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Price is what you pay. Value is what you get.
-- Warren Buffett
Every investor dreams of becoming as successful as Warren Buffett, to be the richest person in the world. But rarely do these investors follow their icon's mantras conversed through television interviews, books, periodic journals, etc. It is worthwhile to pay heed to Buffett's stock investing tips. This knowledge on value investing will help drive investors to make sound investment decisions.
#1: Invest in quality businesses, not in stock symbols
If a business does well, the stock eventually follows.
Most investors don't analyse the businesses they invest in. They simply follow the symbols or brands of successful corporate houses. The best example is the Reliance Power IPO. When the IPO of Reliance Power was announced, many investors rushed to subscribe to it with the reason that it had the brand name 'Reliance'. However, the stock was overvalued at the time of IPO and investors made a considerable loss after the stock was listed on the stock exchange.
When considering IPOs, one needs to do considerable research about the concerned company, it's past performance, how the IPO money will be utilised, details about the company management, and when the operations will commence so that company starts generating profits.
As, Buffett states, 'An investor needs to buy the stock as if he is buying the whole company down the road'. Investors are also expected to be acquainted with the following before buying the company stock:
Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.
Investors get panicky when they track share prices continuously. Share prices are quite volatile in the short-term. However staying invested in a value company will pay you rich rewards over a long-term period, unlike short-term investments that are prone to constant price fluctuations.
Note: A smart investor needs to also think before selling an investment that may be in a loss due to certain economic factors but has tremendous potential to rise in future.
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
A smart investor needs to identify stocks of a company that have great potential to grow in years to come. Most investors buy a stock when it is extremely high because it's in demand. The key is to identify stocks which have potential to grow and are available at a cheap or reasonable price.
Such acumen can be achieved by scanning the company's annual financial reports, understanding its vision and mission statements, its business cycle and business process, long term plans, etc.
Essentially, it means taking some time out to carefully understand and analyse the company and its business. Investors also need to keep updates of their selected companies and sector news on a regular basis. Information about a company is readily available through secondary sources such as journals, economic newspapers, television, etc. Many a time such secondary sources are sufficient for analysing and arriving at a decision for investment.
Beware of geeks bearing formulas.
The money available to the company's management is called capital. The capital comprises the equity and long-term debt of the company. The success of any business depends on how well its management uses its capital. Such an analysis can be made with the help of 2 ratios: Return on Equity (ROE) and Return on Capital Employed (ROCE).
ROE: It measures a company's profitability by revealing how much net profit a company generates through shareholders' equity.
Return on Equity = Net profit / Shareholder's equity
ROCE: It indicates the efficiency and profitability of a company's invested capital; calculated as:
ROCE = EBIT/ Total assets - Current liabilities
EBIT = Earnings before interest and tax deductions
A smart investor must interpret the company's financial statements and understand the quality of return on his investment.
One needs to search and invest in companies with good returns on capital invested while employing little or no debt. This means that ROE and ROCE should essentially be the same.
Rule No 1: Never lose money. Rule No 2: Never forget rule No.1.
There are thousands of stocks traded each day on Sensex and Nifty. A smart investor has to find the best out of the available investment options. There are stocks that have high trading volume, extreme movements in their price (either up or down), or are constantly in news.
A smart investor should examine whether the stock-in-news has some real value or is just glittering at the moment.
For example, remember the Satyam fiasco? The stock was glittering for many years and was a hot pick among investors and analysts alike until its accounting fraud surfaced in 2008 when Ramalinga Raju (the company's mentor) confessed to the crime. The company tampered its annual reports and fooled investors for years, all the time being 'A-listed' on national stock exchanges.
Although the episode is behind us now, it is wise to do your homework before investing in each and every company. You would also be wise to diversify your investments across sectors and asset classes, which will give you the needed cushion from loss from any one investment.
Value is what you get.
Wait...wait...wait until everything is in your favour while buying a stock. These are the stocks with the highest chance of being successful and making you money year after year. To be able to do this effectively, one needs to master the below steps as suggested by Buffett.
As mentioned earlier, invest in stocks that are not glittering on investment magazines or recommended by stock analysts/editors on popular television channels. Perform your own research then make vital investment decisions.
After identifying great businesses to invest in at a fair price, buy a "meaningful amount of stocks in them". That means hold only a limited number of companies in your portfolio; holding excess stocks results in lower returns on your overall portfolio and spending more time to keep track of the same. This may also add considerable risk as it is not feasible for an individual to diligently observe all companies in his/her portfolio.
Ideally, one should limit the number of stocks in his/her portfolio to 10-15. This way, there is an advantage of your portfolio not being cluttered.
Buffett elaborates about knowledge and confidence. According to him, one must require the knowledge of selecting the right stocks by careful research and also build confidence in one's decisions. Market will test your patience to reach the expected returns. So, you need to stay firm with your investment decisions during volatile trading sessions. Do a good amount of homework and keep faith in your research and decisions.
...not whether the stock is undervalued or overvalued, according to some academic model such as the discounted cash flow.
Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.
A smart investor needs to keep an eye on expected returns from particular stocks in the long term and calculate the entry and exit prices of invested companies. This requires thorough research and analysis of the company's available data. Buffett recommends being one's own analyst to profit from investing in stocks.
Someone's sitting in the shade today because someone planted a tree a long time ago.
One of the best practices according to Buffett is to sell loss-making stocks during a bull run and buy the winner stocks during a bear hug.
The amount realised by discarding loss-making stocks can be utilised to invest in stocks with future growth potential and there by achieving better returns.
It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently.
Most of the time investors make little progress due to insensible investment decisions. Their decisions are based on emotion, hope and wishful thinking without carrying out proper research and analysis.
It's necessary for a smart investor to think logically while investing and performing research. You need to keep on asking yourself why you want to invest in a particular company and eliminate decision-making based purely on intuition, emotion and herd mentality.
Due diligence before investing in a particular company saves you from the worry of your money being tied-up in companies and businesses that you have little or no knowledge about.
So follow the sound advice provided by Warren Buffett -- avoid the noise and glitter, do your own research, and constantly update your knowledge and stock-picking skills. In short, be a smart investor!