Read an Excerpt
INTRODUCTION
The Sense of Investing in Others’ Businesses
How do successful investors get to be that way? The steps they take to increase their wealth make up a taxonomy of talents and goals. So much of the literature on how to make money in stocks and bonds, real estate, antiques, art, autographs, and more is about details and histories of prices of this and that. It is looking backward to go forward, which is a dangerous practice if you are driving.
We have a much simpler idea: Run your portfolio as though it were small business you know well. Even though you are buying into others’ businesses, ask this fundamental question any time you give somebody your money: What makes the business function as a tradeoff of people giving it their money for whatever the business will return as income or capital gains?
In the complicated books on stock and bond analysis, little discussion is directed to answer that basic question. Why throw money into somebody else’s business? If you understand the business well enough to answer the question — how does this thing work? — you are off to a good start.
In the bulletins stock brokers send to their clients and in press stories of how businesses are faring, much attention is given to earnings formulations and price-to-sales ratios. In bonds the focus is on macroeconomics and credit ratings. In commercial real estate, it is on ratios of rent to cost. All that matters, of course. But the main thing that you need to be able to answer is that question of what makes the profits. From the top line of how much money they ring in as sales to the bottom line of what is left for the owners — that is, those who hold the common stock — you need to be able that question: How does it work? Next question: If I throw my money into their pot, what do I get? What’s in it for me?
These are basic and essential questions, yet the answers are often made complex by fancy numerical analysis done by men and women with fine academic diplomas and lavish resumés attesting to their acumen. The unspoken secret of the academic/professional analyst biz is that they stick together. And when these well-bred and well-educated analysts work for investment banks, they know that saying unkind things about client companies is not going to advance their careers. Thus, the vast majority of analysts’ reports from the so-called sell side of the investment business are positive. For the would-be private investor, a dose of cynicism is in order.
Our plan, and this book’s plan, is to cut through the complexity of conventional financial analysis and its invocations of mathematical formulas and statistics to what amounts to common sense. We’ll show that paying too much for assets that are always under conditions of uncertainty — after all, nobody knows what trouble a company can get into — is unnecessary. Many of the analysts who hype stocks that are unreasonably expensive work for investment banks that sell the very same shares. There is safety in calculating your own figures.
We should tip our hats to the literature that defines success and traces the steps to it. Financial magazines are often awash with stories of billionaires, their original Renoirs, and their yachts. There is nothing new in this form of envy. It is Biblical, in that it’s critical in making the distinction between the realms of God and of Caesar. It is literary, appearing from Greek drama to the modern stage — think of Oscar Wilde’s The Importance of Being Earnest and the pathology of failure captured in Arthur Miller’s Death of a Salesman — and in the current fascination with the careers of Steve Jobs, Warren Buffett, Bill Gates, and other capitalists whose businesses have thrived on what could be called a single idea. The problem with the latter literature is that it represents the successful explaining how they got to be that way. It is backward looking. Each tycoon’s story is distinct and not necessarily repeatable. In any event, you can’t start out being General Motors.
We propose that growing one’s wealth by investing in others’ businesses by buying stocks and bonds and by buying real estate for development or rental can be done with manageable risk and good prospects for gains. The more you know about your market — in other words, your portfolio, your costs, the achievability of profit targets, and the risks you face — the better your prospects for gain.
Many people, seeing the vast number of choices of stocks and bonds, real estate projects, and even collectibles, give up. We think that’s wrong. You cannot understand the world of finance the first time you see it, but you can grow into it, much as you might open a small store and see its sales and profits grow and turn eventually into a larger business with diverse lines of activity. You cannot have it all at once, but you can learn the ropes and climb them.
TIME AND REALIZATION
How do you judge the success or failure of an investment? A stock may fall after purchase only to rise to astounding heights a few months or years afterward. The investor who expects instant gratification is likely to be disappointed. Even Amazon.com took four years from 2013 to rise from US$275 to the recent price of about US$1,626. If you want faster outcomes, you should go to a casino. Stocks and bonds and real estate seldom have the swift resolution of gambling tables.
Cynics say that buying stocks on tips or even on trends, which are collective tips of winners asking others to join them, is a form of industrial gambling. We concur. The difference between this kind of gambling, which is little more than a play on price, and informed investing is understanding the stocks’ business much as you would understand your own business, and earning dependable income flows that can pay you back even if the stock tumbles and stays down. All this may seem boring, but it is caution put into practice. Be humble about what you know, for in most cases, you will know less than what you do not know. This is humility. It is also honest.
The advice that teaches success tends to be variously inspirational and technical. There are attitudinal books, many rooted in the 1970s, when reforming the self was seen as vital in such neo-theological themes as Rolfing, Esalen, and the cults of various swamis and gurus, not to mention the tongue-in- cheek distillations of business wisdom from the writing and attributed sayings and doings of Genghis Khan (“Don’t negotiate, conquer”), Machiavelli (“It is better to be feared than loved, if you cannot do both”), Abe Lincoln (“Better to be silent and thought a fool than to speak and remove all doubt”), and so on. This is transitory wisdom — clever, but not necessarily applicable to managing money. As well, there are skill-based advisory books that seek to transfer wisdom and investing technique from applications in such things as engineering.
We take the view that fundamental human traits measured by commitment, patience, focus, and a deep understanding of one’s endeavours, which are the foundations of successful lives, can enlarge one’s fortune. The top-line concept is that investors should stay within their circles of competence. Don’t buy what you do not understand, and certainly not because a friend or relative is buying it. Swift jabs into things of which one knows little, such as investments in flavour-of-the-moment companies on the web, are likely to fail. It is the greater fool theory gone digital. Then, however, as one’s knowledge and expertise, experience, and acquired sense of self-preservation grow, one can invest further afield. None of this should seem startling. What is shocking, on the other hand, is how swiftly novice investors pile into bad ideas.
There is a simple numerical test for how well ideas pay. In stocks, the ratio of price per share to earnings per share (the p/e ratio) is a key guide to value. Canadian chartered banks typically have p/e ratios of twelve. That means a dozen years of future earnings will repay your investment in that time or less if you add in the dividends. Some hot web stocks have p/e ratios of two hundred or more. You will have to wait two centuries for the return of your money if there is no dividend, and there usually isn’t. Even if earnings double, you will have to wait a century. If earnings quadruple, you’ll need to wait a more modest fifty years. Investors in these hot stocks are not betting on earnings trends. They are betting on the enthusiasm of other investors. We think that’s industrial gambling, not so far from shooting craps in Vegas.
Investors in dot-coms in the last years of the twentieth century threw money at companies labelled “digital” that had no sales, no profits, no business plans, and no experience in markets and that, to top it all off, were prized for burning up other people’s money. No corner grocer would invest in goods their customers do not want. Paradoxically, in the investment world, unfamiliarity with assets seems no barrier to casting money to the winds. Compared to a casino, stock market bubbles large — the ones we know — and small — they happen every day — are like games the players do not know how to play with odds they cannot fathom. This is idiotic. We think the small shopkeeper knows their own business best. The task of this book is to help transfer that innate, experienced-based knowledge to the larger and more complex world of investing in capital markets.
