Disclaimer: The analysis is the expression and assessment of investments right now. They cannot replace individual counseling. Always research and evaluate the investments you are considering based on your investment strategy, risk, and time horizon. Therefore, following the recommendations, you are responsible for any losses you may incur.
Investing is a practice that can benefit most of us. While making a profitable investment is one aspect, active investors aspire to outperform the broad market. To achieve success in investing, a solid understanding of the basics is crucial.
Simply put, investing involves putting money into mispriced assets and anticipating an increase in value. From a traditional investor's perspective, an asset is something that can generate cash flow, including real estate, bonds, and stocks. On this website, the primary focus will be on stocks. This means that assets like currencies, art, and gold are not considered investments but rather speculation.
Speculation is aptly named because individuals engaging in this type of investment cannot clearly determine whether the speculative asset is overvalued or undervalued without assuming that more people will buy it. This viewpoint aligns with the perspective of the legendary investor, Warren Buffett:
“Gold … has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end”
Buffett, letter to shareholders, 2011
What makes an asset mispriced? In my quest for mispriced assets, I analyze the quality of companies and compare them to their valuations. Quality can be simplified by assessing the return on invested capital (ROIC) and how well a business can operate in an economic downturn.
A high ROIC suggests a competitive advantage, often referred to as an economic moat. An economic moat is crucial because it enables a company to generate a higher return. To maintain profitability, it needs a competitive advantage, allowing it to outperform competitors. Besides ROIC, companies with competitive advantages typically exhibit higher profitability and larger market share.
Determining a sustainable competitive advantage requires understanding the industry and the company since there's no formula to measure the size of the moat. One effective approach is to put yourself in the shoes of a customer. If you understand why a product or service has an edge, it may indicate a sustainable competitive advantage.
Quality analysis is essential, but it's not the only factor influencing when to buy a stock. Successful investors calculate the intrinsic value and compare it with the quality factor. If a stock trades below its intrinsic value, it's considered undervalued. A successful investor buys when there's a significant margin of safety, with the size of the margin determined by the quality factors.
I believe individual investors can formulate a thesis about the general direction of a company's growth in the future, similar to how it's easier and more accurate to determine if a person is overweight than to specify their exact weight. When analyzing a company's growth, we can reasonably predict whether a company like Apple will continue selling phones in the future and whether the sales will increase or decrease. However, predicting the exact number of phones they will sell becomes a more challenging task.
Therefore, an investor should analyze what is already priced into the stock and assess the likelihood of achieving a favorable return on the investment. This is called second-level thinking and was developed by Harvard Marks. I would say that most investors are trading stocks through first-level thinking. A first-level thinking says: “It is a good company, let’s buy the stock.” Second-level thinking says, “It’s a good company, but everyone thinks it’s a great company, and it’s not. So the stock’s overrated and overpriced; let’s sell.” This means a successful investor compares the price to the underlying quality of a company.
“I hear first-level thinking from individual investors all the time. They read the headlines or watch CNBC and then adopt conventional first-level investment opinions.”
Joel Greenblatt, The most important thing
Nonetheless, a successful investor doesn't simply follow the herd but forms their own opinion on how the investment will perform in the future. You don't need to reinvent the wheel to be a good investor. There is a wealth of information on this topic from other successful investors with a proven track record. It's worth remembering that Warren Buffett, one of the richest people in the world, started by following Benjamin Graham's principles.
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