Let me explain how this works in under 2000 words and save you over $800 hundred dollars.
Q2 hedge fund letters, conference, scoops etc
What you will learn…
- What a share is.
- What causes a share price to rise.
- And, how to value a share.
G’day,
Adam here.
I want to reassure you that is not difficult to understand how you can invest your savings into the share market and earn a decent return over the long term.
The merchants of financial theft like to ‘complicate to profit.’
A good rule of thumb is this: If anyone in the financial services industry tells you that a financial product or service is too complicated to explain, it means that their either stupid or their trying to fleece you out of your money.
Both will drain you of your savings.
A true test of one’s knowledge of a subject is their ability to explain it as simply as possible to someone not knowledgeable on that subjectt…
You can learn a lot about a person’s character in situations like this, if they get irritated and annoyed then refer back to our rule of thumb.
Dixon Advisory might be a good case in point.
Okay, let’s start.
Investing can be summed up in a four-step process, which I call the OEDA Loop (not a very catchy acronym).
- Observe: Looking for undervalued stocks & keeping an eagle eye on your shareholdings.
- Evaluate: Evaluate the company.
- Decide: Using your judgment of the facts and information to decide to: invest, sell or do nothing.
- Act: Act on your decision or start back at step 1.
Hold Up
We first need to cover a few basic facts about shares, before covering the OEDA Loop.
Think of a company like a big pizza. One Share is like one pizza slice.
When a company lists on the share market, they sell shares, like slices of pizza, on to the public market.
And, each share represents a piece of the company’s equity.
The equity of a company is what is left over after deducting the company’s liabilities from the company’s total assets, which is called net assets.
Let’s look at the balance sheet of a familiar business we’ve all heard of and shopped in… Woolworths.
On it, you‘ll find a list of all their assets and liabilities, with a total of each.
Looking ¾ down the balance sheet you’ll find the heading Net Assets, and you’ll see a total of $10,669m.
And, you see that the same dollar amount exists under the title Total Equity, a little bit below. That is because equity is the net asset total after deducting liabilities.
So, when you buy a one share in Woolworth’s, you own one small part of the company’s equity.
Furthermore, on page 137 of Woolworth’s annual report, you’ll find the list of the top 20 shareholders.
Number one is HSBC Custody Nominees (Australia) Limited, who own a whopping 25% of the equity of Woolworth’s. That’s a quarter of the pizza.
Please note that HSBC is a custodian and not the principled shareholder (a custodian holds shareholdings on behalf of a large number of different institutional investors).
Now, get ready to repeat this mantra…
“Each share we buy, we are buying a piece of a company’s equity.”
And I’ll say it again.”
“Each share we buy, we are buying a piece of a company’s equity.”
Okay, why repeat it?
Because, this is how you are not going to lose money, investing your savings into the share market.
Wait… What?
Think of it like this.
If you walked into Woolworth’s today to buy a kilo of bananas and they’re on sale for $4 dollars a kilo, and tomorrow they’ll rise to $5 a kilo.
Would you wait till tomorrow to buy them?
Of course not.
The Australian share market operates a bit like a supermarket.
There are over 2000 companies for sale and their share prices are changing by the minute.
Just like buying bananas, we want to buy stocks when they’re on sale.
You say: “Oh yes, you mean buy low, sell high!”
Me: “Well, sort of.”
To understand when you should buy a company’s shares, we first need to evaluate the company’s value.
How?
Start by evaluating the company’s equity value. And, because we own a share in the equity of the company, it entitles us to a share of the company’s profits.
Then our second step is to evaluate the company’s present and future cash flows to fully determine a company’s potential intrinsic value.
Is it making sense?
So, we need to value the company first, before deciding if we should buy a share at its current market price.
Otherwise, how will you know you are not paying too much?
This is one of the most common reasons why people lose money, because the price they pay for a share exceeds the value of the share.
What I am about to tell you is a key tenet of the Share Investor’s Blueprint.
The price you pay for a share must fall below the intrinsic value of that share by a margin of 20+ per cent.
This creates a margin of safety. This margin of safety protects us from risk of loss, and provides us with opportunities for excellent stock returns.
Gentleman, do not piss into the wind.
At this point most people, men in particular, nod their heads in agreement but then do the complete opposite by treating the share market like a casino.
How to avoid becoming one of them?
In step 2 of the OEDA Loop, we are evaluating the company; here, we apply a rational process to valuing what the company is worth.
Our evaluation process has are two main elements: The quantitative analysis and qualitative analysis.
Quantitative analysis involves examining the company’s financial statements – cash flow and assets, including industry statistics. This is the stuff we can calculate to a certain degree of precision.
Qualitative analysis involves examining the company’s unique characteristics that are hard to quantify. This involves examining the potential competitive advantages that may exist in favour of the company, the company’s business model, the industry dynamics, the company’s corporate strategy, and examining management.
The quantitative and qualitative elements are tied at the hip.
This means, if a company earns a high return on shareholders’ equity (it’s a ratio we’ll get too a bit later), consistently over several years, you’ll find that the company has a strong competitive advantage working in its favourr.
A competitive advantage is something that allows a company to earn higher profits compared to its competitors.
This investment process is thorough, which requires concentration and patience, but the rewards are great.
Unfortunately, many people cannot stomach this process, so they seek out easier ways to make money on the share market, which leads them susceptible to scams.
You say: “Are you talking about trading? I heard it’s easier.”
Remember our rule? Go on, say it!
“Each share we buy, we are buying a piece of a company’s equity.”
Traders ignore this fact.
They only care about the movement of the share price.
They look for patterns in historical share price charts and study the trade volume data. They believe they can predict the movement of share prices by identifying a specific pattern.
Looking for patterns in share price charts to predict future stock price movements reminds me of human behaviour called Pareidolia.
Which Wikipedia defines as; the tendency to interpret a vague stimulus as something known to the observer, such as seeing shapes in clouds, seeing faces in inanimate objects or abstract patterns, or hearing hidden messages in music.
Trading drains your bank balance.
As it requires you to make hundreds of trades per week, and at 11 dollars per trade, it is only making your broker rich.
And, that’s exactly how you’ll save over $800 dollars per year, by not becoming a trader, according to CANSTAR research.
You say: “Okay, I get it so far, and I want to know what causes the share price to rise?”
Me: “That’s a great question.”
There is a timeless quote by Benjamin Graham (who is considered one of the forefathers of investment analysis) that fundamentally answers the question.
“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”
Let’s explore what Benjamin Graham meant by this statement.
We’ll break it into two parts.
Firstly, what Graham was referring too when he used the term ‘voting machine’ in the short term, was the influence of human behaviour to influence share price movements over the short termm.
Our behaviour is driven by the same instincts of survival, which can be found in all other species living on this planet.
When we are faced with danger, our instinct tells us to fight or flight. Same occurs when a financial markets crash; we panic and follow the herd stampeding towards to exit.
We are also willing to follow the herd when the good times are flowing, as what happened leading up to 2008 GFC.
Which includes jumping on the bandwagon of an individual stock.
Look at the massive share price gains, over two years, of Afterpay (ASX:APT).
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Are these 8x gains justified considering that the company doesn’t earn profits?
If it is justified, then how? Or is the market too optimistic of Afterpay’s abilities to create profits?
These questions we need to ask ourselves.
Poseidon, back in the 1970s, is a great example of herd stupidity in Australia.
Question the wisdom of crowds.
A company’s share price, at a moment in time, is a snapshot of the market’s perception of that company’s ability to produce profits now and into the future.
But the market’s perception is made up of a combination of individual human perceptions.
Moreover, human perceptions are riddled with flaws.
Some of the best stocks to buy are those that look, sound, and produce boring profits.
Because they don’t sound exciting or newish, they get overlooked, which is great for us!
As a wise man said;
“If I could just avoid all the folly, maybe I could get an advantage without having to be really good at anything…And so this process I have gone through life identifying folly and trying to avoid it has worked wonderfully for me….It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
Charlie Munger (Warren Buffett’s right-hand man)
And that is what I want you to do too.
So, avoid the folly but do profit from it.
And, this brings us to the second part of Graham’s quote: ‘but in the long run, it is a weighing machine.’
Graham was inferring that companies, that earn above-average returns on equity, will see the value of their shares, over the long term, march steadily upwards as the share price mimics the returns of the businessm.
Let’s get super-specific.
Remember our mantra?
You yell cheerfully: “Each share we buy we are buying a piece of a company’s equity.”
Me: “Oh, damn, you’re pretty good.”
Well, one of the most effective ratios we can use to identify a great company is called return on equity.
Why?
Return on equity (ROE) measures the rate of return the company is earning on shareholders equity.
And, is calculated by dividing the current financial year’s net income by the ending equity total from last financial year.
What this means is for a company to earn revenues, and thus net income, an investment is made into operations of the company from the company’s equity.
Remember that equity is net assets, and net assets are made up of current and non-current assets, which are used to earn revenues. Once the expenses are accounted for we end up with the net income the company has earned from revenues.
So by dividing net income by last financial year’s equity total, we directly measure management’s ability to invest our share of the equity to grow net income.
Woolworth’s 25% ROE is a great return. And it indicates that management are efficiently allocating the firm’s capital.
Some businesses require little capital investment to earn high revenues, but some require large amounts to earn revenues. These businesses are referred to as either capital-light or capital intensive businesses.
Mining companies are by nature capital intensive, requiring large amounts of capital invested into plant property and equipment to dig stuff out of the ground, like gold, coal, silver and other commodities to sell.
Whereas, software companies are generally capital-light, requiring little investment in plant, property or equipment to produce high revenues. And, a2 Milk Company is a great example.
Graham was inferring that companies, that earn above-average returns on equity, will see the value of their shares over the long term, march steadily upwards as the share price mimics the returns of the business.
A Bullet Point Summary.
- A share is a piece of the company’s equity.
- To learn the value of a share, you need to value the company.
- Share prices in the short term are influenced by human behaviour.
- ROE measures the ability of management to allocate the company’s capital.
- Over the long term, the share prices of stocks follow the performance returns of the company.
If you like what you read and ready to invest your savings into the share market, then I invite you to the Share Investors Blueprint (Bluey).
Bluey is your companion to navigating the ins and outs of investing your savings into shares.
Bluey has 7 steps for you follow that allow you to know with absolute certainty if you should buy, sell or hold a stock.
If you have formed a conclusion from the facts and if your judgment is sound, act on it – even though others may hesitate or differ. (You are right because your data and reasoning are right).
Ben Graham
Article by Adam Parris, Searching For Value
