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DIY Shares - Value Investing Education articles

Invest, don't speculate

By Roger Montgomery

Many investors believe they are investing when they buy a share, hoping it will go up. But betting on ‘up’ & ‘down’ is no different to betting on ‘red’ or ‘black’ in roulette, yet many who wouldn’t dream of gambling do so on the stock market every day.

Many years ago I discovered what I think is the key to successful long term share market investing. It is easy to follow, and simple to explain. For many investors, the share market is confusing. Down one day on fears that interest rates might rise, and up the next day on confirmation that they have! Your returns and emotions are destined to rise and fall with the market.  But I have made share market falls a time of great joy – much like discovering, for one day, the Bugatti I always dreamt of can be bought for the price of a Camry.

So what are the steps involved? Firstly, don’t treat shares like bits of paper that wiggle up and down, hoping the next wiggle is up. That’s gambling and a recipe for disaster. Second, don’t obsess over share prices. They simply reflect what someone else, perhaps foolishly, is willing to pay. Instead, treat the stock market as a place to purchase shares of some of Australia’s best businesses for less than they are worth.

Remember this - Price is what you pay and value is what you get.

Your job is to pay a lower price than the value you receive. So which are the good shares ? They earn profits, have little or no debt, high rates of return on equity, and sustainable competitive advantages. Ensure you use the formula for calculating what they are really worth, because a great company bought at the wrong price will be a lousy investment.

Example:

A business is for sale and it holds the exclusive distribution license for a fast-moving consumer good. Last year the business made a cash profit after tax of $10 million. This business is for sale for $15 million.

Would you buy this business ? It has no debt and the license runs for another 25 years. My hope for you and your family is that you would buy it. Now suppose that in the first year of owning the business, you collect a $15 million profit, followed by $25 million, $30 million, and $50 million. Just by looking at the business performance, you can determine that you have made the right decision to purchase it.

Suppose the same business is for sale, but you are only able to acquire 50%. The remainder of the company is listed on the stock exchange. Nothing has changed except that 50% of the business trades on the stock market as shares, and in the five years you have owned it, the shares have fallen from $50 to 5cents.

Do you feel uncertain about whether you have made the right decision ? Many people would. They are focussed on the wrong thing. Don’t take cues from the share price. You still made a great decision to buy the 50% of the business as you have kept 50% of the profits reported previously. You could take some of those profits and buy the rest of the company very cheaply.

Focussing on price leads to speculation, and speculation is not investing. Treat shares are pieces of business, not chips at a casino.

Roger Montgomery shares his step-by-step guide to valuing the best stocks and buying them for less than they're worth in his new book, Value.able, available exclusively at www.rogermontgomery.com. Roger also shares his stock market insights at this blog http://blog.rogermontgomery.com

Investors should obtain relevant and specific professional advice before making any investment decision. The information contained herein does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision investors should consider, with or without the assistance of a licensed advisor, whether the information contained herein is appropriate in light of their particular investment needs, objectives and financial circumstances.

The articles herein contain the current opinions of the author only. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of the author.