Here at Morningstar, our stock analyst staff has nearly a thousand years of collective investment experience. In this final lesson of the stocks Investing Classroom, we’ve boiled down some of our most salient observations into 20 suggestions we think will make you a better stock investor.
1. Keep It Simple.
Keeping it simple in investing is not stupid. Seventeenth-century philosopher Blaise Pascal once said, “All man’s miseries derive from not being able to sit quietly in a room alone.” This aptly describes the investing process.
Those who trade too often, focus on irrelevant data points, or try to predict the unpredictable are likely to encounter some unpleasant surprises when investing. By keeping it simple–focusing on companies with economic moats, requiring a margin of safety when buying, and investing with a long-term horizon–you can greatly enhance your odds of success.
2. Have the Proper Expectations.
Are you getting into stocks with the expectation that quick riches soon await? Hate to be a wet blanket, but unless you are extremely lucky, you will not double your money in the next year investing in stocks. Such returns generally cannot be achieved unless you take on a great deal of risk by, for instance, buying extensively on margin or taking a flier on a chancy security. At this point, you have crossed the line from investing into speculating.
Though stocks have historically been the highest-return asset class, this still means returns in the 10%-12% range. These returns have also come with a great deal of volatility. (See Lesson 103 for more.) If you don’t have the proper expectations for the returns and volatility you will experience when investing in stocks, irrational behavior–taking on exorbitant risk in get-rich-quick strategies, trading too much, swearing off stocks forever because of a short-term loss–may ensue.
3. Be Prepared to Hold for a Long Time.
In the short term, stocks tend to be volatile, bouncing around every which way on the back of Mr. Market’s knee-jerk reactions to news as it hits. Trying to predict the market’s short-term movements is not only impossible, it’s maddening. It is helpful to remember what Benjamin Graham said: In the short run, the market is like a voting machine–tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine–assessing the substance of a company.
Yet all too many investors are still focused on the popularity contests that happen every day, and then grow frustrated as the stocks of their companies–which may have sound and growing businesses–do not move. Be patient, and keep your focus on a company’s fundamental performance. In time, the market will recognize and properly value the cash flows that your businesses produce.
4. Tune Out the Noise.
There are many media outlets competing for investors’ attention, and most of them center on presenting and justifying daily price movements of various markets. This means lots of prices–stock prices, oil prices, money prices, frozen orange juice concentrate prices–accompanied by lots of guesses about why prices changed. Unfortunately, the price changes rarely represent any real change in value. Rather, they merely represent volatility, which is inherent to any open market. Tuning out this noise will not only give you more time, it will help you focus on what’s important to your investing success–the performance of the companies you own.
Likewise, just as you won’t become a better baseball player by just staring at statistical sheets, your investing skills will not improve by only looking at stock prices or charts. Athletes improve by practicing and hitting the gym; investors improve by getting to know more about their companies and the world around them.
5. Behave Like an Owner.
We’ll say it again–stocks are not merely things to be traded, they represent ownership interests in companies. If you are buying businesses, it makes sense to act like a business owner. This means reading and analyzing financial statements on a regular basis, weighing the competitive strengths of businesses, making predictions about future trends, as well as having conviction and not acting impulsively.
6. Buy Low, Sell High.
If you let stock prices alone guide your buy and sell decisions, you are letting the tail wag the dog. It’s frightening how many people will buy stocks just because they’ve recently risen, and those same people will sell when stocks have recently performed poorly. Wakeup call: When stocks have fallen, they are low, and that is generally the time to buy! Similarly, when they have skyrocketed, they are high, and that is generally the time to sell! Don’t let fear (when stocks have fallen) or greed (when stocks have risen) take over your decision making.
7. Watch Where You Anchor.
If you read Lesson 407 on behavioral finance, you are familiar with the concept of anchoring, or mentally clinging to a specific reference point. Unfortunately, many people anchor on the price they paid for a stock, and gauge their own performance (and that of their companies) relative to this number.
Remember, stocks are priced and eventually weighed on the estimated value of future cash flows businesses will produce. Focus on this. If you focus on what you paid for a stock, you are focused on an irrelevant data point from the past. Be careful where you place your anchors.
8. Remember that Economics Usually Trumps Management Competence.
You can be a great racecar driver, but if your car only has half the horsepower as the rest of the field, you are not going to win. Likewise, the best skipper in the world will not be able to effectively guide a ship across the ocean if the hull has a hole and the rudder is broken.
Also keep in mind that management can (for better or for worse) change quickly, while the economics of a business are usually much more static. Given the choice between a wide-moat, cash-cow business with mediocre management and a no-moat, terrible-return businesses with bright management, take the former.
9. Be Careful of Snakes.
Though the economics of a business is key, the stewards of a company’s capital are still important. Even wide-moat businesses can be poor investments if snakes are in control. If you find a company that has management practices or compensation that makes your stomach turn, watch out.
When weighing management, it is helpful to remember the parable of the snake. Late one winter evening, a man came across a snake on the path. The snake asked, “Will you please help me, sir? I am cold, hungry and will surely die if left alone.” The man replied, “But you are a snake, and you will surely bite me!” The snake replied, “Please, I am desperate, and I promise not to bite you.”
So the man thought about it, and decided to take the snake home. The man warmed the snake up by the fire and prepared some food for the snake. After they enjoyed a meal together, the snake suddenly bit the man. The man asked, “Why did you bite me? I saved your life and showed you much generosity!” The snake simply replied, “You knew I was a snake when you picked me up.”
10. Bear in Mind that Past Trends Often Continue.
One of the most often heard disclaimers in the financial world is, “Past performance is no guarantee of future results.” While this is indeed true, past performance is still a pretty darn good indicator of how people will perform again in the future. This applies not just to investment managers, but company managers as well. Great managers often find new business opportunities in unexpected places. If a company has a strong record of entering and profitably expanding new lines of business, make sure to consider this when valuing the firm. Don’t be afraid to stick with winning managers.
11. Prepare for the Situation to Proceed Faster than You Think.
Most deteriorating businesses will do so faster than you anticipate. Be very wary of value traps, or companies that look cheap but are generating little or no economic value. On the other hand, strong businesses with solid competitive advantages will often exceed your expectations. Have a very wide margin of safety with a troubled business, but do not be afraid to have a much smaller margin of safety for a wonderful business with a shareholder-friendly management team.
12. Expect Surprises to Repeat.
The first big positive surprise from a company is unlikely to be the last. Ditto the first big negative surprise. Remember the “cockroach theory.” Namely, the first cockroach you see is probably not the only one around; there are likely scores more that you can’t see.
13. Don’t Be Stubborn.
David St. Hubbins memorably said in the movie This is Spinal Tap, “It’s such a fine line between stupid and clever.” In investing, the line between being patient and being stubborn is even finer, unfortunately.
Patience comes from watching companies rather than stock prices, and letting your investment theses play out. If a stock you recently bought has fallen, but nothing has changed with the company, patience will likely pay off. However, if you find yourself constantly discounting bad news or downplaying the importance of deteriorating financials, you might be crossing that fine line into stubborn territory. Being stubborn in investing can be expensive.
Always ask yourself, “What is this business worth now? If I didn’t already own it, would I buy it today?” Honestly and correctly answering these questions will not only help you be patient when patience is needed, but it will also greatly help you with your selling decisions.
14. Listen to Your Gut.
Any valuation model you may create for a company is only as good as the assumptions about the future that are put into it. If the output of a model does not make sense, then it’s worthwhile to double-check your projections and calculations. Use DCF valuation models (or any other valuation models) as guides, not oracles.
15. Know Your Friends, and Your Enemies.
What’s the short interest in a stock you are interested in? What mutual funds own the company, and what is the record of those fund managers? Does company management have “skin in the game” via a meaningful ownership stake? Have company insiders been selling or buying? At the margin, these are valuable pieces of collateral evidence for your investment thesis on a company.
16. Recognize the Signs of a Top.
Whether it is tulip bulbs in 17th century Holland, gold in 1849, or Beanie Babies and Internet stocks in the 1990s, any time a crowd has unanimously agreed that a certain investment is a “can’t lose” opportunity, you are probably best off to avoid that investment. The tide is likely to soon turn. Also, when you see people making investments that they have no business making (think bellboys giving tips on bonds, auto mechanics day-trading stocks in their shops, or successful doctors giving up medicine to “flip” real estate), that’s also a sign to search for the exits.
17. Look for Quality.
If you focus your attention on companies that have wide economic moats, you will find firms that are virtually certain to have higher earnings five or 10 years from now. You want to make sure that you focus your attention on companies that increase the intrinsic value of their shares over time. These afford you the luxury of being patient and holding for a long time. Otherwise, you are just playing a game of chicken with the stock market.
18. Don’t Buy Without Value.
The difference between a great company and a great investment is the price you pay. There were many fantastic businesses around in 2000, but very few of them were attractively priced at the time. Finding great companies is only half the equation in picking stocks; figuring out an appropriate price to pay is just as important to your investment success.
19. Always Have a Margin of Safety.
Unless you unlock the secret to time-travel, you will never escape the inherent unpredictability of the future. This is why it is key to always have a margin of safety built in to any stock purchase you may make–you will be partially protected if your projections about the future don’t exactly pan out the way you expected.
As you have seen in recent lessons, having a margin of safety is a recurring theme among several great investors. This is no accident; margin of safety really is that important.
20. Think Independently.
Another common characteristic you will find in the next section is that great investors are willing to go against the grain. You should find zero comfort in relying on the advice of others and putting your money where everyone else is investing. Quite simply, it pays to go against the crowd, because the crowd is often wrong.
Also remember that successful investing is more about having the proper temperament than it is about having exceptional intelligence. If you can keep your head while everyone else is losing theirs, you will be well ahead of the game–able to buy at the bottom, and sell at the top.
The Bottom Line
We’ve distilled a lot of information and collective wisdom into these 20 tips, most of which we have touched on in greater depth elsewhere in this Investing Classroom series. We firmly believe that if you heed the advice contained here, you will make better decisions when buying and selling your stocks.