A short guide to stock investing

Ricky Yeo

Introduction
Learning to invest in the stock market is different from say, learning maths. Whereas
everyone eventually reaches the same solution in the latter, theres no one right answer on
how to invest well. Nonetheless, there are overriding similarities between learning the
both, or any sorts of skills. The fastest way to learn a skill is to deconstruct it by breaking it
into pieces, strip down to their essence, and examine the fundamentals.

Fundamentals provide a solid foundation, like a sturdy building holding up against shocks,
so you wont fall apart during a market panic. Investing is a slow learning process, same as
everything you set out to do, like a car in first gear going uphill. And dont worry about
missing out opportunities. If the boat is not in the right direction, it doesnt matter how
fast it goes. Instead, aim for 1%, strive to improve yourself by 1% every day, it adds up over
time. Build a long runway, and focus on what matters and ignore the trivial. When your
knowledge compounds, your wealth follows.

Ownership of a business
In the stock market, every share you own is a slice of ownership in the business,
essentially, you are the owner. You are entitled to vote, receive a dividend, if theres one,
and participate in the fortune of the business as a shareholder. You grow your wealth
through the dividends received, and share price appreciation as the business makes more
money.

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Most investors watch their shares like a hawk, reasoned a drop in share price would impair
investment capital. That is true if the shares are sold to realize the loss, but otherwise, flies
in contrary to the mindset of an owner. If an asset can be acquired at a lower price, in this
case, the whole business, isnt that a positive thing? As opposed to a falling share price, the
risk of an investor comes from not knowing what he is doing. If one buys a property but
never take the trouble to inspect, or walk around the neighborhood, is it a surprise if the
house is in a poor condition sitting in an unsafe neighborhood?

Similar to doing research before getting a fridge, a car, or a house, a big part of investing
lies in preparation, doing the work before buying, and spending the time to understand the
business. These knowledge create a psychological edge, and the ability to think
independently, a rare and valuable trait in investing during market panic. You can assess
the situation with a calm head before making the right decision rather than rushing to the
exit doors like everyone else.

Your profession or things that surround your daily life are good starting points to learn
more about a business and industry. If you work in the I.T industry, chances are you will
be familiar with some software providers; if you are a car enthusiast, which stores do you
always visit and for what reasons? Even if youre a stay at home mom, you might have
developed a good understanding where to find quality ingredients. By observing things
around you, you have a good judgment on whats selling, and what doesnt. Look for the
label, find out which company produce it and how well the business is doing.

What is the return?

Given the choice between a wonderful and an average business, youll prefer to invest in
the former. But how do you distinguish the former from the latter? Is there any
characteristic that defines a company as wonderful?

If one of your friends comes to you with an idea of starting a business together, you will ask
questions like:

1. What kind of business is it?

2. How much investment do I have to put into the business?
3. How much money can the business make every year and how fast?

The first question focuses on having a good grasp on what the business does. If your friend
is going to start something that you cant get your head around, never ever get involved.

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The subsequent two questions are the litmus test to see how attractive an investment can
be, or how wonderful the business is. To start with something simple. If you decide to open
a savings account, you would prefer a bank that offers a better rate, say 2% instead of 1%.

To express it in an equation:
The savings account earns you $2,000 / You have to put in $100,000 = You earn 2%
return

or put it another way:

How much money can the business make / How much investment to put in = X% return

To simplify it:
Profit / Shareholders Equity = X% return (Return on equity)

Shareholders equity means the total amount of money that have been put into the
business. Return on equity or ROE for short, expressed in percentage, measures how well
the business is generating a return on its investment. In the savings account example, you
get a 2 cents return for every dollar of investment or a ROE of 2%.

A business can report they made 1 million or 100 million in profit but that information has
little value without knowing how much investment had been put in. The ROE decides how
attractive a business is. In running analogy, a runners performance is determined by the
time required to achieve an X amount of distance. In investing, it is the investment
required to generate an X amount of profit that determines the share price & business
performance.

Business Wonderful Average

Investment $1.00 $1.00

Profit $0.20 $0.10

Total $1.20 $1.10

Rate 2x 1x

ROE 20% 10%

Years to reach $2 72/20% = 3.6 years 72/10% = 7.2 years

Comparison: A wonderful business generating 20% ROE and a mediocre business generating 10% ROE

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As shown above using two businesses as a comparison, business wonderful can produce 20
cents of profit on every dollar of investment per year, compared to 10 cents of profit by the
average. Therefore, it is producing profit at twice the speed of average.

Using the Rule of 72 (last row), which is a quick way to estimate how long an investment
will double given an annual rate of return, you will reach the same conclusion. The
wonderful can double the return in half of the time it takes for the average to do so, 3.6
years instead of 7.2 years, due to its ability to generate profit at twice the rate. So it makes
sense to own a high ROE business than a low one, but theres a catch. Wonderful business
generally commands a higher share price (in relative to average ones) because investors
are attracted to its wonderful future prospect and they are willing to pay up for it. This is
an important point as share price and future return has an inverse relationship.

Price and value

To understand this relationship we have to start with the concept of price and value. To put
it simply, price refers to share price, the numbers that goes up and down every second,
whereas value refers to the value of a business or how much it is worth. You can easily find
out the price of a stock but the value of a business is obscure.

In general, the share price is a good reflection of how much the business is worth over a
long time frame of 5 to 10 years. However, in the short near term, the share price is driven
by the manic depressive emotions of investors. Factors from economic outlook or company
specific news such as earnings release constantly affect the market sentiment. As a result,
the market can be overly pessimistic or optimistic on the future prospect of a stock and
from time to time, causes the share price to deviate away from its value.

A brilliant old adage describes the market as a beauty contest in the short term, and a
weighing machine in the long run. In the short run, investors tend to flock to popular
stocks that are flavor of the month, in disregard of the business fundamental and pushes
up their share price in the process. But ultimately, it is the performance of the business
that determines the share price over the long run. So when over-optimism causes the share
price to increase, the future return is likely to be lower because, over the long run, price
will self-adjust and return to where its value is. Hence, the inverse relationship between
share price and future return.

Going back to our wonderful example above, that means yes, youll want to own a
wonderful business but without overpaying for it.

To illustrate this further, you decided to buy a wonderful stock with a great record of
generating 20% ROE per year. If you buy it:
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1. At a fair price, where price equals value, the share price return will be similar to the
return of the business in the long run, which is 20%.

2. At a high price, where price exceeds the value, the share price return will be less than
20% as price adjust downward to reflect where the value is.

3. At a low price, where value exceeds price, the share price return will be more than 20%
as price adjust upward to reflect where the value is, followed by the 20% ROE return of
the business.

Price will always revert back to where the value is over the long run. Therefore, if you
overpay for a stock, you run the risk of getting a dismal return or worse, impair your
capital permanently. Many thinks that a wonderful business is worth a buy regardless of
the share price, thats no different from a property agent telling you a house can worth any
price because it has the best location in town. At a certain price, a wonderful business can
give you an above-average return; at a higher price, the return becomes average; at an even
higher price, the return will turn dismal. Price is what you pay, value is what you get.

The emphasis here is to buy wonderful stocks at a fair price or even better, at a cheap price.
When do wonderful stocks usually sell at a cheap? When the market turns manic
depressive and everyone is cramming at the exit door. The psychological makeup of
thinking like a business owner is inherently contraries. When share price is soaring, and
the crowds are jumping on board for the fear of missing out, you stay prudent; when the
share price is in free fall, and the crowds are jamming through the exit door, you turn
aggressive. The mindset of following the crowd is naturally wired in our brain, therefore it
feels safe and natural to follow the majority. But where will the advantage be if you do the
same things as others?

As the value dictates your investment return, you need a good grasp on how much a
business should worth to find out if its expensive, fair, or cheap relatively to its share
price. The value of a business is not a precise figure but an estimate of a range. Unlike
share price, which is susceptible to big swing in market sentiment, the value of a business
tends to be gradual, changing slowly from year to year.

The main ingredient to good estimate starts with a good understanding of the business.
Using the analogy of guessing age, theres a better chance to take a correct guess on
someones age as compared to an animals. Why? Because we grow up around people, and
every person acts as a reference point, which can be easily accessible by memory for cross-

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reference. This is why it is critical to understand the business or any estimation will be way
off the mark.

Roughly right than precisely wrong

While a good estimate is a must, precision is inessential. You dont need to know the exact
age to be able to tell if a person is in his/her 20s or 50s. Put it another way, wait for the
market (crowd) to make a huge mistake. When the market is pricing a stock thats worth
$100 to $200 at $50, you dont need to be precise to be right. This serves two immediate
benefits. By treating the value as a range of two numbers, you are free from the stress of
being precise, and in the process, reduce your losses and maximize gain. During market
panic, fear overwhelmed rationality, people wants to avoid uncertainty at all cost, as a
consequence most stocks get oversold. When you buy a stock selling at a dime to its true
value, your entry price dilutes the risk of any bad outcome, while increase chances for
above average return. The common phrase High-Risk High Return is true, but this is
something better, Low-Risk High Return.

Margin of safety
Despite our best effort to avoid losing money, the future is never certain. We make
mistakes, get a few bad apples, as long its not fatal. The last point brings us to the concept
of Margin of Safety. Like having a spare tire at the back of the car or extra fuel in the tank
for a long trip, paying a lot less for what something is worth gives you a buffer in case the
unfortunate happens. Margin of safety is about being conservative in every decision you
made as well. When you understand a business before investing, thats a margin of safety
against the risk and greed of buying things you cant fathom; when you own a wonderful
stock, the quality of the business is the margin of safety; by being patient, you reduce the
amount of decisions you need to make (less buying decisions, less error); and so does
paying a lot less for what something is worth, you guard yourself against any worse case
scenario.

Conclusion
If we are to summarize this post into a sentence, that would be Buy a wonderful business
thats worth a dollar selling for 50 cents.

I have presented little calculation to keep it simple, and underline an important aspect of
investing. A good grasp on accounting and maths are important but you will do fine with
basic arithmetic. Whats more critical to the success over the long run lies in having the
right temperament, and the ability to think independently. Not having the right
temperament will give you the biggest disadvantages in investing. Although learning how
to think well is beyond the scope of this post but I sincerely hope that these fundamentals
will serve as the bedrock for your investing journey. Something for you to anchor on,
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perhaps, to discard as well (think independently) should you find other fundamentals that
can serve you better.

I have written the 2nd part on how to start picking stocks by applying screening criteria on
a separate post, you can find it here.

Once you have done the screening. Go through this checklist before you buy anything.

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