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You can teach yourself to invest in the stock market, and with the right help and knowledge, you can reach your goals. To become an investor, you do not necessarily need pre-existing knowledge; you can learn while you invest. Below you will learn how the pros do it by applying value investing principles to invest in the stock market.
Value investing is understanding what you are buying and holding the stock long-term. This means staying updated with your investment without clouding your judgement by short-term market turbulence.
There are many ways to invest in the stock market. The least risky and most rational way is value investing. Value investing considers the company’s financial and competitive position in the market and only buys the company when the price is available at an attractive price.
The value investing strategy was invented by Benjamin Graham (The father of value investing) and passed down to his students Warren Buffett (The world’s best value investor), who improved on those principles which can be applied by anyone and can compound your money for the long term.
The 4 Principles of Value Investing
The value investing strategy has 4 principles. When those principles are applied well by the investor, it can significantly tip things in their favour and increase the chances of high return.
Meaning of the company
The meaning is to buy a company you understand based on your interests and what you do for a living. Understanding the company business is the first step to picking a stock. You must understand what the business does and how it makes money.
Your edge in the market is what overlaps between the circles of Passion, Talent and Money, as shown below:
You should only aim to invest in companies you are interested in and can understand the business model easily. If you do not know your edge in the market, filling in the circles above can show you if your circle of competence is in tech, consumer goods, retail, etc.
Moat of the company
The company’s moat is the competitive advantage that allows it to stay in the market safely from competitors. This is a principle that Warren Buffett invented, and it is basically trying to determine how the company manage to compete in the market and stay on top of its competitors.
Examples of companies’ moats
- Brand: Companies you are willing to pay more for because you trust them. Coca-Cola is a good example of a Brand company because it can raise its prices, and people will still pay for it.
- Secret: Companies that have the authority or trading secret that makes it very difficult for competitors. Pharmaceutical companies that develop vaccines and drugs are companies that have a secret.
- Tolls: Companies that have control over the market and collect bills or tolls for services, such as Utility companies.
- Switching: Companies that are too hard to switch from. Companies like Apple are too difficult to switch from because of their ecosystem.
- Price: Companies that price their products so low that it makes it difficult for other companies to compete with, such as Walmart.
Some companies do not have a moat, such as commodity companies (steel, oil and airline companies), making it very cyclical and risky.
Management of the company
The role of company management is to increase earnings which can increase the share price; they operate the business through a series of decisions that can increase the company’s competitive advantage or reduce it. Therefore having good management is crucial to value investing.
In a nutshell, good management can influence the following 5 figures that can be determined from the company’s annual reports.
The Big Five:
1. Return on Investment Capital (ROIC): Measure company profitability relative to the amount of capital invested by its shareholders.
2. Sales growth rate: Total annual sales, which you can find in the company income statement. It is also known as the Topline.
3. Earnings per Share (EPS) growth rate: Business profit per share, also known as the bottom line found in the income statement.
4. Book Value per Share (BVPS) growth line: Ratio of total equity divided by the number of shares outstanding. You can find the Book value in the company balance sheet.
5. Free Cash flow (FCF) growth rate: The amount of cash the company has after operations which you can find in the cash flow statement.
If those figures show a year-over-year increase and are bigger than 10%, it indicates a strong company moat.
On top of the company, management is the company’s CEO, who makes the top executive decisions.
The Company CEO need to be:
- Owner-Oriented: Act for the benefit of the shareholders.
- Driven: To increase earnings.
Margin of Safety
The Margin of Safety is buying a company on sale that can give you a high return on investment and reduce risks. This is the most important step in value investing, in which you determine the fair value of the price but only buy the business when it is available for 50% or 30% below its fair value, which is known as the margin of safety.
If you can find a company that qualifies for all the above but has a price higher than the Sticker value, you should wait until it is available at the Margin of Safety price.
There are four numbers required to calculate the Margin of Safety:
- Current EPS.
- Estimated future EPS growth rate.
- Estimated future PE
- The minimum rate of return.
Calculating the margin of safety is a lengthy process if you have not done it before and require some knowledge of the above principles and how to calculate them; we have made a full guide on Calculating the Margin Of Safety you can check here.
9 Ways to teach yourself to invest
After going through the value investing principles, it is time to focus on proven techniques that make you more mainstream in your investing journey. The following are 9 ways to teach yourself to invest in the stock market.
If you have never invested in the stock market before, then you should check the 5 Actionable Steps To Start Investing In The Stock Market.
1- Read investing books
The best way to know something is to learn from people who spend their life doing that thing. Reading investing books is probably the most important thing you can do to get the required knowledge before investing. You can skip the guesswork and negligence by learning from their experience. The following is a collection of the best-written books on stock market investing that you can buy on Amazon (Click the image to go to Amazon):
You can also check our guide of the TOP 10 books to read to teach yourself stock market investing.
2- Get the latest news
There are many ways to get news and updates about the stocks you are interested in, and there is no right or wrong way to do it. You just need to find a way that you are most comfortable with. You can find news by reading blogs, listening to podcasts, watching youtube … etc. news helps you spot good deals and opportunities within your competence circle.
3- Understand your circle of competence
Understanding your circle of competence is a crucial step in your investing journey. Not every business you come across is suitable for you, even if it is trading ten times below its intrinsic value. Simply because what you understand in the world is usually limited, and sticking with what you know can help you along the way when the business is in distress. In doing so, you are more rational in making decisions, and less stressed when the price is falling.
It ain’t so much the things that people don’t know that makes trouble in this world, as it is the things that people know that ain’t so.
Mark Twain
So how can you distinguish between the stocks you know well and those you do not know? The answer lies in your experience; what you do for a living and what you buy and use in your day-to-day activities is probably within your competence circle. You do not have to invest in a complicated business you do not understand. If you work in hospitality, your circle of competence is probably in retail stores, restaurants and food, not pharmaceutical companies or microchips.
People usually overestimate what they know and only search to confirm their pre-existing beliefs. Therefore, it can be extremely difficult to know exactly what you know, so you should write down your circle of competence and be specific.
4- Understand the companies you want to invest in
After finding your circle of competence, you will stumble on companies that you understand the business model very well. And with some research, you become pretty familiar with the company structure. In general, to understand the company, you need to know three things:
- Meaning: what is the business about, and the different sources of income (How it makes money).
- Moat: what is the competitive advantage of this business over other companies that offer similar products and services?
- Management: How is the management running the company? Are those people you can trust running a company you are investing in?
5- Learn what the smart money is buying now
Websites such as dataroma.com are dedicated to tracking the 13F reports of super investors (A mandatory requirement by the SEC for any institutions with at least $100 million of assets under management), and those reports are required to be released every quarter, which gives insights into what the smart money is buying.
We can learn what Warran Buffett or Charlie Munger is buying by browsing those reports and finding businesses that can fall in our circle of competence. It is essential to know that the reports on those websites were released after those investments were made by those investors, which is why you should not buy stocks blindly because you can be buying at a market high.
Moreover, even the pros can make mistakes; therefore, such websites can be used as a source to find good companies you understand and can buy at the right time.
6- Give yourself a big Margin of safety
The margin of safety is a way to protect yourself if you were wrong in your analysis. Since the market can be irrational for a long time, the margin of safety can protect against such volatility and assure you will at least not lose your original capital. While if you were correct in your analysis, the margin of safety could increase your earnings since you were buying below the fair value.
Essentially, you want to find the business’s intrinsic value or fair value and give it a margin of safety of your choosing, such as 30% or 50%. In this case, you only buy the stock when it trades way below its intrinsic or fair value.
7- Start small
If you are new at something, you should take your time learning. There is no need to put in a huge amount of money at once. Spend your time finding companies with a good moat and under good management. Keep those companies on your shortlist until they are available at an attractive price. This process can take months or years, so you need to be patient. You can buy heavily when the opportunity presents itself.
Moreover, you do not have to own 10 or 20 companies. You only need a few to be successful. Investors like Charlie Munger have a stock portfolio that rarely changes, while the holdings stay for 10-15 years. Focus on two or three good investments. The more concentrated portfolio you have, the better chances you have to keep track of business changes.
If you are worried about diversification, look at the superinvestors portfolios and compare them to mutual funds. Superinvestors such as Mohnish Pabrai have consistently beaten the market with an average return of 28% with few stocks compared to mutual funds managers, who have usually failed to beat the market while having at least 20 different positions. This proves that diversification is not always the way; you just need to invest in companies you know well and believe in.
8- Stay on top of your investments
You have to stay on top of your investments once you buy them. That means keeping track of the latest news, management, insider trading and financial report. If you are a value investor, you have to review the quarterly reports and annual reports when they are out and stay on top of your investments to distinguish between short-term and long-term changes in the stock price.
Staying on top of your investments is a way to ensure that the business is not going bankrupt or not heading for trouble while ensuring that you will get your target of compound earnings while owning this business.
9- Master your exit strategy
Even after you buy a business at an attractive price and keep track of its annual reports, you still need to have an idea of your exit strategy. There are many exit strategies. The following are a few:
- Selling when the stock price trade just above its intrinsic value (can be short term).
- Selling after a long time to avoid short-term capital gains (To reduce taxes).
- Selling when the company fundamentals have changed (The business is no longer attractive).
- Selling to avoid a drop in stock price due to legal issues or product issues (Sometimes short-term changes).
- Selling when a more attractive investment opportunity is available (An opportunity to increase your compound interest).
- Selling to offset capital gains or to reduce further losses (To reduce taxes)
You can learn more about When Should You Sell a Stock for Maximum ROI?
In general, If you understand what you are buying, you will not stress as much when the stock goes down. It would help if you had an exit strategy before deciding to go in. The longer you hold, the more chances you have to increase your earnings. Therefore, you should ensure that you only buy something you want to keep, ideally for a few years, to pass the short-term turbulence.
Finally, do not put money in the stock market that you will need in a few months, as it can force you to exit at a loss. Only invest money you do not need now. This way, you are not stressed by any current financial needs.
The new investor feedback loop
There are four critical stages that every long-term investor needs to go through to become more sophisticated with their choices. Teaching yourself to invest is to educate yourself, understand yourself, make your goals and obtain experience. The following is a rundown of those four points:
Stage 1 – Educate yourself
This is where you get your fundamentals and start formulating your plans and retirement goals. By educating yourself, you understand why it is critical to participate in the stock market and how to participate in it. Financial literature is the most crucial thing in this stage.
You can learn more by reading: How to Become Financially Literate by Yourself?
Stage 2 – Understand yourself
To invest, you need to understand your circle of competence and what type of business you are interested in and can simply understand. It can be within your profession (What you do for work) or your hobbies. In addition, you need to get your emotions in check. If you think you can not control your emotions, you should not invest because most people can be emotional with money, especially if they do not know how to leverage it.
Stage 3 – Make your goals
In this stage, you will formulate your goals and when you want to retire, which involves understanding your environment, retirement age, and lifestyle. As you develop your goals, you will become more familiar with your weaknesses and strengths and how much you are willing to sacrifice to get what you want in the future.
Stage 4 – Obtain experience
The last stage is to act on what you have learned according to your goals and strengths. It is critical to start small by making small investments as you unravel your ability to control your emotions and compare your expectations to reality. There is no need to rush and take your time to analyse, learn from your mistakes, and wait for the right opportunity to present itself.
The feedback loop
As you go on your investing journey, mistakes and misjudgements can happen, so you should keep educating yourself, then reshape your ideology based on that knowledge, which you will make changes to your goals and then act based on that feedback loop.
