There are really only two key ways investors can gain a reliable edge on the market; to be better informed, and to act with more discipline.
Fortunately, with so many market participants unprepared to put in the work, or operating under different circumstances and motivations, a little bit of effort here can yield big returns for private investors. Especially at the smaller end of the share market where there is little professional coverage.
Being more informed doesn’t mean access to ‘inside’ information, either. It’s about taking the time to understand exactly what it is you are buying and having a reasonable idea of future potential. That requires a good deal of reading, and plenty of contemplation, but it’s well within the reach of anyone who’s prepared to put in the hours.
Discipline, too, takes effort, although it’s of a different kind. It requires mastering your emotions and often acting against one’s natural instincts, but without a well thought out process you’re destined to make plenty of poor decisions — even if you are well informed.
So, without further delay, here are five questions that will help you gain an edge on the market.
How does the company make money?
At a high level this will always seem pretty obvious, but to simply say “they sell product or service X” is not good enough.
What is the business model? What are the unit economics like? Who are the customers and what are their motivations and choices? What are the drivers of revenue and costs? How and why are these likely to evolve over time?
Maybe you can’t answer these questions, and there’s no shame in that. Many of the world’s best pass on stocks not because they are necessarily a bad investment, but rather because the business machinery is complex and unfamiliar. But simply going through the process is vital if you’re ever to build real conviction in a stock.
What is the business really worth?
Determining whether a company is cheap or expensive requires you to have an independent idea of the true value of a stock — what’s sometimes called its intrinsic value. A value that is grounded in the economic reality of the business, and a plausible view as to its future trajectory.
There are a myriad of approaches, and all are only as good as the assumptions used, but without some sense of value investors are sailing without a compass.
The best approach is to test a variety of assumptions, and apply a wide margin of safety to account for the inherent difficulties of forecasting. But simply going through the process will help you better understand the business and have a greater appreciation for the risk/reward trade-off.
By recording and tracking your valuation for companies (using Strawman, of course) you’re far better placed to withstand the volatility of markets and, indeed, take advantage of it.
Would I buy today?
Most of us tend to base our sell decisions on our personal profit or loss situation. By anchoring on our purchase price, though, we forget that the only thing that matters is how our investments perform from here.
One way to build a better discipline around sell decisions is to ask yourself whether you’d buy back the same shares, in the same proportions, if your portfolio was forceably converted to 100% cash. If not, it suggests you probably need to make some changes to your portfolio.
What’s the other side of the argument?
For every buyer there is a seller, and for every seller a buyer. Why is it that they are happy to take the other side of your trade?
Charlie Munger says that you need to be better able to articulate the counter-view better than the detractors. Having a clear idea of how and why something could go wrong helps you better understand the risks, and forces you to question your conviction.
As Charlie says, tell me where i’m going to die, so I’ll never go there.
We too often act to preserve our ego, to shut out negativity and seek confirmation — but this can be an especially pernicious problem. It’s exactly why Strawman is designed to encourage the sharing and informed debate of different perspectives.
Only by challenging an investment idea, can you hope to improve it.
Is this the best opportunity?
We all have limited capital, and because the benefits of diversification rapidly diminish past a certain point, investors need to focus on the very best opportunities. Plenty of successful investors ignore decent prospects; not because they are especially unattractive, but because they are inferior to what’s already held.
As Peter Lynch said, the best stock to buy is the likely one you already own.
So when evaluating a potential investment, or deciding what to sell, your thinking should be framed in relative way. With over 2,000 listed shares on the ASX, you can afford to be picky!
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Disclaimer– The author may hold positions in the stocks mentioned in this publication, at the time of writing. The information contained in the publication and the links shared are general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser.
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