Art of War Chapter 3 Summary defines the source of strength as unity, not size, and the five components that you need to succeed in any war.
Fundamental Stock Analysis
As with any other craft it is imperative that one understand the fundamentals of stock investing prior to engaging in any other activity in relation to investing. If you make it a goal to understand and perfect the fundamentals of investment analysis it will give you a distinct competitive advantage over average investors. Mainly because you will understand the two key factors of intrinsic value and time. You may find that you do not have millions of dollars to invest and therefore it is imperative that you focus on obtaining extreme value in the stocks that you allocate your hard earned capital into. With that being said let’s dive a little deeper into the purpose of stock analysis.
Stocks Are Businesses – A stock is a fractional piece of ownership in a business. All too often individuals make the mistake of believing shares of stock are simple pieces of paper. When you purchase a stock within the stock market you are agreeing to purchase a piece of that particular business for a set price. Most investors have the common misconception of “buying low & selling high,” I personally would like to “buy low and hold forever!” Think about it for a moment, if you could purchase McDonalds at a price you were happy with then sit back and passively collect the cash that is generated from that purchase, why in the world would you ever sell?
What Is A Stock Worth? – Now that we know stocks are actually businesses it would be in our best interest to assign a value to that business. Bottomline, we want to know how much that business is worth so we can make an accurate offer, who in their right mind wants to buy a business for $5 million dollars when it is only worth approximately $100,000?! This happens almost daily in the stock market and makes absolutely no sense.
Buy the Best Businesses – I want to make this clear upfront, not all businesses are created equal. Inevitably all businesses fail and therefore we must be vigilant in the businesses we choose to invest our hard earned capital into. With that being said it is absolutely crucial that we purchase the best and largest businesses. These businesses have been around for decades and possibly even centuries which almost guarantees they have a wide moat. Additionally they have large competitive advantages and can ride out harsh economic times.
Buy Cheap Stocks – Based on the 3 principles above we now have a blue print to successful stock market investing but there is one last thing we must consider. You can always identify a great business, determine it’s worth, and decide to own shares in the business but the thing that makes or breaks investors over the long term is the price they agree to pay for their shares. Purchase a business for too steep a price and it will be decades before you recoup your initial investment. However, if you are patient and willing to purchase the stock at a discount you can not only recoup your initial investment quickly but you can compound your wealth for years on end.
I know valuing a company is easier said than done but there are two quick ways you can evaluate a company to see if it is worth your time.
When Purchasing an Operating Company – An operating company generates a product. A good example of this is Coca-Cola (KO). Coca-Cola is a beverage company that owns more than 500 nonalcoholic beverage brands. When looking at an operating company the number one thing I am looking for is their cash flow. Once I determine their cash flow per share I typically don’t pay more than 8 – 10 times and have Dividend Kings I’m willing to pay up to 15 imes cash flow per share.
When Purchasing an Asset Company – An asset based company acquires assets and generates profits from those assets. Take Bank of America (BAC) for example, it’s a financial institution with a wide range of financial products and services. BAC generates revenues from the assets they currently hold. In relation to asset companies I use book value to determine their value, think of book value as your personal networth, it is simply all of the company’s assets minus its liability. Therefore when looking to purchase an asset company I typically want to pay less than book value, this allows me to buy a dollar at a discount.
You may not find this particular advice standard but I have etched it into my standards when conducting fundamental analysis. When screening for companies to invest I have the following two “non negotiables”
Must Pay a Dividend – Dividends have historically accounted for more than half a stock’s total return, this has been particularly true in regards to the S&P 500. I believe companies should treat their shareholders well and that is why I only invest in companies that return excess cash to their shareholders. Please do not make the mistake of believing all dividends are created equal. I have known many income investors who have suffered catastrophic losses to their portfolio chasing high dividend yields. As I stated above focus on the best and largest blue chip companies that pay a dividend and have a track record for increasing that dividend.
Share buy backs – The majority of income investors focus on dividend yield but they often overlook share buyback yields (also referred to as share repurchases). Imagine that you have a large pizza and it was cut into 8 equal slices, then you stick it back in the oven and cut it into 7 equal slices. The size of the pizza is still the same but each slice is now bigger. This is the same concept with share buybacks, everytime a company conducts share buy backs you own a little bit more of the company.
As Sun Tzu said focus on learning and mastering the core fundamentals and strategies of your craft in order to be successful.
Do you conduct fundamental analysis? What are some of your “non negotiables” when you looking for stocks to invest in??