A 10-step Guide to Stock Investments: Part 1

In a 10-step guide to stock investments, we discuss the principles and methods used by great investors past and present. There are some common factors, although they achieved their success in different ways.

We’ll discuss those different investing style later in a deeper dive. For now, in this three-post series, let’s focus on some shared principles and methods.

Getting Our House in Order First

Investments always carry short term market risk that can never be eliminated entirely. So, it is crucial that you don’t invest money you need for other purposes in the next two years. That’s because Bear markets since 1930 had an average duration of 18 months and an average loss of about 40%.

It is also recommended that you develop a Personal Financial Plan (PFP) to map out the steps to achieve your long term financial goals. A PFP considers your financial goals and time frame to assure they are compatible with each other and is discussed here.

This article also assumes you read why you should consider stocks here and mutual funds here and that you are ready to invest in individual stocks. To do that you will need a brokerage account.

The online ones are easy to open with straight forward instructions provided by each company on their site. I have experience with Charles Schwab, Fidelity and TD Ameritrade and like them. There are many others to consider.

The Authentic Investor

Have you ever been lost listening to others talk about how they investment? Its often because they use different approaches, jump form one method to another and, in my view, a lot of it is not investing.

They may think they are using an investment strategy, but they are not authentic investment strategies. The primary goal of this 10-step guide to stock investments is to help you recognize authentic investing.

Authentic investors styles or approaches can vary, but fundamental investing contain the critical elements in this 10-step guide to stock investments.

A farmer knows you can’t harvest a crop before you plant it. Authentic investors realize you can’t harvest monetary rewards investing without first adopting the fundamental principles of investing.

Paradigm Shift

The 10-step guide to stock investments is built on the principles and methods used by the best investors in the world. And to implement them it may require a paradigm shift.

A paradigm is how we view the world through our own eyes. Think of it as the map we use to make quick, easy, and comfortable decisions. Maps help navigate us through our investing lives. But, we will never get to our destination if the map is wrong.

Many “investors” as discussed here cannot achieve average stock market performance. That is because they use the wrong maps. Some need a paradigm shift to the map of principled center investing.

Principle-Centered Investing Habits

We can think of these investing principles in the 10-step guide to stock investing as good investing habits. Good habits can be learned. And, bad ones unlearned but it is usually not a quick fix.

Aristotle said, “We are what we repeatedly do. Excellence, then, is not an act, but a habit.”

It is hoped on completion of the 10-step guide to stock investments you will be able to identify practices such as following the crowd, timing the market, and day trading that violate the basic principles of effective investing.

In “The 7 Habits of Highly Effective People” author Stephen Covey defines a habit as the intersection of knowledge, skill, and desire. Knowledge is knowing what to do and why. Skill is knowing how to do it. Desire is the motivation to do it. To make something a habit, we need all three.

The primary purpose of this guide to stock investments is to outline the “what and why” or the knowledge component.

The skills component will overlap and vary depending on the style of investing you chose. We’ll cover skills in an upcoming series focused on investment styles used by the best.

Our motivation, of course, is the desire to increase our wealth.

If you are new to investing where better to start than the culmination of investment wisdom from the best investors in the world? If you are an experienced investor, you may recognize many if not all of the steps.

Amazingly, relatively few investors study the great investors or adopt their approach. Part of the problem is there are so many willing to help you invest for a fee. And, to justify the fee they need to come up with something unique whether it works or not.

Others may study the great investors but fail to follow the principles consistently.

This is a summary of the 10-step guide to stock investments.

1. When you buy a stock, you become the owner of the business
2. Business owners should think differently
3. Focus on the value of the company, not the price
4. Set a long term investment horizon
5. Understand the business you buy
6. Identify a good business to buy
7. Return on Equity
8. Find companies with exceptional management
9. Require a Margin of Safety
10. Know the difference between investing and speculation

10-step Guide to Stock Investment

1. When you buy a stock, you are an owner of the business

A share of stock is your title of ownership in the company. The shares represent the portion of the business’s assets, sales, and earnings that are legally yours.

The board of directors hires the CEO to operate the business on your behalf. Over time the value of your business will rise or fall based on the performance of management and the underlying company.

Traders follow share prices. Investors as business owners follow the value of the underlying company. In the short term share prices change frequently and can vary widely from the underlying value. But, over the long run the share price will reflect the changing value of the company.

2. Shareholders should think like business owners

As an owner it follows we should think like business owners. And good business owners track the value of the company over the long term rather than the frequently changing price of shares.

We want management to make money for us from our investment in the business. The shareholder/owners are in partnership with management, and good management thinks of shareholders as partners as well.

There are two primary ways for owners to make money.

The first is for management to distribute a dividend from excess cash generated beyond the needs to run and grow the business. The dividend is the portion of earnings distributed to shareholders each quarter from a steady flow of income often in mature and stable companies.

The second way is to sell your shares in the future for a price higher than you paid. This requires either an increase in the underlying value of the business that owners can follow. Or, a rising share price due to favorable market conditions that can be random or arbitrary.

At times there are sound reasons to sell the shares of a company. But, if it is a good company increasing in value, why not continue to enjoy your increasing value of ownership over the long term.

Warren Buffett and Charlie Munger explain their view in the Berkshire Hathaway Owner’s Manual: “Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous.”

3. Focus on the value of the business, not the price

Price is what we pay, value is what we get. We pay the share price to become an owner, and the value is what we will get in return for that price.

The share price is reported on the stock market continuously, but the value is harder to find. Don’t assume the price is the value, this can lead to big mistakes.

We need an independent estimate of value to compare against the market price to know the difference. That is because, like anything else in life, it is best to buy companies when they are on sale. The stock price is below the value.

Great companies purchased below (or near) their fair value become successful long term investments. Prices that are lower than value eventually catch up to value. Prices also increases with value over time. Alternatively, paying a price above the company’s value usually turns out bad.

The underlying economic value is estimated with different financial measures and tends to be much more stable than share price. The share price can reflect value. However, it can also deviate significantly depending on the mood of the market.

We invest in a disciplined manner if we estimate the value and compare it to the share price. We want to buy when the price is below the value and consider selling when the price is near or above the value.

Without an estimate of value, we are guessing, speculating or gambling. We’ll cover valuations in greater detail in the upcoming articles. In the meantime there are excellent resources for the individual investor discussed in Part 2 of the 10-step Guid to Stock Investments.

The key is to focus on what we can estimate and know; the value and the price, not market direction.

4. Set a long term investment horizon

A fundamental principle to enduring investment success is establishing long term expectations centered on value. The value of outstanding businesses continue to increase for many, many years. And, price eventually follows as the increased value is slowly recognized.

Some Wall Street analyst publishes “price targets” six to eighteen months in the future. They are apparently trying to anticipate price changes due to news or market sentiment.

But, if a good business is increasing in value, and the share price will follow, why worry about short term price fluctuations? As business owners, we will benefit from the miracle of compounding following value, not random stock market prices.

“The stock market is a device to transfer money from the ‘impatient’ to the ‘patient.'”

– Warren Buffett

Warren Buffett and Charlie Munger continue to discuss this in the owners manual. “We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family.

Trying to guess future prices better than the crowd or anticipate how the crowd might act can lead to big mistakes. A long term focus on value is a much safer and more rewarding path.

Benjamin Graham, the author of ‘The Intelligent Investor,” writes that those who try to follow the market transform their basic advantage into a disadvantage: “…Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. By refusing to let Mr. Market be your master, you transform him into your servant”.

We want to own companies that we can entrust our money to for many years and benefit from compounded returns. Even more this avoids un-necessary transactions costs and taxes on the gains for many years.

5. Understand the business you buy

Peter Lynch, established a fantastic investment record with the Fidelity Magellan Fund between 1977 and 1990 posting an annual average return of 29%, and beating the S&P 500 index in 11 out of 13 years.

He writes in his excellent book “One Up on Wall Street” that investment opportunities are plentiful for the layperson who simply observes business developments and takes notice of their own world.

In other words, companies with good prospects are right in front of us successfully selling products and service to you, your friends, and employers. They are in the stores, malls, and the workplace.

On the other hand, it is challenging if not impossible to know if a big pharmaceutical company will successfully develop a new blockbuster drug, obtain successful test results, or receive FDA approval.

Similarly, Warren Buffett advises all to invest in businesses that are simple and understandable.

Select companies whose products you buy and understand. Or, ones where you have a skill or expertise in a particular field to help you estimate their prospects. These are the companies within our “circle of competence.”

Companies in your own internet security field will be more understandable to you than the research of a large pharmaceutical company. Likewise, you understand the products and services you use better than the new widget yet to be made and sold.

By carefully applying these five principles in every investment that we make, we’ll be off to a good start. In the next articles Part 2 here, and Part 3 here, we’ll discuss the remaining five principles in the 10-step guide to stock investments.