How do you invest in a way that isn’t pure speculation or group-think, and which also prevents you from being fooled by randomness? Well, apparently value investing is one way to do this, so I’m going to learn about it. To put it simply, value investing means that you should buy and hold a stock when its price is below its “true value”. You can also sell it if it’s crazily overvalued.
It’d be nice to know whether a company was worth investing in for the long term just by reading through their financial statements. My reason for learning how to value invest is to get growth rates that are greater than my index fund growth rates (right now at ~12%, but we’re in a bull market) and which are greater than my student loan interest rates (right now at 3.45%, but interest rates are very low at the moment – my federal loan interest rates are 0% for the next two years).
How have I been investing so far? By copying other people, of course. The most popular companies on the stock market, like Apple and Google, are bought because they’re popular. I doubt that the vast majority of people who have bought apple or google stock have read through their respective balance sheets. If people are buying through speculation alone, the stock is probably overpriced, compared to a stock that wasn’t popular and fell prey to group speculation.
An alternative to buying hyped up stocks is to invest in microcaps. These are stocks that have a market capitalization of less than $300 million in Canada. Because they’re not very big and sexy, not many crowds are drawn to invest in them. This makes them the perfect place to practice value investing.
Who will teach me value investing? Warren Buffet, and the book on his investment strategy, called Warren Buffet and the Interpretation of Financial Statements. Here’s a summary of what I’ve learned so far.
Chapter 3:
Buy a company stock if they have one of the following competitive advantages:
- they sell a unique product
- they sell a unique service
- they buy and sell a product/service at very low cost, and the public consistently needs this.
Unique services are generally institutions. The people in an institution should be replaceable for it to be a good buy. In Suits, Harvey Specter negotiates with his boss Jessica Pearson by threatening to take all of his clients and leaving the firm if she doesn’t give him what he wants. Warren Buffet would see this, and avoid investing in Pearson Spector Litt because the people there are irreplaceable. If it’s a people specific firm, then its workers will demand and get a majority of the profits in it. This leaves a lot less money for shareholders. Compare that with a Dairy Queen, where each worker is basically a cog that can be replaced.
An example of the last point is Walmart. Buy goods as cheaply as you can get them, and then sell them as cheaply as you can too. This draws customers to you and keeps your margins larger (because you’re spending less).
Chapter 4.
Consistency of a product or service is what lets a business rake in all the money. If customers want you to sell the same thing over and over again, then the business doesn’t need to change! The business then avoids spending money on research and development, or changing factories to build a new version of their product.
This consistency is what makes a company promising from its financial statements. But what are financial statements?
First, there’s the income statement: how much the company earned during a set period of time. Second, there’s the balance sheet: how much money the company has in the bank and how much money it owes. Last, there’s the cash flow statement: it looks at how cash has been moving out and in of the business. It’s good for looking at how it spends on capital improvements and bond/stock sales and repurchases.
The rest of the book is pretty straightforward, and you’re basically just calculating sums from a balance sheet. If you don’t print out a balance sheet to experiment with, the book gets super boring super quickly.