Last week I listed ten justifications we give ourselves when buying a stock.
I shared these ten reasons from personal experience. Over time, I have encountered all of them in one way or another. I have acted on some, while letting others pass. Sometimes they turn out well, other times not so well and I am left either rueing my loss or the missed opportunity.
I have also invited readers to share their experiences. Thank you for your comments and emails.
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Allow me to share my thoughts.
Reasons number 1 and 2 are reasons to trade.
Reasons to trade do not always make for good reasons to invest. (And reasons to invest may not be good reasons to trade, we will come to that later).
Traders thrive on volatility and volume. Investors tend to be wary of volatility. On the contrary, investors seek stable growth.
Being volatile and of high volume usually means a stock is very much in the news and on everyone’s radar. As a result, many ‘investors’ end up being tempted to buy the stock. They get fooled into thinking they are investing when they are punting, or at best, trading.
It is important to know the fundamental differences between trading and investing. It is even more important to know, each time you are tempted to buy something, whether it is a trade or an investment.
Reasons 3, 6, 7, 8 and 9 are narrative stories.
As human beings we are constantly seeking to explain the world around us.
Let me use the missing Malaysian Airlines B777 as an example. As of now, it has been missing for almost a month and not a single stitch of debris has been found.
Yet, despite the fact that no one knows what happened to the aircraft, a huge number of theories that have sprung up to try and explain the disappearance. They range from terrorism to pilot suicide to a catastrophic failure of systems on the aircraft.
Because of the mysterious circumstances in which the plane disappeared, we need these theories and narratives to help us make sense of what is happening.
We cannot live our lives void of understanding. When the real reason is unknown to us, we make up explanations and anchor our minds to it.
We do the same when it comes to stocks. When the price rises, we assign a story to it. When the price falls, we assign yet another story to it. These stories may not explain completely the entire cause for the price movement, but we buy into them wholesale nevertheless. They allow us to make sense of the otherwise seemingly random movements of the stock market.
Assigning a story after the price has moved is harmless enough. The problem arises when we use the same set of stories to try and predict price increases.
Investing based on a story is comfortable and easy. But it pays to always bear in mind this – how exciting a story is, really depends on the story teller. A good story teller can spin a yarn convincing enough for us to part with our money.
Hence, stories are fun and exciting, but it is hardly a good structure for us to base our investment decisions on.
The next time you are deciding whether to make an investment, ask yourself – am I investing because of a story?
Reason #5 is related to earnings.
The financial markets are earnings driven, that is indisputable. Every single day we get bombarded by incessant earnings reports and growth forecasts by brokers. Company A is expected to report good earnings, target price goes up – Buy. There is a chance company B might miss its forecast – Sell.
The biggest issue I have with investing based on earnings is this. I cannot forecast earnings. I cannot forecast unless I have in depth knowledge of the industry and the company itself.
For a really accurate forecast, I would even require specific information only company management would have access to.
And even when the information is laid out for all to see, there is still another layer of subjectively involved. Analysts will make their buy-sell call based on the numbers presented. Analysts unfortunately are human too, and it is hardly surprising for human beings to think differently.
When presented with the same set of numbers, two different analysts will apply their own assumptions and come up with different forecasts. The following instance of shipbuilding firm Yangzijiang just about illustrates that.
Reason #4 relates to dividend.
Investing for cashflow is definitely sound. Investing in businesses that distribute a part of their profits to reward shareholders is a good strategy to obtain a source of passive income. Many investors are doing it successfully, I have no arguments with that.
However, for myself, dividends payout should never be a primary consideration to purchase a stock.
Having said so much, it all but leaves us with the last reason. If I am only able to choose one single reason out of all, I would go for the most compelling and safest from the bunch. I have found that in number ten.
Price to Book (PB) Ratio is 0.5. The company has strong assets, substantial cash and no debt. Operating cash flow and earnings are positive and stable. Volume is low and there is little retail interest in the stock.
For a company with a PB ratio of 0.5, its market capitalization is half of what its assets are worth. In other words, if an investor is able to buy the entire company and sell off all its assets, he would have gotten double his money back.
For that to happen, assets have to be good assets. Not all assets are made equal. Land and buildings in prime area hold their value much better than inventory or country club membership. Even better if the company has a substantial cash hoard.
Additional considerations include the cash flow situation of the company. If operating profits are positive and regular, the company is likely to remain in operation for years to come.
The lack of volume and the fact that it is a cold stock is not a major concern. In thinly traded stocks lie market inefficiencies. In inefficiencies lie mispricing. In mispricing lie great potential profit.
As an investor I am willing to buy and hold for years. In the meantime I sleep safe knowing that the value of my investment is much more than what I have paid for.