About the book
Successful investing is simple, but it’s not easy. One of the big myths of the bull market of the 1990s was that the stock market was essentially a savings account that returned 15 percent per year. You picked up a copy of Fortune, you watched a little CNBC, you opened an online account, and you were on the road to riches. Unfortunately, as many investors discovered when the bubble popped, things that look too good to be true usually are.
Picking individual stocks require hard work, discipline, and an investment of time (as well as money). Expecting to make a large amount of money with only a little effort is like expecting to shoot a great round of golf the first time you pick up a set of clubs. There is no magic formula, and there’s no guarantee of success.
That’s the bad news. The good news is that the basic principles of successful stock-picking aren’t difficult to understand, and the tools for finding great stocks are available to everyone at a very low cost – you don’t need expensive software or high-priced advice to do well in the stock market. All you need are patience, an understanding of accounting and competitive strategy, and a healthy dose of skepticism. None of these is out of the average person’s grasp.
The basic investment process is simple: Analyze the company and value the stock. If you avoid the mistake of confusing a great company with a great investment – and the two can be very different – you’ll be already be ahead of many of your investing peers. (Think of Cisco at 100 times earnings in 2000. It was a great company, but it was a terrible stock.)
Remember that buying a stock means becoming part owner in a business. By treating your stocks as businesses, you’ll find yourself focusing more on the things that matter – such as free cash flow – and less on the things that don’t such as whether the stock went up or down on a given day.
Your goal as an investor should be to find wonderful businesses and purchase them at reasonable prices. Great companies create wealth, and as the value of the business grow, so should the stock price in time. In the short term, the market can be a capricious thing – wonderful businesses can sell at fire-sale prices, while money-losing ventures can be valued as if they had the rosiest of futures – but over the long haul, stock prices tend to track the value of the business.
It’s the business that matters – In this book, I want to show you how to focus on a company’s fundamental financial performance. Analyst upgrades and chart patterns may be fine tools for traders who treat Wall Street like a casino, but they’re of little use to investors who truly want to build wealth in the stock market. You have to get your hand dirty and understand the businesses of the stocks you own if you hope to be a successful long-term investor.
When firms do well, so do their shares, and when business suffers, the stock will as well. Wal-Mart, for example, hit a speed bump in the mid-1990s when its growth rate slowed down a bit – and its share price was essentially flat during the same period. On the other hand, Colgate-Palmolive posted great results during the late 1990s as it cut flat from its supply chain and launched an innovative toothpaste that stole market share – and the company’s stock saw dramatic gains at the same time. The message is clear: Company fundamentals have a direct effect on share prices.
This principle applies only over a long time period – in the short term, stock prices can (and do) move around for a whole host of reasons that have nothing whatsoever to do with the underlying value of the company. We firmly advocate focusing on the long-term performance of businesses because the short-term price movement of a stock is completely unpredictable.
Think back to the Internet mania of the late 1990s. Wonderful (but boring) businesses such as insurance companies, banks, and real estate stocks traded at incredibly low valuations, even though the intrinsic worth of these businesses hadn’t really changed. At the same time, companies that had not a prayer of turning a profit were being accorded billion-dollar valuations.
The long-term approach – Given the proclivity of Mr.Market to plead temporary insanity at the drop of a hat, we strongly believe that it’s not worth devoting any time to predicting its actions. We’re not along in this. After talking to literally thousands of money managers over the past 15 years or so, we’ve discovered that none of the truly exceptional managers spend any time at all thinking about what the market will do in the short term. Instead, they all focus on finding undervalued stocks that can be held for an extended time.
There are good reasons for this. Betting on short-term price movements means doing a large amount of trading, which drives up taxes and transaction costs. The tax on short-term capital gains can be almost double the rate of long-term capital gains, and constant trading means paying commissions more frequently. As we’ll discuss in Chapter 1, costs such as these can be a huge drag on your portfolio, and minimizing them is the single most important thing you can do to enhance your long-term investment returns.
We’ve seen this borne out in long-term studies on mutual fund returns; Funds with higher turnover – ones that trade more – generally post lower results than their more deliberate peers, to the tune of about 1.5 percentage points per year over 10 years. This may not sound like much, but the difference between a 10 percent annual return and an 11.5 percent annual return on a $10,000 investment is almost $3,800 after 10 years. That’s the price of impatience.
Having the courage of your convictions – Finally, successful stock-picking means having the courage to take a stance that’s different from the crowd. There will be always be conflicting opinions about the merits of any company, and it’s often the companies with the most conflict surrounding them that make the best investments. Thus as an investor, you have to be able to develop your own opinion about the value of a stock, and you should change that value only if the facts warrant doing so – not because you read a negative news article or because some pundit mouths off on TV. Investment success depends on personal discipline, not on whether the crowd agrees or disagrees with you.
My goal in this book is to show you how to think for yourself, ignore the day-to-day noise, and make profitable long-term investment decisions. Here’s our road map.
First, you need to develop an investment philosophy, which I’ll discuss in Chapter 1. Successful investing is built on five core principles:
1. Doing your homework
2. Finding companies with strong competitive advantages (or economic moats)
3. Having a margin of safety
4. Holding for the long term
5. Knowing when to sell
Building a solid stock portfolio should be centered on these five ideas; once you know them, you’ll be ready to start learning how to look at companies. Second, I’ll take a step back and review what not to do – because avoiding mistakes is the most profitable strategy of all. In chapter 2, I’ll go over the most common mistakes that investors make. If you steer clear of these, you’ll start out ahead of the pack. In Chapter 3, I’ll show you how to separate great companies from mediocre ones by analyzing competitive advantages, which we call economic moats. I’ll explain how economic moats are what help great companies keep their top-tier status and why they’re a big part of what separates long-run winners from flashes in the pan. Understanding the sources of a firm’s economic moat is critical to thoroughly analyzing a company.
Chapters 4 through 7 show you how to analyze companies by reading their financial statements. First I’ll describe how financial statements work – what the line items mean and how the different statements fit together. Once you know how to read balance sheets and income statements, I’ll show you a five-step process for putting all the numbers in context and finding out just how solid a company really is. I’ll also show you how to evaluate management. In Chapter 8, we’ll look at how you can detect aggressive accounting, and I’ll tell you what red flags to watch out for so you can minimize the odds of a big blow up in your portfolio.
In Chapters 9 and 10, I’ll show you how to value stocks. You’ll learn the underlying theory of investment value, when ratios such as price-to-earnings are (and aren’t ) useful, and how to figure out whether a stock is trading for more or less than its intrinsic value. The cheapest stock isn’t always the best investment, and what looks expensive may actually be cheap when viewed from another angle. Chapter 11 provides two case studies. I’ll apply the tools presented in the previous chapters to two real-world companies, so you can see for yourself how the process of fundamental analysis works in practice.
In Chapters 13 through 26, I’ll lean on Morningstar’s team of equity analysts to give you tips for analyzing different sectors of the stock market. From semiconductors to drugs to banks, we’ll tell you exactly what you need to know to analyze companies from every corner of the market. You’ll learn what industry-specific characteristics separate the great firms from the also-rans, what industry jargon means, and which industries are more (and less) likely to offer fertile hunting ground for great investment ideas.
Finally, we’ll wrap up with some recommended readings for those who want to learn more. The structure of the book is the same as the basic investment process that we advocate: Develop a set of investing principles, understand the company’s competitive environment, analyze the company, and value the stock. If you can follow this process while avoiding most big mistakes, you’ll do just fine as an investor.
Pat Dorsey
Picking individual stocks require hard work, discipline, and an investment of time (as well as money). Expecting to make a large amount of money with only a little effort is like expecting to shoot a great round of golf the first time you pick up a set of clubs. There is no magic formula, and there’s no guarantee of success.
That’s the bad news. The good news is that the basic principles of successful stock-picking aren’t difficult to understand, and the tools for finding great stocks are available to everyone at a very low cost – you don’t need expensive software or high-priced advice to do well in the stock market. All you need are patience, an understanding of accounting and competitive strategy, and a healthy dose of skepticism. None of these is out of the average person’s grasp.
The basic investment process is simple: Analyze the company and value the stock. If you avoid the mistake of confusing a great company with a great investment – and the two can be very different – you’ll be already be ahead of many of your investing peers. (Think of Cisco at 100 times earnings in 2000. It was a great company, but it was a terrible stock.)
Remember that buying a stock means becoming part owner in a business. By treating your stocks as businesses, you’ll find yourself focusing more on the things that matter – such as free cash flow – and less on the things that don’t such as whether the stock went up or down on a given day.
Your goal as an investor should be to find wonderful businesses and purchase them at reasonable prices. Great companies create wealth, and as the value of the business grow, so should the stock price in time. In the short term, the market can be a capricious thing – wonderful businesses can sell at fire-sale prices, while money-losing ventures can be valued as if they had the rosiest of futures – but over the long haul, stock prices tend to track the value of the business.
It’s the business that matters – In this book, I want to show you how to focus on a company’s fundamental financial performance. Analyst upgrades and chart patterns may be fine tools for traders who treat Wall Street like a casino, but they’re of little use to investors who truly want to build wealth in the stock market. You have to get your hand dirty and understand the businesses of the stocks you own if you hope to be a successful long-term investor.
When firms do well, so do their shares, and when business suffers, the stock will as well. Wal-Mart, for example, hit a speed bump in the mid-1990s when its growth rate slowed down a bit – and its share price was essentially flat during the same period. On the other hand, Colgate-Palmolive posted great results during the late 1990s as it cut flat from its supply chain and launched an innovative toothpaste that stole market share – and the company’s stock saw dramatic gains at the same time. The message is clear: Company fundamentals have a direct effect on share prices.
This principle applies only over a long time period – in the short term, stock prices can (and do) move around for a whole host of reasons that have nothing whatsoever to do with the underlying value of the company. We firmly advocate focusing on the long-term performance of businesses because the short-term price movement of a stock is completely unpredictable.
Think back to the Internet mania of the late 1990s. Wonderful (but boring) businesses such as insurance companies, banks, and real estate stocks traded at incredibly low valuations, even though the intrinsic worth of these businesses hadn’t really changed. At the same time, companies that had not a prayer of turning a profit were being accorded billion-dollar valuations.
The long-term approach – Given the proclivity of Mr.Market to plead temporary insanity at the drop of a hat, we strongly believe that it’s not worth devoting any time to predicting its actions. We’re not along in this. After talking to literally thousands of money managers over the past 15 years or so, we’ve discovered that none of the truly exceptional managers spend any time at all thinking about what the market will do in the short term. Instead, they all focus on finding undervalued stocks that can be held for an extended time.
There are good reasons for this. Betting on short-term price movements means doing a large amount of trading, which drives up taxes and transaction costs. The tax on short-term capital gains can be almost double the rate of long-term capital gains, and constant trading means paying commissions more frequently. As we’ll discuss in Chapter 1, costs such as these can be a huge drag on your portfolio, and minimizing them is the single most important thing you can do to enhance your long-term investment returns.
We’ve seen this borne out in long-term studies on mutual fund returns; Funds with higher turnover – ones that trade more – generally post lower results than their more deliberate peers, to the tune of about 1.5 percentage points per year over 10 years. This may not sound like much, but the difference between a 10 percent annual return and an 11.5 percent annual return on a $10,000 investment is almost $3,800 after 10 years. That’s the price of impatience.
Having the courage of your convictions – Finally, successful stock-picking means having the courage to take a stance that’s different from the crowd. There will be always be conflicting opinions about the merits of any company, and it’s often the companies with the most conflict surrounding them that make the best investments. Thus as an investor, you have to be able to develop your own opinion about the value of a stock, and you should change that value only if the facts warrant doing so – not because you read a negative news article or because some pundit mouths off on TV. Investment success depends on personal discipline, not on whether the crowd agrees or disagrees with you.
My goal in this book is to show you how to think for yourself, ignore the day-to-day noise, and make profitable long-term investment decisions. Here’s our road map.
First, you need to develop an investment philosophy, which I’ll discuss in Chapter 1. Successful investing is built on five core principles:
1. Doing your homework
2. Finding companies with strong competitive advantages (or economic moats)
3. Having a margin of safety
4. Holding for the long term
5. Knowing when to sell
Building a solid stock portfolio should be centered on these five ideas; once you know them, you’ll be ready to start learning how to look at companies. Second, I’ll take a step back and review what not to do – because avoiding mistakes is the most profitable strategy of all. In chapter 2, I’ll go over the most common mistakes that investors make. If you steer clear of these, you’ll start out ahead of the pack. In Chapter 3, I’ll show you how to separate great companies from mediocre ones by analyzing competitive advantages, which we call economic moats. I’ll explain how economic moats are what help great companies keep their top-tier status and why they’re a big part of what separates long-run winners from flashes in the pan. Understanding the sources of a firm’s economic moat is critical to thoroughly analyzing a company.
Chapters 4 through 7 show you how to analyze companies by reading their financial statements. First I’ll describe how financial statements work – what the line items mean and how the different statements fit together. Once you know how to read balance sheets and income statements, I’ll show you a five-step process for putting all the numbers in context and finding out just how solid a company really is. I’ll also show you how to evaluate management. In Chapter 8, we’ll look at how you can detect aggressive accounting, and I’ll tell you what red flags to watch out for so you can minimize the odds of a big blow up in your portfolio.
In Chapters 9 and 10, I’ll show you how to value stocks. You’ll learn the underlying theory of investment value, when ratios such as price-to-earnings are (and aren’t ) useful, and how to figure out whether a stock is trading for more or less than its intrinsic value. The cheapest stock isn’t always the best investment, and what looks expensive may actually be cheap when viewed from another angle. Chapter 11 provides two case studies. I’ll apply the tools presented in the previous chapters to two real-world companies, so you can see for yourself how the process of fundamental analysis works in practice.
In Chapters 13 through 26, I’ll lean on Morningstar’s team of equity analysts to give you tips for analyzing different sectors of the stock market. From semiconductors to drugs to banks, we’ll tell you exactly what you need to know to analyze companies from every corner of the market. You’ll learn what industry-specific characteristics separate the great firms from the also-rans, what industry jargon means, and which industries are more (and less) likely to offer fertile hunting ground for great investment ideas.
Finally, we’ll wrap up with some recommended readings for those who want to learn more. The structure of the book is the same as the basic investment process that we advocate: Develop a set of investing principles, understand the company’s competitive environment, analyze the company, and value the stock. If you can follow this process while avoiding most big mistakes, you’ll do just fine as an investor.
Pat Dorsey
Available at Amazon India : http://goo.gl/vC31GM
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