Beat the market – Part I

Beat the market – Part I

With Christmas holidays fast approaching, it is worth considering using the free time to invest in yourself. One way to do this of course is to read.

Today’s article is not to be consumed in one sitting and yet it is not all that can be said about establishing a successful investing track record that beats the market.

We know something about what is required to generate wealth from investing in shares. At Montgomery not only has every fund beaten its benchmark and the broad market since inception but the pattern of returns – capturing most of the market’s up moves but less than half of its declines, in the case of The Montgomery Fund – has indeed also been palatable.

Not everything we know about identifying winners, valuing those companies and assessing prospects and management can be distilled into one article but this one should go at least some of the way to putting you on the right path. If this article fires up your desire to learn more, get yourself a copy of Value.able* – how to value the best stocks and buy them for less than they’re worth for Christmas.

Let me begin by correcting a fatal flaw that we see in many investors we meet.

Unwittingly, you are probably a speculator rather than an investor and I’m making it my role to encourage you to turn your back on speculating forever and to become an investor.

Sustained sharemarket success begins with thinking like a business owner, rather than a trader of stocks. Betting on the next ‘up’ or ‘down’ is tantamount to betting on black or red at the casino. It’s not investing.

When colleagues tell you about a hot stock they own and you buy it, or a newspaper story makes a compelling case for selling a stock and you sell it, you are not acting like an investor. When a broker publishes an aggressive research note on a stock and you buy, or maybe you have a hunch that China will grow faster than expected, so you punt on quick gains in commodity and resource stocks, you aren’t investing either.

The common hotchpotch of ideas and beliefs painted above is common and will usually amount to little. Worse, when something inevitably does go wrong, you have learned nothing from the experience because none of it was systematic, replicable or repeatable.

It’s not all your fault. A simple search of listed Australian companies that earned more than $1 in their latest reporting period reveals that only about a third of the 2,188 ASX-listed entities made a profit and a large number of those were barely in the black. Two in every three listed companies could not cover their costs, and many will have to rely on capital raising to stay alive. Owning such stocks requires a leap of faith that the company will eventually be profitable and while faith may prove beneficial spiritually, there is little place for it in investing.

You don’t need to trade the two-thirds of loss-making companies on the ASX to boost your portfolio’s value over time. There are more than enough opportunities in the universe of profitable businesses to make double-digit returns from the sharemarket without excessive risk.

Become an informed investor
It’s among the profitable companies where you should truly start to think like an owner of a business rather than a renter of pieces of paper that wiggle on a screen in some broker’s office. And it’s here where you’ll find extraordinary businesses at bargain prices.

Arguably, the best long-term risk adjusted returns come from buying exceptional businesses and holding them for as long as they remain exceptional, continue to have bright prospects for intrinsic value growth and share prices do not diverge too far above forecast intrinsic values.

Sustained equity investment success requires two core skills and the right temperament – the latter is up to you and your parents. The two core skills are the ability to identify a superior business and the ability to value that business.

The ability to value businesses produces a list of those that are expensive and those that are cheap. When the vast majority of companies are expensive and there are few securities worthy of investment, the only conclusion is that more funds must be allocated to cash. In one sense, a bottom up approach, such as the one contemplated here, produces the only sensible asset allocation.

Don’t be an unwitting speculator
If you don’t have an estimate for the value of a business and you buy its shares, you are, by definition, speculating and betting someone will be willing to pay more at a later date than you just did.

This is a critical point. Speculation is not just owning an unprofitable exploration or biotech company and hoping it will one day make money. It also occurs when investors buy a profitable company, perhaps even a so-called blue-chip, without having a view on its valuation, or how that valuation is changing over time. In effect, the person is unwittingly speculating rather than investing.

Imagine if a friend or colleague asked you to invest in a private company. Your first question would probably be, “What are the chances of the business going bust?” That is, is the business profitable, how much debt does it have, and can it comfortably meet its interest repayments?

Your second question might be, “Is it a good business?” Does it operate in an attractive industry, sell a good product, have an excellent reputation and client list? Does it have a long-term record of rising profits and, more importantly, a rising return on equity (ROE) or return on shareholder funds? Do you believe the ROE will continue to rise over time and lead to a higher company valuation? And will the ROE be sufficiently high to compensate for the risk in this investment?

Your third question would probably be, “How much do I have to pay to own X% of the company?”

From the answers, you determine what the company is worth, and assess that against the asking price. A view of the company’s worth (its intrinsic value) helps you make astute decisions when prices rise or fall because you understand the difference between value and price.

Don’t be swayed by market noise
So what stops us thinking like a part-owner in a business when it comes to listed companies, and instead act like part of a herd? Market noise plays a big role. We are seduced by media headlines, stories about “hot stocks under $1”, television finance channels, and broker reports. We fear missing out more than we fear losing money. We latch on to supposed expert views and succumb to ever-larger waves of stock commentary, failing to realise that the entire machine has been set up to promote noise and activity.

Investors instead need a quiet, controlled detachment from the sharemarket. Step number one simply involves turning the sharemarket noise off.

Market noise amplifies those two great investing emotions: greed and fear. Market noise triggers the purchase of low-quality companies in the hope of making a quick buck, and market noise triggers the sale of high-quality companies because there was no appreciation that a sharply rising price was simply following the company’s rising intrinsic value or was all occurring well below that value. Having a clear yardstick for company value helps you know when to be greedy and fearful, usually well in advance of the herd that uses sharemarket noise as its decision-making trigger.

So, to begin, remember the following:

• the focus on price movement, and the expectation of profit from it rather than from business performance, is pure speculation, not investing.

• instead of renting bits of paper and hoping they will go up in price tomorrow or next week or next month, investing involves buying a slice of a business after considering the facts and applying common sense.

• buy shares in order to own businesses. Don’t buy shares merely to sell them.

Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.

MORE BY RogerINVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.