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3 golden rules to be a top investor

This article appeared in the October 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Avoid market noise, think like a business owner rather than a speculator, and learn how to value companies.

Photo of Roger Montgomery By Roger Montgomery, The Montgomery Fund

Unwittingly, you are probably a speculator rather than an investor, and the aim of this first of a three-part series on becoming a successful long-term investor is to encourage you to turn your back on speculating forever.

ASX Investor Update readers can obtain a free download of my Full Three-Part Investing Guidebook.

Sustained sharemarket success begins with thinking like a business owner, rather than a trader of stocks. Betting on the next "up" or "down" is tantamount to betting on black or red at the casino. It is not investing. Further, when someone says they "invested" in a tech start-up, they are incorrect. Speculating is not investing.

When colleagues tell you about a "hot" stock they own and you buy it, or a newspaper story makes a compelling case for selling a stock and you sell it, you are not acting like an investor. Nor are you when a broker publishes an aggressive research note on a stock and you buy, or perhaps you have a hunch that China will grow faster than expected and punt on quick gains in commodity and resource stocks.

Not only are these approaches a common way to construct a portfolio, but the portfolio that is constructed is merely a hotchpotch of ideas and beliefs that will usually amount to little. Worse, when something inevitably does go wrong, you have learned nothing from the experience because none of it was systematic, replicable or repeatable.

A simple search of listed Australian companies that earned more than $1 in the latest reporting period reveals that only about a third of the 2188 ASX-listed entities made a profit and a large number of those were barely in the black.

Two of every three listed companies did not cover their costs and many will have to rely on capital raisings to stay alive. Owning such stocks requires a leap of faith that the company will eventually be profitable, and while faith may prove spiritually beneficial, there is little place for it in investing.

There is nothing wrong with experienced day-traders punting on loss-making companies, provided they understand the risks of speculation and have enough skill to overcome the odds stacked against them, including

  • The impossibility of properly valuing loss-making companies
  • The potential for higher price volatility in such stocks
  • The huge dangers of illiquidity (low share turnover).

You do not need to trade loss-making companies to boost your portfolio's value over time.

There are more than enough opportunities among profitable businesses to make double-digit returns from the sharemarket without excessive risk. Montgomery has achieved this as a manager of other people's money. Consider these three rules:

1. Become an informed investor

It is among the profitable companies where you should start to think like an owner of a business rather than a renter of pieces of paper represented by wiggles on a screen in a broker's office. You will find extraordinary businesses at bargain prices.

Arguably, the best long-term, risk-adjusted returns come from buying exceptional businesses and holding them for as long as they remain exceptional, continue to have bright prospects for intrinsic value growth, and share prices do not diverge too far above forecast intrinsic values.

Sustained equity investment success requires two core skills and the right temperament. The two skills are:

  1. The ability to identify a superior business
  2. The ability to value that business.

You might also have been told that "asset allocation" is an important driver of investment returns. Indeed, some studies and their highly regarded authors do show that asset allocation is a meaningful driver of overall investment returns.

Generally speaking, however, tactical asset allocation requires the rather arrogant belief that one can predict asset class returns reliably. Promoting such a requirement best serves those professionals who would have you believe you need them in order to invest successfully.

My view is that the top-down approach is fraught with errors from which little can be learned for the purposes of future exclusion. However, the ability to value businesses produces a list of those that are expensive and those that are cheap.

When the vast majority of companies are expensive and there are few securities worthy of investment, the only conclusion is that more funds must be allocated to cash. That's the best "tactic", in my view. In one sense, a bottom-up approach, such as the one contemplated here, produces the only sensible asset allocation.

2. Betting on someone paying a higher price

Without an estimate of the value of a business, buying its shares is, by definition, speculating and betting on someone being willing to pay more at a later date.

This is a critical point. Speculation is not just owning an unprofitable exploration or biotech company and hoping it will one day make money. It also occurs when investors buy a profitable company, perhaps even a so-called blue chip, without having a view on its valuation, or how that valuation is changing over time. In effect, the person is unwittingly speculating, rather than investing.

Imagine if a friend or colleague asked you to invest in a private company. Your first question probably would be, what are the chances of the business going bust? That is, is it profitable, how much debt does it have, and can it comfortably meet its interest repayments?

Your second question might be, is it a good business? Which means does it operate in an attractive industry, sell a good product, and have an excellent reputation and client list? Does it have a long-term record of rising profits and, more importantly, a rising return on equity (ROE) or return on shareholder funds? Do you believe the ROE will continue to rise over time and lead to a higher company valuation? And will the ROE be sufficiently high to compensate for the risk in this investment?

Your third question would probably be, How much do I have to pay to own X per cent of the company?"

From the answers, you determine what the company is worth and assess that against the asking price. A view of the company's worth (its intrinsic value) helps you make astute decisions when prices rise or fall, because you understand the difference between value and price.

3. Don't be swayed by market noise

So what stops people thinking like a part-owner in a business when it comes to listed companies, and instead act like part of a herd? Market noise plays a big role. Investors are seduced by media headlines, magazine stories on 'Hot stocks under $1', television finance channels, and broker reports.

They fear missing out more than they fear losing money. They latch on to supposed expert views and succumb to ever-larger waves of stock commentary, failing to realise that the entire machine has been set up to promote noise and activity.

Instead, investors need a quiet, controlled detachment from the sharemarket. Step number one simply involves turning the sharemarket noise off.

Market noise amplifies those two great investing emotions: greed and fear. It triggers the purchase of low-quality companies in the hope of making a quick buck, and triggers the sale of high-quality companies because there was no appreciation that a sharply rising price was simply following the company's rising intrinsic value, or was all occurring well below that value.

Having a clear yardstick for company value helps you know when to be greedy and fearful, usually well in advance of the herd that uses sharemarket noise as its decision-making trigger.

Having discussed the subject of adopting the right mental framework, the next step will be to look at how to assess a business's quality, and step three will be calculating a business's intrinsic value.

Before moving on, however, remember these three rules:

  1. The focus on price movement, and the expectation of profit from it rather than from business performance, is pure speculation, not investing.
  2. Instead of renting bits of paper and hoping they will go up in price tomorrow or next week or next month, investing involves buying a slice of a business after considering the facts and applying common sense.
  3. Buy shares in order to own businesses. Don't buy shares merely to sell them.

About the author

Roger Montgomery is Chief Investment Officer at The Montgomery Fund. Access a free download of my Full Three-Part Investing Guidebook.

From ASX

Revisit Roger's most recent ASX Investment video 'Value Investing with the experts'.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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