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A Beginner's Guide to the Stock Market

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When investing in the stock market you can easily get misguided by Wall Street. Wall Street wants to make sure that investing in stocks is extremely hard so that they can sell you their mutual funds - and earn fat fees. Is there a way for the retail investor to beat Wall Street? Of course!

When evaluating a stock you need to understand that a stock is a piece of a business. It isn't a piece of paper. There's a little business attached with real people making real products. Many people discount this since you are only owning fractional pieces of the business. Let me ask you this: What's the difference between owning 10% of a house that is generating $10,000 in rent or owning 100%? The only difference is the person who has control over the house and how the profits are divided. This is also applicable in the stock market.

Let's imagine that there's an entrepreneur Joey who found the greatest concept ever - selling candy. He did his research and it's super popular in his home town. Unfortunately, he has no money. He can't borrow from the bank as they're strict on lending and/or his business is too small to finance. He decides to sell 50% of his business in order to raise financing for his business. He thinks to himself - "Gee, 50% of something is better than 100% of nothing." He can either sell it through two different means - publicly on a stock exchange or privately among friends and family. He decides that the cost of getting his company publicly traded is too expensive so he resorts to seeking help from a friend of his - Timmy.

Timmy convinced that the product will be a success in the United States he decides to pour in $100,000 to Jimmy. In exchange he gets half of the business. Fast forward one year later and Jimmy has used the capital well and has started making money.

The business is generating $100,000 a year selling candy. The owner is split between two owners 50/50 and he's selling a hot product. The owner spent $100,000 as the original cost to create the business. After all the costs and expenses associated with doing business the business makes a 100% return on capital. On an initial investment of $100,000 by Timmy - our investor quickly recovered his initial investment and makes 100% on the capital he put in to the business using Timmy's money. What does Jimmy do with the $100,000 in profit? He can either pay himself and Timmy 100% of the profit. Since our investor didn't put in anything to the business he's making $50,000 as a "dividend" (money distributed to shareholders by the company) if he distributes it to himself. He then has to distribute the other $50,000 to Timmy as he is a 50% owner.

Or he can reinvest back into the business. He'll need to pay the costs of growing the business - which includes buying inventory, hiring more staff, buying new stores, etc. If he takes the accumulated profits + the original investment (which is now $200,000), he makes $200,000 a year instead of $100,000. By retaining the profits and earning high returns on your capital the money will grow quicker than paying everything out as a dividend. Jimmy decides to be wise and reinvests back into the business.

Timmy is quite pleased 5 years later. The business generates $500,000 a year - $250,000 in which goes back to Timmy. Our investor stopped growing his business due to being in a niche market. The reason why the business did so well was because our investor obtained a family secret recipe. As part of his capital expenditures he spent money on marketing his delicious candy. He also told his family to spread the word about the candy he makes. His customers are willing to pay a higher premium than his competitors due to the candy tasting so great and the branding associated with it. Our investor has marketed his candy as high quality with the best ingredients. The candy business has no competitors due to our investor operating in a small pond. Our investor feared that if he grew too much the returns on his capital would drop significantly. He would rather stop growing and keep on making $250,000 every year. Jimmy can now do whatever he wants with his profit - fund his lifestyle, reinvest into some other project, or donate it to charity.

After a while Jimmy doesn't like the fact that Timmy is making a lot of money. He now wants to take the business private. He goes up to Timmy and asks whether he can buy back the 50% that he owns. The dialogue goes like this...

JIMMY: How much would you want for me to buy your stake out?

TIMMY: Hmm. Well let's take a look here. I'm making $250,000 a year consistently on an initial investment of $100,000. Your business is quite good. For me to sell this stake means that I have to give up $250,000 in income per year. I know this business will continue to make stable profits. Alright pay me $2.5 million and I'll call it a deal.

JIMMY: Although I'd pay less - this is a fair price. You are giving up 10 years’ worth of profits in exchange for the right to earn 10 years profit right now. I'll agree.

TIMMY: Deal.

What was illustrated here were two concepts: the time value of money and the famous P/E ratio. You can see that within the dialogue both investors had to adjust for the present and the future. The investor is getting 10x earnings or 2.5 million dollars for his 50% stake. The entire business is worth 5 million dollars as it makes $500,000 a year or a 10% return. Timmy got 10 years’ worth of profits NOW in exchange for our investor to make money LATER. He will have to wait 10 years for him to recoup his investment but he'll continue to make more money after 10 years since he is confident of the success of his enterprise. The P/E ratio involves basic math. Within our example: 250,000 / 2.5 million = 10%. The other way around is 10x. What you saw illustrated here (oversimplified I admit) is a private transaction of how a business like this should be sold.

The concepts we have illustrated in our previous examples are very applicable in the stock market. Instead of being a 50% owner like Jimmy and Timmy you’ll own smaller stakes in the business. In relation to your ownership you the shareholder are entitled to the future profits of the business. You want to find a decent business that has a management who is shareholder friendly. A shareholder friendly management reduces the risk of your ownership in the stock. In this way you won’t have to resort to uniting with the other shareholders and force the Board of Directors to make better capital allocation decisions (yes you can do that).

In our previous post we discussed an application of returns on capital. A good business is defined as any business that makes excess returns above the average ROC in the United States which is roughly 10-11%. As an investor you want to own a good business that knows how to invest your money properly. You also don’t want to pay too much for the future profits of the business (here’s where the P/E ratio comes handy). Who doesn’t want to pay a low price for a good thing? This is what you are doing in the stock market.
By now I think you are realizing that this isn’t the quickest way to make money in the market.

As illustrated in our example investors have to adjust for the time value of money. How much is a dollar worth today and a dollar 2 years from now worth? How much will I pay? The market is increasingly getting more short-term as Wall Street really doesn’t care about the long term prospects of publicly traded business. What they want is a higher commission – which requires you to trade more. Buy the hottest IPOs, the new growth stock, etc.
Check this news article out http://www.forbes.com/sites/timworstall/2014/07/12/sec-suspends-cynk-technology-stock-but-which-way-was-the-manipulation-working/.

A company with 39 dollars in assets and a semi-functional website had the stock pumped to a valuation of approximately a billion dollars! Talk about overpaying! How could this happen? The stock was pumped to death by brokers. You the investor want to do the exact opposite. You want to pay the future profits of a business on the cheap. If you do your risk gets lower (risk in investing is the probability of losing your money – NOT BETA. Beta is a measurement which calculates how volatile an asset is) and who doesn’t want that? People are commonly taught that you need to take high risk to earn high rewards. This is normally true but what you aren’t taught that it is also possible to take low risk high reward. It’s common sense really. The lower you pay for an asset relative to the amount of cash flow it can make your risk is considerably much lower. There’s a big difference between paying for a house that generates $100,000 for $1,000,000 then compared to paying it for $50,000. This concept is called the “margin of safety.”

Imagine you are a world class engineer who just built a bridge. The max capacity of the bridge is 8000 pounds. Would you put 10,000 pounds into the bridge? No. You’d want to be safe and put 7000 pounds into the bridge. Putting 10,000 pounds could stress the bridge. This is the margin of safety concept. If there’s an asset that is making $1000 a year, you calculate the fair price of the asset to be $10,000. Using the margin of safety principle you decide you want to pay a discount to the $10,000. Within this example you’d be making 10% a year. You decide you want to pay a discount to that fair value. You’d be making more than 10%. If you paid $5000, you’ll be making 20% a year instead.  The thing to remember is that paying lower is better.

There’s two ways you can make money in the stock market and that depends on the level of effort you wish to put in. Either you buy the entire stock market in the form of index funds or you handpick your stocks. Buying the entire stock market is akin to apple picking. If there’s a farm producing apples you have the choice of either handpicking the apples or taking all of the apples. If you take all of the apples on average the apples you take will be decent. There will be some bad apples here and there but overall you will have satisfactory apples. If you decide to put in the effort you can decide to find the best apples out of the farm. This will require effort and superior knowledge of what is the best apple.

If you apply it within the stock market you can either buy the entire stock market (all the apples) or handpick the best stocks (being a stock picker.) Being a stock picker will require more effort (such as knowledge of financial statements, accounting, industries etc.) which is beyond the scope of this article.) If you wish to purchase the entire stock market open up a brokerage and buy the ticker symbol “VTI.” This will give you exposure to the entire stock market. The entire stock market has averaged roughly 7-9% per year. Compounding at 7-9% for someone who has put in no effort is a good return. Those who are stock pickers can expect to make much more than 7-9%. Depending on the time and effort that you take you can make anything beyond 15%+ a year.

For those who want to be stock pickers I’d recommend buying durable high quality companies. These companies are the established companies that raise their dividends every year. Such companies are: General Electric, Coca Cola, Pepsi, Nestle, General Mills, Kellogg, Proctor & Gamble, etc. All of these businesses are examples of businesses with a long history and sustainable competitive advantages. A stock picker would want to seek a business that has stable profits, has good management, cheap relative to the future profits of the business, and predictable in terms of the future prospects of the business.

How do you know if a company’s stock is cheap? Purchase these high quality companies at multiples in relation to their profits. It is required that the investor waits for these opportunities or he risks being burned: similar to the dot com bubble. A general rule of thumb would be to get a 10% dividend yield from a high quality company. This little requirement will toss out all work needed in order to determine the company is cheap or not. Getting a 10% dividend yield will allow you to earn 10% on your money every year – while getting the additional earnings growth for free. You can make much more than 10% if the earnings that management is being allocated to the right opportunities.

Remember the value of a stock is how much cash flow or profit it can give you. One way of determining that is simply requiring a high dividend yield. When buying it at a high dividend yield it already means that you are paying a low multiple for the earnings that are being reinvested due to the valuation of the dividend stream that you are getting. If there’s any success with growing the business you’ll make much more than 10%. If there’s no success and profits remain constant you’ll continue to make your 10% dividend. This is your “margin of safety.”

There’s three ways of making money on a stock. This is listed below.

1. The price goes up: This is the most obvious element. Why would the price go up? Because you bought it at a low price to earnings. If you bought a piece of real estate at a fraction of what it’s worth – it is inevitable that the market will eventually recognize it. If you are able to buy a high quality company at a low price it will be inevitable for the market to recognize. Look at Coca Cola during 2008. The stock fell as low as $15 a share. The dividend yield was well over 10%+. The stock is currently at roughly $40 a share. This illustrates the concept of the market re-valuing the asset if it falls too low.

2. Profits go up: Let’s get into some basic math. If you have a stock with $2 in earnings and the market placed a 5 multiple, you get a $10 stock price. This is what the stock is theoretically worth if a 5 multiple is placed. What would happen if the earnings went from $2 to $4? The new stock price would be $20 a share. The market is forced to revalue the company in order to maintain that multiple. If the market wished to keep the stock price the same then the new multiple would have to be 2.5. However, this will lead to a lower multiple which implies the stock is cheaper. If the stock continues to get cheaper something WILL happen. Management can take the company private, an activist could starting buying shares, a buyout offer, a share buyback can occur etc. Many steps can be taken in order to ensure the market will not maintain the stock price even if profits increase. If the stock is bought at an artificially low multiple then you also have the multiple being raised to reasonable levels. Within our example what would happen if profits increase and the multiple is revalued at 10? You now have a $40 stock price, a quadruple from your previous $10. The reason why the market might revalue the multiple is it could be a potential fair value for that stock.

3. Good capital allocation. What management is doing with shareholder money is extremely important. There’s no point in having a profitable business if the profits aren’t being deployed correctly. If management doesn’t send a check to the owners or burns money away in speculative ventures then there’s no point. The shareholders aren’t making any money. If a dividend is paid, shares are bought back it could be a possibility that shareholder money is being wisely spent. A shareholder friendly management brings the odds to your favor that you will make money in the investment.

There’s yet another way to make money in the stock market. Instead of focusing on dividend yields why not just focus on the earnings yield? If the business can properly deploy the earnings back into the business the business is bound to be more valuable over time. The reason why some businesses might not immediately pay a dividend is the fact that it may be possible for the earnings to be reinvested at high rates of return. This is the time value principle at work. Instead of paying a dividend this year you could potentially get a much larger dividend in the future. Now the question is will you prioritize dividends from the company or do you have the patience for the business to reinvest your earnings in lucrative projects? That is up to you decide.

There you have it. This is the real guide on how to make money on the stock market. If you have any misconceptions/questions/problems please email me at simonleonardo13@gmail.com

Here are some books that I recommend for people to read

“Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports” – Thomas R. Ittelson (This book is about accounting and it is critical that a beginning investor learn it. It is the language of business after all.

“The Little Book That Still Beats the Market” – Joel Greenblatt (This book hammers down the concepts I’ve illustrated in this article.)

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