great investment could result from such an arrangement.
  • Beware the company with the exciting name. As often as a dull name in a good company keeps early buyers away, a flashy name in a mediocre company attracts investors and gives them a false sense of security. For example, if the company name has "advanced," "leading," "micro," or something with an X in it, or it is a mystifying acronym, people will fall in love with it.

Twenty four investment rules

Few things are easier to ignore than trading or investment advice. Many of the most significant investment rules have been so widely circulated that they have lost their ability to provoke any thought in the new investor. Thus, valid market insights are often dismissed as obvious clichés.

The most followed investment guru is probably Warren Buffet. He has added to his phenomenal lifetime investment performance by becoming a sought after speaker, commentator and writer. But there are many other commentators, bloggers and analysts who have interesting insights to add to the body of general knowledge.

If you Google 'investment tips' you will be presented with thousands of possible links to explore further. You will note that some of the advice may even be contradictory! We have put together a list of 12 tips that come from a range of sources, including Warren Buffet, Vikesh Jain and Steve Sjuggerand. Links for these sources are at the end of this section. The first ten tips are from Warren Buffet, the next four are from Steve Sjuggerand and the last twelve are from Vikesh Jain. Readers will note that the tips include advice on life style and spending habits as well as investing.

Rule #1: Live a very modest life, always avoid lavish spending - In other words save as much money as possible to enable you to invest majority of your earnings. Though Warren Buffett is among the richest men in the world but he still lives in a very modest house and still drives his own car. He believes that majority of his earnings shall be used for share investing to build as much asset as possible.
(Warren Buffet)

Rule #2: Avoid being a compulsive buyer and seller of shares - It is not always important to keep on buying and selling stocks. Buffett's believes that investors shall show patience and should be ready to wait indefinitely for that right time to invest their savings. The right time as per Buffett is during stock market collapse where great companies stocks becomes undervalued and are worth buying.
(Warren Buffet)

Rule #3: Do not buy shares what everyone else is buying - It is best to buy that share which has not drawn attention of others. When everyone starts buying a particular share its market price is bound to go up above reasonable price levels making it overvalued. Or in other words buy those stocks which are considered as bad purchase by majority of investors. Of course it is important to check the fundamental of the company before buying one.
(Warren Buffet)

Rule #4: Buy shares of companies which have simple products and services - Buy shares of company whose product or services are understandable to you. Understanding the business process is important before buying its shares.
(Warren Buffet)

Rule #5: Use your own method to evaluate value of shares - The basic of any share investing strategy is to learn the process of fundamental evaluation of a company. It is also important to learn the trick evaluating the value of shares. Fundamental analysis and share valuation are two preconditions of value investing.
(Warren Buffet)

Rule #6: Always buy undervalued shares - Warren Buffett calculates an intrinsic value of a share. If the market price of share is trading below its intrinsic value then it can be termed as an undervalued share. Warren Buffett first checks the fundamental strength of company and then calculates its intrinsic value to judge its status of being overvalued or undervalued. Warren Buffett calls purchase of undervalued shares as buying shares by maintaining "margin of safety'. The trick Warren Buffett uses to calculate the intrinsic value of share is the heart of his share investing wisdom. Intrinsic value is nothing but present value of all future cash flows linked with a particular shares. In calculating the intrinsic value Buffett pays more attention to (a) return on equity (ROE), (b) operating margin, (c) and on reasonable or no debt at all. Warren Buffett does not do analysis of shares on basis of only one year figures; instead he works on figures for at least last five years.
(Warren Buffet)

Rule #7: Buy shares of companies doing monopoly business - Such companies are becoming less and less in today's world, but still there are companies you can find who can manipulate their selling price at will without effecting their sales a lot. One example is Microsoft's Windows OS, Airbus A380 and likes. It may be difficult to locate too many of Microsoft's today but careful study will make it evident that there are companies that enjoy major competitive advantage than others. Warren Buffett will buy such companies over others.
(Warren Buffet)

Rule #8: Only confused people diversify their investments - If you will ask Warren Buffett about investment diversification he will give you a glare eyes. He believes that all investors shall be ready to wait indefinitely till share prices of fundamentally strong companies become undervalued. Till such time all investors shall save all of their earnings, so that when the time comes they shall not fall short of money for shares investing.
(Warren Buffet)

Rule #9: Buy shares to hold them for life - This does not mean that one shall go on holding a share even if the business has gone sick. Warren Buffett says that periodic evaluation of portfolio is very important. If the company us losing its competitive edge or its fundamental superiority then it is better to quit it than holding it forever. But what Buffett means when he says that 'hold it forever' is that before you buy share you should evaluate the share such that you are going to hold it forever as for your kids.
(Warren Buffet)

Rule #10: Do not invest to make money. Instead invest your money with the objective of generating more and more assets - There are people who enter the share market for making a quick buck. Warren Buffet will call such people fools. Share investing is not for making quick bucks, but instead it is a longer-term money making machine. The term is so long term that investors even loose the interest of making money. Then what is the motivation for such long term investors? Their drive for investment is driven by their desire to become financially independent and go on accumulating as much "asset" as possible.
(Warren Buffet)

Rule #11: An attempt at making a quick buck often leads to losing much of that buck - The people who suffer the worst losses are those who over-reach. If the investment sounds too good to be true, it is. The best hot tip I have found is "there is no such thing as a hot tip."
(Steve Sjuggerud)

Rule #12: Do not let a small loss become large - Do not keep losing money just to "prove you are right." Never throw good money after bad (do not buy more of a loser). When all you are left with is hope, get out. (Steve Sjuggerud)

Rule #13: Cut your losers; let your winners ride - Avoid limited-upside, unlimited-downside investments. Do not fall in love with your investment; it would not fall in love with you.
(Steve Sjuggerud)

Rule #14: A rising tide raises all ships, and vice versa. So assess the tide, not the ships - Fighting the prevailing "trend" is generally a recipe for disaster. Shares will fall more than you think and rise higher than you can imagine. In the short run, values do not matter.
(Steve Sjuggerud)

Rule #15: Decide whether you are a trader or investor? - Many people want to trade but then discover that they really are not suited for it. They may not have the time to watch the markets on a daily basis or the time horizon may just be too short. If you do not want to sit in front of your computer monitor, jobbing the market all day long, then do not even consider a day-trading method.

You would need to examine your reasons and think about why you really want to trade. There will be a conflict between your motives and the activities that result from it. If a part of you is pulling you in the opposite direction, you will have lost the game before have you even started. If the only reason for trading is for some excitement; then rather go off to the casino and play Blackjack. The market does not take any prisoners. You have to bend the odds in your favour to win.
(Vikesh Jain)

Rule #16: Choose an investment strategy that suits your personality - Following on from the previous rule, it is also critical to choose an investment strategy that is consistent with your own personality and comfort level. You may be a conservative investor or more moderate when it comes to taking risks. Some experts also feel that it is not necessary to define whether you are a value investor or a growth investor.

One's investment strategy, however, needs to be constantly reviewed and adapted according to the general economic condition and market trends. If you cannot stand to give back significant profits, then a long-term buy and hold strategy may prove to be a disaster because you will never be able to stick to it. Whatever strategy that you decide to use, however, must be right for you and must feel comfortable.
(Vikesh Jain)

Rule #17: Know your financial situation - This is one of the most important aspects of investing on the share market according to Vikesh Jain. In light of your financial objectives, consider answering the following questions:

  • Do you have sufficient starting capital?
  • Will you start-off small and then increase or add to the amount over time?
  • What is your time horizon?
  • Do you have realistic expectations with regards your returns?
  • Are you aware of the risks involved?
  • Can you handle the stress of a volatile market?
  • Can you devote as much mental effort to the share market as you do to earning your livelihood?

Rule #18: The trend is your friend - As long as the majority of both technical and fundamental indicators point in the same direction, one may logically conclude that the trend will continue in the same direction. Shares go from absurd undervaluation to outrageous overvaluation and it is within these parameters that the major investment opportunities lie. There is nothing to suggest that the approximate 20% annual historic rate of return that shares have been enjoying for the past 40-years, is about to drop. It is also impossible to identify the exact bottom or top of the market. However, for those investors who take appropriate action once the connections are recognised, the rewards can be substantial.
(Vikesh Jain)

Rule #19: Do not mistakenly call the market too high or too low - Again following on from the previous rule, the market is not a game of logic, but rather of mass emotion or psychology. It is not foolish enough to do what other people are doing. The public is right more often than not. Humans tend to imitate and it is the foundation of habit and custom. But be careful as the public is right mostly during the trend, but wrong at both ends.
(Vikesh Jain)

Rule #20: If you make a mistake, acknowledge it quickly - Charles H Dow once said "Pride of opinion caused the downfall of more men on Wall Street than all other opinions put together." This rule says that one must not continue with an incorrect decision. Forget about trying to recover your costs as this is an academic approach. Rather invest your money in a share that at least gives an opportunity to recover your losses. The saying in the market is "do not throw good money after bad" and contrary to what some analysts may recommend, this rule also applies to those people who love to average down.
(Vikesh Jain)

Rule #21: Cut your losses quickly and take your profits slowly - Do not be eager to sell too soon or put a ceiling to your income. Conversely, one can add, do not fail to take profits. However, once you are in a loss-making situation, do not be locked in. Sell soon and buy something else that is rising. Discipline is probably the word most frequently used by exceptional traders. There are two basic reasons why discipline is critical. First, it is a prerequisite for maintaining effective risk control. Second, you need discipline to apply your investment strategy without second-guessing and choosing which investments to take. You are almost always guaranteed to pick the wrong ones. Why? Because you will tend to pick the comfortable investments or in other words, what feels good is often the wrong thing to do. Remember, you are never immune to bad investment habits.
(Vikesh Jain)

Rule #22: Learn from each transaction and then move on - Do not have regrets as the past has happened. If you read the market incorrectly, go back and find out why. Keep a record of your transactions, not only for tax reasons, but also for further analysis. This will enable you to analyse your investment decisions, good and bad, and learn from the experience. Remember, the virtue of patience. Waiting for the right opportunity increases the probability of success. You do not always have to be in the market. Remember, as a value investor, you need patience!
(Vikesh Jain)

Rule #23: Markets move in cycles - After a strong rally, you should expect some profit taking. Following every rise in the share market, there is a correction or fall.
(Vikesh Jain)

Rule #24: Withdraw to fight another day - If you are unsure about an investment, rather wait. You do not have to be fully invested at all times. With experience you will develop intuition and begin to judge the temperature of the market. Understand that you are always responsible for your own results, whether you win or lose. Even if you lost money on your broker's recommendation, you are responsible because you made the final decision and acted upon it. Successful investors do not blame others for their losses.
(Vikesh Jain)

Sources:
http://jainvikesh.blogspot.com/2009/04/12-golden-r...
http://www.investmentu.com/research/timelessrules....
http://www.getmoneyrich.com/top-10-stock-investing....

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