Successful investors apply what they already know in picking stocks, choosing exchange traded funds and investing their money. Retailers have insight into retail stocks and computer programmers have insight into software companies. Doctors and others in the medical field have insight into medications and the tools used in treating diseases. And, if a successful investor is interested in a stock outside of his field of expertise, he learns what the company does to earn money, how much money it will continue to make over the years (intrinsic value of the stock) and what factors exist that protect the value of the stock in a market downturn (margin of safety).These are basics of successful investing. In Basics of Successful Investing I we talked about getting your personal finances in order before investing in stocks, picking a few stocks and getting to know how to track a stock intelligently and deciding how much money to put at risk. In Basic of Successful Investing II we will discuss how to pick a specific investment and when to invest in it.
Stay with What You Know: Picking Stocks
Picking sound investments stocks or otherwise, may simply be a matter of keeping your eyes open. A now-famous investor went to the mall with his wife and two daughters. The girls dragged their parents to a new store that was packed with adolescent females buying sweaters, blouses, slacks, etc. The father was impressed by how much business the store was doing and investigated the stock. It was the Gap. This stock sold for nine cents a share adjusted for stock splits and now sells for $40 a share. The same investor, Michael Lynch, noted that in the late 1970s the popular investment for physicians was railroad box cars which they would then lease to railroads. This turned out to be a bad idea and many docs lost money. At the same time Smith-Kline-French marketed the first effective drug to treat heartburn and peptic ulcers, Tagamet. This drug was sold in huge quantities and SKF stock went up. This is where the basics of successful investing dictate that you invest in what you know or what you see and do research on. Dads who invested in Gap in the early days made money and so did docs who invested in SKF and ignored an investment (railroad box cars) about which they knew nothing.
Choosing to Invest or Not: Intrinsic Value
One of the basics of successful investing is intrinsic value. This concept was introduced by Benjamin Graham in the aftermath of the 1929 stock market crash as part of the concept of value investing. The idea was to develop a rational means of investing in stocks. Intrinsic stock value is its fundamental value derived from solid numbers and not the current stock price which is often driven by current market sentiment. If the intrinsic value of a stock as calculated by the Graham formula is higher that its market value the basics of successful investing dictate that you buy the stock. If the reverse is true you sell the stock if it is in your portfolio. The Graham formula considers earnings per share, a five year growth estimate and the current rate of interest on AAA corporate bonds. Here is the formula as updated by Graham in 1974.
V = (EPS x (8.5 + 2g) x 4.4)/Y
- V is the intrinsic value.
- EPS is earnings per share.
- G is the expected five year growth of the company.
- Y is the current yield on AAA corporate bonds.
To use the formula do the calculation and then divide the calculated intrinsic value of the stock by its current price. The result is called the relative graham value or RGV. If the RGV is less than one the stock is overvalued and a bad investment and if the ratio is above one it is undervalued and may be a good investment.
Look for article III about the basics of successful investing next week.