When Investing in Stocks, Your Job Is to Buy Profits
Some Tips for New Investors Who Want to Invest in Stocks
When you go shopping for school supplies, you buy notebooks and pens. When you go shopping for groceries, you buy fruits, vegetables, milk, bread, and cheese. When you go shopping for clothes, you buy shirts and pants. When you go shopping for investments, your job is to buy profits. This is true whether you are investing in stocks, investing in bonds, investing in real estate, or any other asset.
Your job is to buy profits. I'll repeat it one more time: Your job is to buy profits.
Beyond that, there are a few rules you must follow to be successful in your investments over the long-term, just like the millionaire dairy farmer near Kansas City, or Anne Scheiber, the IRS agent who turned $5,000 into $22 million, or Grace Groner, the secretary who gave away $7 million. Many new investors have no idea that 1 out of every 25 people in the United States is a millionaire. They have this illusion that financial riches always mean a Bentley, private jet, and trips to Saks, when those folks represent a minority of the rich. Most financially successful people live in ordinary towns, drive ordinary cars, and outwardly live ordinary lives. The difference is, they invested their money wisely and now rank among the capitalist class.
Rule #1 for Investing in Stocks: Stick to What You Know
First, because you are buying profits, you need to focus on owning assets that you understand.
If you owned a toll bridge, it’s easy to see that your profit is going to come from people going over your bridge in exchange for paying tolls. If you own a coffee shop, it’s easy to see that your profits come from selling coffee. If you don’t understand computers, how can you tell how a computer company is making its money?
If you don’t understand aerospace defense, how can you properly evaluate the future earning power of the business? Use Warren Buffett's tool: KISS, or Keep It Simple, Stupid!
Stick to what you know and take advantage of your unique knowledge. A construction worker probably has an advantage when evaluating construction companies over a banker. A banker probably has an advantage when evaluating bank stocks over a grocery store manager. A grocery store manager probably has an advantage when evaluating food stocks over a construction worker.
Rule #2 for Investing in Stocks: Pay a Fair Price
Nothing matters as much as the price you pay for your investment. Going back to the theme I’ve discussed, if your job is to buy profits, the lower the price you pay, the higher your return. That is, if you are buying $1 in profit, your return will be 10% if you pay $10. Your return will be 5% if you pay $20. The price you pay is paramount to your results. Never forget that. It is the heart, the very secret, of those who are successful at investing in stocks.
Rule #3 for Investing in Stocks: Always Build in a Margin of Safety
A margin of safety is a buffer you build into the price you pay for a stock to protect yourself on the down side.
If a company is healthy and you think it is worth $15 per share, you might want to only buy it if trades at $11 per share on the stock exchange. Just like an engineer builds a 15-ton bridge to withstand 20 or 30 tons as a margin of safety, only buying stocks for less than they are worth can provide the potential for a pleasant upside over the years. In the event of a market crash, it can help mitigate your losses as the underlying dividends and earning power of the business carry you through until more prosperous times.
Rule #4 for Investing in Stocks: There Will Be Years a Stock Is Down 40% to 50% or More
I’ve been writing about this a lot lately following some case studies I did for my family holding company. It began with a 20-year review of Colgate-Palmolive. Then came a 20-year review of Procter & Gamble.
Then Hershey Foods. Then McDonald's. It kept going. A pattern emerged. Good investments over the past two decades went virtually unnoticed by Wall Street, chugging along at a decent, but not exciting pace, as earnings and dividends continued to rise regularly. In almost all cases, these stocks had a few years in there where they lost 50% of their market value.
Those kinds of fluctuations shouldn’t matter for a true investor. If they cause you emotional turmoil, you don’t know what you are doing. If I buy a business that earns $1 of profit for every $10 I invest, I don’t care if the guy next to me comes along and offers to sell his shares for $5. In my mind, that gives me another opportunity to buy more ownership in the company at a better price as long as the underlying business remains healthy and my assets are diversified enough that if I turn out to be wrong, one position won’t hurt my long-term goals. In the wisdom of Benjamin Graham, stock prices are there for you to ignore or take advantage of based upon what is best for you. They are not there to inform you of what a company’s intrinsic value is. That is your job to calculate.