10 Rules of the Intelligent Investor
Keep it simple.
1. Invest
2. Only do what you understand
3. Know yourself, your needs, and how much
risk you can stomach
4. Emotions make for bad advice
5. Costs can turn success into failure
Study your investment choices carefully.
1. Invest
Keeping your money as cash makes you poorer – to
compensate for inflation alone you need at least some short
term investment: savings account, fixed deposit, call
money, money market funds. In the long run, bonds are
better, and stocks are best.
The 1997 value (inflation adjusted) of one 1802 dollar if it
had been invested in the U.S. in the following (ignoring
taxes and all costs): The difference
Cash $ 0.07 (-1.35% p.a.) between 3.5 % and 7%
may not seem so big at
Gold $ 0.84 (-0.09% p.a.) first, but it makes up for
Bonds $ 803 (3.5% p.a.) a fortune in the long
Stocks $ 558,945 (7% p.a.) ! 10 years and you'll soon see the differences (tools for
p.a. = per annum (Data:Siegel 1998)
2. Only do what you understand
You must know what you are doing if you want to succeed.
To properly deal with a topic you must know something
about it. Now, we all can't know everything – therefore we
must keep with the things we do understand.
At the least you should learn the basics or you may pay for
it sooner or later. Investment then becomes a form of
gambling. You should be able to judge the risks and
rewards of an investment before you put your money in the
line.
So, set yourself some boundaries: countries, currencies,
investment types - and study your choices well.
3. Know yourself, your needs, and how much risk
you can stomach
There are no "good" investments – just investments that suit
your needs. Some people plan for retirement, some need to
make money quick – and there are trade-offs.
Investing is a personal affair. Ask yourself: When will I
need money and how much of it? Can I stomach, and can I
afford, to ride out emotionally trying times (bear markets)?
What unforeseen events may occur? What's my "Plan B"?
Some hints:
”One year time horizon: savings account, fixed
deposit, call money, money market funds.
”Three to ten year time horizon: bonds.
”Set the interest payment and redemption dates of
your bonds to suit your needs (same for dividends).
”> ten year time horizon: stocks.
4. Emotions make for bad advice
Emotions are the enemy: you'll run with the pigs to the
slaughter. If you're buying when they're all buying, you'll
be buying at a premium. If you don't buy because nobody's
Nov-05 Edition
6. Don't take risks in bonds, it's not worth it
7. Only buy good companies
8. Buy at the right price
9. Carpe diem
10. Trust no one but your own judgment
buying, you are missing your chance.
It's hard to go against the trend – besides, that alone does
not guarantee success. But, it does prevent you from losing
your money in turbulent times, and it allows you to buy
stocks at the right price.
5. Costs can turn success into failure
Beware of the costs! Costs can devaluate your property and
you may not even notice it. It helps to plan and to calculate
to see things clearly.
”Many institutions such as banks and insurance
companies try their best to hide their costs: comparing
and bargaining will pay off here. Compare costs over
this can be found at www.sec.gov).
”Calculate the cost of tax and inflation on your fixed
deposit account. Higher yield investments will carry
even higher costs for information, transactions and
deposit.
”Lower your cost: plan your taxes, avoid high
inflation countries, lower costs of deposit, (fund)
management and transactions.
6. Don't take risks in bonds, it's not worth it
Fixed value investments (limited return) are not worth
taking risks for. Your maximum profit is limited in advance.
Your whole analysis should focus on security (see Graham
& Dodd 1934):
”What counts is the ability of the creditor to pay your
money back with interest, and not your collateral or
other rights.
”Consider the worst case scenario for the creditor.
”High yield does not compensate for high risk
”Criteria of exclusion and quantitative tests for fixed
interest investments:
¾ countries: market economy, rule of law.
¾ only large firms, sector not restructuring,
cyclical or unpredictable
¾ profits = 3 times interest payments or more
¾ market value of stocks > market value of bonds
¾ sufficient cash; current assets vs. current
liabilities in reasonable balance
¾ Owner's equity must be at least 40% of assets
(exception banks, insurances)
7. Only buy good companies
A company is a good company if there is a high probability
that it needs little capital, that it generates a high amount of
free cash and if this benefits the shareholders in some way
(Company Analysis).
The basics
”The Management must be trustworthy in allocating
assets and in accounting .
”The area of operation, the company itself and its
accounting must be easily understood.
”The return on owner's equity (asset turn and profit
margin) must be sufficiently high.
”The capital structure, especially owner's equity,
must be adequate.
”The market position must be excellent.
”Revenues and profit must grow.
”The track record must be consistent.
The analysis
Get an overview: Evaluate the properties and potential of
the company, the sector, and the position of the company
within it:
¾ The business environment of the company (sector):
products (commodities or franchises), margins, capital
requirements, regulatory environment, risks, expansion,
cyclidity, stability.
¾ The company itself: Specific market position,
business model, communication, competitive
advantages, products / services (commodities or
franchises), development stage, risks and dependencies,
capitalization, accounting, acquisitions, dividends.
Next, income statement and balance sheet analysis (and
don't forget the cash flow statement either):
Revenue
EBITDA (Earnings Before Interest, Tax, Depreciation and
Amortization), EBITDA margin (EBITDA / revenue)
EBIT, EBIT margin (EBIT / revenue)
Profit margin (profit / revenue)
Equity vs. liabilities (or assets)
Current ratio (current assets / current liabilities)
ROTA (Return Of Total Assets):
Profits / assets = (revenues / assets) x (profits / revenues)
Asset turn (revenues / assets)
ROE (Return On Equity):
profit / equity = (profit / assets) / (assets / equity)
The Cash Flow Statement shows actual money transfers
during a period of time. No capitalization, depreciation or
amortization are involved. Cash Flow is much less sensitive
to creative accounting and should be a strong factor in your
analysis.
Related Karner Consult Pte Ltd Fact Sheets
Company Analysis
Companies Table
Bonds For Investment
Stocks At The Right Price
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The ROE is the only purpose of the owner: The ROE is the
interest yield he gets of his equity.
8. Buy at the right price
The value of your investment has to exceed its price. The
price is given by the stock market, the value has to be
determined by … you! (Stocks At The Right Price)
Bonds give you safety and you can easily calculate your
return. Stocks may yield more but your expected return is
harder to evaluate. Therefore, your expected return from
stocks must exceed your return from bonds.
Price-earnings ratio of a stock (PE = price / earnings; the
inverse is the earnings yield EY) :
”A PE of about 10 or lower is best, 16 is the upper
limit (a PE of 16 would mean an EY of 6.25 %).
”A stock's PE should beat the PE of a first rate bond
by 50 % at least.
Calculate the PEs as an average over the past 5-7 years.
You may include future expectations in a meaningful way.
Advantages of using PE ratios: simple and easy to use,
accessible historical data.
Drawbacks: sensitive to creative accounting (write-offs,
hidden stock options). If zero or negative earnings (losses)
are made, the PE becomes useless.
Other, important numbers: revenues / price, EBITDA /
price, EBIT / price, various cash flows / price, tangible
assets / price, liquidation value / price.
Other methods: discounted cash flow.
9. Carpe diem (seize your chance)
In good times, prices are high. In bad times, the trust is
gone. If you never invest because the time is not right, you
won't get anywhere. Every situation, political, economical,
social, has its risks – and opportunities!
10. Trust no one but your own judgment
Think by yourself. Otherwise you depend on other people's
agendas. You need your own frame of reference. Don't just
trust somebody's assessments. Take a look backstage
yourself. Believing your sources means legitimizing them.
You need to know enough to decide who is knowledgeable!
Literature
Graham Benjamin (1973): The Intelligent Investor, Harper
Business | Graham Benjamin & Dodd David (1934):
Security Analysis, McGraw-Hill | Siegel Jeremy J. (1998):
Stocks for the Long Run, McGraw-Hill | Vause Bob (1999):
Guide to Analysing Companies, The Economist Books |
Standard & Poor’s annual guides, McGraw-Hill.
Internet (external links)
http://www.berkshirehathaway.com/
http://www.sec.gov/
http://www.edgar-online.com/
http://www.standardandpoors.com/