How to Invest in Shares – The Smart Way

Investment Perspective – December 2016

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

The Sustainable Competitive Advantage

Last article I highlighted the importance of the sustainable competitive advantage because it is one of the most important aspects of investing to take into account. It really is key to investment success. 

Let’s go back a couple of steps though, most people invest using Modern Portfolio Theory, which is basically about diversifying to manage risk (e.g. Kiwisaver). That approach is not without merit, however, for advanced investors (or those expecting more), diversification gets to the point where it actually detracts from returns. 

“Diworsification”

That is because it is just not possible for a wide selection of investments all to be the best performers. Some are better than others and so wide diversification for value investors can actually slow down investment performance because the diversification in effect “waters down” the investment mix to a less effective and slower performing collection of investments.

Many years ago, Warren Buffett referred to this as “diworsification.” 

Playing the markets

How we invest – the method – is a real driver of results. So then, there are the hedge fund managers, the share brokers and an assortment of other types of advisers, managers and investors who essentially play the markets. Whilst some are successful for a period of time, inevitably, longer term, as Warren Buffett knows only too well, the economics of the business determines the return rather than the short term pricing. Even the short term financials (e.g. turnover, profit, price earnings growth ratio, return on shareholders’ funds, price to sales ratio and other assorted analysis) whilst necessary and useful still do not complete the formula for successful investing long term. 

An important part of that is to be able to invest not only with certainty but also with absolute conviction, particularly during volatile markets. That is when some investors worry and stray, however, that is when the best buying opportunities emerge. 

Relying simply on financial analysis as a basis for certainty around investing is a lot like taking cough medicine for a bad cough – actually, apart from the psychosomatic benefits it does not work – really. And yet, just as many people believe (want to believe?) that cough medicine will help, investors, fund managers and brokers the world over use the financials as the favoured approach, believing financial analysis (the more complicated the better), provides all the answers.

The underlying business economics trumps the financials.

Invest and Hope!!

By the way, relying on movement in the share price as a measure of certainty and conviction I hope you can see is simplistic at best. 

For example, how many investors have invested on the basis of the share price moving ever higher over several years only to be disappointed when, for one reason or another, market sentiment suddenly turned negative (a sudden change on the downside in dividend policy is a common example), sending the share price tumbling. Investing in a share price propped up by an unsustainable dividend is a difficult way to grow capital.

The point here is that when we invest in businesses without sound underlying economics, risks increase and longer term, returns tend to decline. 

Remember too, the pricing power offered by sound business economics means more profit.  Added up and compounded over 25 years, the difference between investing in a good business and either diversifying widely or playing the markets via managed funds and share brokers can be significant. 

Even 2.0% per annum difference (e.g. 7.0%pa rather than 5.0%pa) on say $250,000 amounts to a difference of $90,663 over 10 years and a difference of $183,811 over 15 years. 

Here is another way to make more money as an investor

It is as simple as minimising fees, costs and charges. 

The problem with that though is that there is a vast array of different methodologies and charging structures that are not always obvious or transparent. 

I notice that new legislation is coming soon that will force New Zealand fund managers to outline all of their fees in dollar terms rather than just some of their fees in percentage terms.  I suspect some savers and investors might be surprised at the level of fees involved. More surprisingly though, most people have no idea or don’t even care.   

On the other hand, the world has a funny way of ensuring that we get what we pay for. As investors, it is about understanding what quality looks like and within reason, paying what we need to, to get it. 

That is a different approach to cutting costs to the bone for the sake of it regardless of the underlying quality of the good or service. Usually goods and services of lower quality cost less to buy. Longer term though, that can be a false economy and their underlying poor quality can actually cost us more in the long run. 

The Point …

Just as it can be wise to engage with quality goods and services and pay a reasonable price to do so, as investors it usually pays off to invest in quality businesses at a reasonable price.  Cutting costs then is less about paying as little as possible and more about paying a fair price for value and keeping long term transaction costs low. 

Paying little for high quality is difficult – nice if you can. Better just to pay a fair price. 

Paying a lot for inferior quality can be a losing proposition. When it comes to investing, good quality is not always obvious. Especially when investors confuse price and value, thinking that are the same thing.

From an investment point of view, small start-up technology companies in New Zealand might be an example of high risk, lower quality investment options when compared to larger, global organisations such as Google or Berkshire Hathaway. 

Sure, we can argue that some investors made a lot of money out of Xero, particularly if they purchased in the early years, however, there was no real science, methodology or structure to selecting that investment that can be reliably replicated long term. It was just plain luck and the last time I checked, luck is not a strategy! For every success such as Xero, there are countless other failures. 

At WISEplanning, we are fortunate to have the value investor’s methodology that keeps us out of trouble and allows us to grow our capital longer term with a good degree of certainty, regardless of economic conditions. 

Low investment turnover (no “churn”)

Whilst we do not subscribe to a traditional buy and hold approach, indeed we like the idea of buying good businesses and holding long term and where possible, increasing our holdings as market conditions allow (cheaper prices when available). This in turn allows us to apply a low investment turnover policy to investment portfolios. This is important for two reasons:

1. It saves on brokerage costs. Whilst each individual transaction is not expensive, add up those transactions over the long term and the cost can be significant. For example, one study showed a few years ago that the amount of dividends paid out on the US share market was roughly equivalent to the amount of brokerage paid to share brokers to transact, due in part because many people like to play the markets. In other words, they trade in and out of the same business on several occasions because of that methodology. Value Investors sit tight on a good business and buy more when the price declines rather than moving in and out, incurring costs each time.

2. There is always the chance we get it wrong. The more investors and their advisers interfere with investment portfolios, the greater the chance that somewhere along the way, they will make a mistake. Notwithstanding the rule of five, maintaining our discipline around the methodology of buying good businesses, there is no need to be trading unnecessarily incurring additional costs or worse still, making a mistake by getting the timing wrong. Timing the markets is something that everyone can do successfully… that is until they don’t. Chances are for most, in the longer term, playing the markets, is a “zero sum game”. By the time we add up the losses and the gains, many studies show that investors would have been better off to sit tight, thus eliminating costly errors of timing. Belief in the idea that we can outwit the markets looks a lot like believing in the myth of cough medicine. Anyway, Value Investors, as you know, prefer to price for risk rather than time the markets. 

Okay – I know that talking about a low turnover policy with investment portfolios sounds pretty basic. No apologies though. It is about what works rather than what might sound “sexy”, if you know what I mean. Remember too, “business economics trumps business financials”.

“Long time ago, Sir Isaac Newton gave us three laws of motion which were the work of genius but Sir Isaac’s talents did not extend to investing: he lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars but not the madness of men.” If he had not been traumatised by this loss, Sir Isaac might well have gone on to discover the fourth law of motion: for investors as a whole, returns decrease as motion increases.“

Warren Buffett