Buying Stocks Means Buying Companies#
What are you buying when you buy stocks? Are you buying a stake in the company or a tradable instrument in the stock market? In fact, stocks have both equity and instrument attributes. These two attributes correspond to two ways of making money.
If you consider stocks as part of the company, that is, equity, then you can earn a portion of the company's annual net profit as income based on the proportion of your investment to the total market value. If you consider stocks as a medium of exchange, that is, instruments, then you can buy them at a low price from others and sell them at a higher price to another person. Your profit comes from the higher price at which the buyer purchases the stock, and it has little to do with the company's operations.
In the stock market, people make money using both of these methods, but the second method requires you to find buyers and guess whether they are willing to buy your stocks at a high price. Whether you can find a buyer or whether they are willing to buy is unknown. As the saying goes, human hearts are unpredictable. I can't accurately guess what my girlfriend is thinking, let alone guess the thoughts of the buyer who wants to buy my stocks at a high price.
So how do you make money relying on equity?
Our profit = (selling price - buying price) x number of shares held, and the stock price = P/E ratio x earnings per share, where earnings per share = net profit / total shares. Therefore, the stock price = P/E ratio x earnings per share / total shares.
When buying stocks, we always expect the stock price to rise in the future. In a situation where the total number of shares usually remains constant, for the stock price to rise, at least one of the two variables that determine the stock price, the P/E ratio and the company's net profit, must increase.
Let's start with the P/E ratio.
The P/E ratio can also be calculated as the company's current market value / its profit. For example, if the company's current market value is 10 billion and its profit for the year is 200 million, then the P/E ratio is 50, which means investors believe that the market value is 50 times the profit. Is a P/E ratio of 50 considered reasonable? Sometimes it is, sometimes it isn't. Some people think it's reasonable, while others think it's not. Therefore, the P/E ratio is a reflection of the overall sentiment of all participants in the market. When they are optimistic, they believe that a higher P/E ratio is better, and when they are pessimistic, they believe that a lower P/E ratio is better. This P/E ratio, influenced by alternating emotions, is unpredictable, and spending time on unpredictable things is a waste of life.
Therefore, it is illogical to expect the stock price to rise by relying on an increase in the P/E ratio after buying stocks. It is a matter of luck.
So, the only variable left to consider is the company's net profit.
If you can predict the company's future net profit, then you can consider buying the company's stocks at a reasonable price. Can the company's net profit be predicted?
Yes, it can.
Circle of Competence#
Let's say you are an employee. Although you have never started a company, you can consider yourself as a company. By selling your labor and providing services to your employer, you earn a salary. You know how much you can earn each month, how much bonus you can get at the end of the year, and roughly estimate how much you can spend in a year. Therefore, you can accurately calculate how much money you can have each year, and the money you save is your net profit.
Why can you calculate your net profit for a year? Because you understand yourself, know your income and expenses each year, and know how you make money.
The same applies to predicting a company's net profit. As long as you can understand how the company makes money and what its unique competitive advantage is, you can predict its future profits. This is much more logical than predicting other people's emotions. And logical things can be made simple by developing certain competencies that make them replicable and actionable.
This brings us to a key term: competence. Emphasizing that you need to have the ability to understand the company.
In addition, you need to know where the boundaries of your competence lie. If you have the ability to understand the consumer industry, do you also have the ability to understand the technology industry? Not necessarily.
There are thousands of companies listed in the stock market. Do we need to understand all of them? No, and it's not possible. Our energy and competence are limited, so we should focus on a few select companies.
This brings us to another core concept of value investing: the circle of competence. It refers to the areas that you truly understand, the areas that match your skills and expertise.
However, it is important to distinguish between understanding and thinking you understand. This is the guarantee of your future returns. As Warren Buffett once said, the size of your circle of competence is not important, but knowing its boundaries is vital. You need to understand what you truly know and not overly confident in investing your money in an area you think you understand.
Know your circle of competence, and stick within it. The size of that circle is not very important; knowing its boundaries, however, is vital - Warren Buffett
By sticking to and deepening your circle of competence, you can gain an advantage in understanding certain information. For example, based on your understanding of a company's business model and unique competitive advantage, you can predict its future profits for the next few years. The limitations of the circle of competence also reduce the number of stocks you can choose from, reducing the possibility of making poor investment decisions.
For example, Bill Gates is a good friend of Warren Buffett for many years, but Buffett has never bought Microsoft stocks because he cannot determine whether Microsoft will continue to make money decades later, which means Microsoft is outside his circle of competence. Jeff Bezos, the founder of Amazon, is also a friend of Buffett, but Buffett has not invested in Amazon either. This reflects Buffett's adherence to the principle of sticking to his circle of competence and truly practicing what he preaches.
Margin of Safety#
When you find a company with an excellent business model and a unique competitive advantage, such as Maotai and Tencent, should you buy their stocks immediately? Of course not. Just like buying things, not losing money is the bottom line. It's good to have good quality at a reasonable price, and it's even better if you can get a bargain. Therefore, if the stock price is too high, you should not buy it.
If you know that a watermelon is worth 5 yuan per kilogram, and someone is selling it for 2.5 yuan per kilogram, would you buy it? Definitely.
But what about buying stocks? According to the concept of buying stocks as buying companies within your circle of competence, how do you know how much a company is worth?
After understanding the company, you can use the discounted cash flow (DCF) method to calculate the intrinsic value of the company. I will explain this method in detail in the next article. For now, let's assume that you can roughly estimate the intrinsic value of the company, that is, the company's intrinsic value.
If the intrinsic value of a stock is 5 yuan per share, and someone is willing to sell it to you for 2.5 yuan per share, would you buy it? Definitely. And the price difference of 5 - 2.5 = 2.5 yuan is usually called the margin of safety - the difference between the intrinsic value of the asset and the price you buy it for.
Don't underestimate the margin of safety. It is one of the core concepts of value investing and a magic weapon to ensure that you make continuous profits because buying at a high price can lead to permanent losses.
In addition to the desire to get a good deal, what are the reasons why we must consider the margin of safety when buying stocks?
Combining what we have discussed earlier, investing means using cash to buy stocks of companies within your circle of competence. However, people make mistakes from time to time, and unexpected disasters often occur in the capital market. In such cases, the margin of safety ensures that you do not or minimize losses when you make mistakes in assessing the company, overestimate the company's profits, or encounter economic crises or black swan events.
Furthermore, considering the margin of safety, the buying price will be relatively discounted compared to the intrinsic value. That is, the price you buy is reasonable or relatively low. Driven by the instinct to seek profits, capital flows into assets with strong profitability (remember you bought stocks of companies whose profits are expected to grow?), pushing up the prices of these assets and narrowing the gap between your buying price and the intrinsic value. There is a high possibility that the stock price will rise to a level that scares you. Your job is to sell when the stock is overvalued and earn high returns. Therefore, the margin of safety is also the source of excess returns.
You may ask, are there really stocks in the stock market that are priced below their intrinsic value? Why would someone be willing to sell them to you at a low price? Isn't that foolish behavior?
It may not happen in a fruit store or a vegetable market, but it does happen in the stock market, and it can happen at any time. This brings us to an important assumption of value investing: Mr. Market. The aunt selling vegetables will not sell them to you at a loss, but Mr. Market will.
Imagine that you are trading stocks with a person named Mr. Market, and every day Mr. Market will offer a price at which he is willing to buy your stocks or sell his stocks to you.
Mr. Market's mood is very unstable. Therefore, on some days, Mr. Market is very happy and only sees the bright side, so he will quote a high price. On other days, Mr. Market is quite depressed and only sees the difficulties, so he will quote a low price.
In addition, Mr. Market has a lovely characteristic. He doesn't mind being ignored. If what Mr. Market says is ignored, he will come back tomorrow with a new offer.
What is useful to us about Mr. Market is the prices in his pocket, not his wisdom. If Mr. Market seems abnormal, you can ignore him or take advantage of this weakness. But if you let him control you completely, the consequences will be unimaginable.
This is a fable about Mr. Market mentioned by Benjamin Graham in "The Intelligent Investor" (1949). Mr. Market is always ready to trade with you, to buy the stocks you hold and sell you the stocks he holds. He is the person behind the stock trading software who ultimately trades with you. They are not specific individuals, but rather a crowd of people.
Mr. Market is crazy, and his behavior is unpredictable and cannot be followed. You can only take advantage of him in extreme situations. Mr. Market, composed of a crowd of people, vividly reflects human greed and fear, and his emotions swing between excessive optimism and extreme pessimism.
When he is in a good mood, he will offer a high price to buy the stocks you hold. If his offer is much higher than the intrinsic value of the stocks, you can consider selling them to him and make a good profit. When he is in a bad mood, he will sell the stocks he holds to you at a low price. If his offer is lower than the intrinsic value of the stocks and there is enough margin of safety, you can happily buy them and take advantage of his offer.
But what about situations other than these extreme cases? Ignore his offers and focus on the company you bought, just like the exciting performance of players on the basketball court is more important than the changing scores on the scoreboard.
If you still don't know who Mr. Market is, when you become anxious and confused by the fluctuations in stock prices, and when you are in intermittent ecstasy and pain, just open the front camera of your phone and you will see the true face of Mr. Market.
Conclusion#
- Buying stocks means buying companies.
- Buy stocks of companies within your circle of competence.
- Consider the margin of safety and buy stocks at a certain discount within your circle of competence.
- Due to the madness of Mr. Market, you have the opportunity to buy stocks of companies within your circle of competence with a certain margin of safety. Beyond the extreme offers of Mr. Market, you should focus on the company itself, not the fluctuating prices on the chart.
Follow me on Twitter:
https://twitter.com/onecellinglamp
References#
- Tang Chao. Practical Value Investing. China Economic Publishing House, 2019.
- Understanding and Not Understanding
- Circle of competence - Wikipedia
- How to explain "Margin of Safety" with vivid examples? - Zhihu