The answer to the following question will literally save you thousands of dollars and hours of headache…
What is a stock?
Here is our textbook definition:
A stock is not a piece of paper that rises and falls in valuation on a daily basis. Instead, a stock is a portion of a business. Owning a few shares may be a very small portion of a business and owning millions of shares may equate to a very large portion of a business. But at the end of the day you are part owner of a publicly traded company and will receive income/profits from the business.
Here is an example:
This would equate to each share of Apple Inc representing .1% (1/1000) of the entire company.
If you were to purchase 80 shares; you now own 8% of the company.
This means you are now entitled to 8% of the company’s profits, without having to run any day to day operations. This is the type of business owner we would like to be. Invest in a profitable company, collect profits, rinse, wash, and repeat. It seems very simple right?
The Majority of Investors Are Doing It Wrong
Most investors are not concerned with how profitable the company is or has been. They simply want to buy shares of the company and hope they go up in value. This is the underlying problem with investments in the stock market for the average person. They simply do not understand how to value a company.
The first thing I would like for you to understand is that “shares of a company” and the “stock market” are two completely separate things.
The stock market, is a marketplace where individuals such as you and I come together to buy and sell stocks.
Using our example above, Apple only has 1000 shares available. Therefore the only way for individuals to acquire shares in Apple would be to buy them from other investors via the stock market.
This means investors can name their own price for which they are willing to sell their shares. The price could be significantly more or significantly less than what you feel they are worth. Regardless of the sell price, the value of the underlying asset which is Apple Inc has not changed. The stock price is not going to effect the business of Apple Inc, they will continue to sell iPhones, iPads, and Macbooks.
Imagine Yourself As A Business Owner
After conducting your due dilligence you calculate the Washington Redskins have a profit of $1 million a year.
You then contact partial owners of the Washington Redskins letting them know you are interested in purchasing their stake in the team. You finally find someone who is interested. Now remember, the price you are willing to pay and the price the current owner is willing to accept is completely between you and him.
You could offer to pay $1 million.
He could ask for $5 million because he thinks the teams future value is worth that much.
He could quite well agree to sell you his stake for $500k because the Redskins had a horrible season and he feels they’re a horrible investment.
Regardless of the price you two agree upon, the underlying profitability of the Washington Redskins for that year does not change. The Washington Redskins do not care about deals between part owners. As long as the majority of the shares are maintained by the head owner it will be business as usual.
If you want to be successful at investing over the longhaul then you need to treat stocks as if you were acquiring businesses.
Stop Gambling With Your Life Savings
There are three common thought processes when it comes to investing in the stock market:
- Investing In individual stocks is a fool’s game: This type of investor has likely read an investment book or two highlighting the importance of diversification. Therefore they only consider investing in exchange traded funds (ETFs) or mutual funds.
- I will pay someone to invest for me: In theory one would think this investment concept would work. This investor openly admits they don’t have the education or motivation to understand the stock market let alone analyze individual stocks. Therefore they defer to recommendations from their broker. The problem with this concept is not all brokers are created equal and they charge enormous fees.
- Set it and forget it: Most investors fall underneath this category. Chances are they attended a seminar or received advice from a trusted friend/family member. The advice was to contribute monthly to their 401k, IRA, or Thrift Savings Plan then forget about it and that’s exactly what they plan to do.
These are the core thought processes the majority of investors have in regards to opportunities in the stock market. Before we get into the advantages and reasons to take a semi active approach to investing we have a quick exercise for you.
What Is The Last Financial Asset You Purchased?
Humor us for a moment and think about 3 purchases you made at least 5 years ago that cost over $1,000. Now I want you to answer the following questions:
- Did you use credit to purchase these items?
- Are you still making payments on these items?
- Do you still own these items?
- Have any of these items appreciated in value?
- Have any of these items generated any income for you?
When my wife and I did this exercise years ago the answers we gave were astounding.
Before we even began it was a challenge to remember purchases we made five years ago. This drove a hard point home right away, if we couldn’t remember our purchases, then chances were they added no value to our family or our future.
The only item which came close to being of value was the home we purchased. But everything else:
- Kitchen remodel
They didn’t appreciate in value or contribute to our finances monetarily. Not to mention their notoriety quickly wore off. As the years went by we saw our purchases not only depreciating in value but also becoming obsolete.
We believe it goes without saying these purchases weren’t terrible financial decisions. After all, everyone needs some form of transportation, entertainment, etc. We simply want to give you some perspective.
Do you really need a $35,000 car when you could easily get by on a reliable $15,000 car? The same thing with a house, how much square footage do you really need in order to live comfortably?
When you purchase legitimate businesses the right way, you acquire a financial asset that will put money into your pocket over the course of your lifespan. Every dollar you invest literally has the potential to multiply 100 times over. This is the concept that generates the type of wealth that can be passed down to your children.
Invest In Yourself While Investing In The Best Businesses
We want you to understand something very clearly, if you don’t look out for your own self interest nobody else will. That is the cold hard truth.
Investing towards your retirement is the most common recommendation you will hear amongst investment theories. There certainly isn’t a problem with that theory in the least bit, however we believe you can and should take your investments one step further.
Most people understand the basic concept of the stock market advancing over time. While there is no guarantee your investment will always increase in value, generally speaking American businesses are going to be worth more money over the long term. This can be attributed to our capitalist market and a variety of other factors. Regardless of your beliefs, we will all be better off owning productive assets over the next 50 years versus purchasing products.
Chances are we’re not telling you something you don’t already know, but here’s what you probably haven’t heard…
Investing in stocks over the long term simply isn’t enough.
In order to accumulate true wealth, the type of wealth that gets passed down from generation to generation. You have to buy the best and largest businesses. These type stocks can be used to make down payments on your children’s homes when they start a family of their own or for whatever you choose. Anything is a possibility when you start investing in your future and stop investing in someone else’s.
How do you identify the best and largest businesses?
It’s not easy but it’s a lot simpler than you probably think. You simply have to follow these four principles when evaluating businesses:
Always own the number one company – You want to own the champion of the industry, the company that has a virtual monopoly on that market, a proven track record that dominates it’s industry. Take McDonalds for example, McDonalds is the premier fast food restaurant in the world. This company has increased its market share and profitability year after year. The chances of McDonald’s going out of business are slim to none.
Own companies with mountains of cash – Invest in companies who produce positive cash flow year after year. Most investors won’t find these businesses as compelling or attractive because the chances of their share prices doubling or tripling over night are slim to none. Instead these companies produce large steady amounts of cash flow year after year as they continue to dominate their industry.
Make sure companies have their shareholders best interest at heart – Good businesses return cash to their shareholders year after year in the form of dividends. But the best businesses also increase those cash returns year after year. McDonald’s has raised their dividend every year since 1976, that’s going on 40 years almost.
Always look to have your initial stake in the company increased over time – Great businesses buy back their own shares. If you truly believed in your own brand, why wouldn’t you purchase your own shares? When businesses buyback their shares, it creates more value for the share holder. Think of a company as a pizza, the more slices it has the less pizza the owners have per slice. This is why we like to see the number of outstanding shares decreasing over time or at the very least stabilizing.
Buying The Best Businesses At The Best Prices
Earlier we explained if you want to accumulate wealth through investing in stocks then you have to start investing in the best businesses. This is true, but there’s one last caveat, you have to buy them at a discount to their true worth.
You will often find the best businesses can be expensive. And rightfully so, you shouldn’t expect a juggernaut of an industry to ever trade at a discount. But there are certain times throughout history when even these great companies go on sale. And this is when you want to acquire them as quickly as you can. Buying great companies at a discount ensures you have a comfortable cushion in regards to market fluctuations and you will likely never have to sale.
Here is a chart of McDonald’s performance during 2nd worst stock market crash in American history.
If you look closely, you will see at the height of the market in 2008 shares of McDonalds traded for $58.50 Once the market crash ensued the lowest price point shares of McDonald’s traded for was around $46.
That’s a 21% loss of equity in your position, during the 2nd worst stock market crash in American history! To put this in perspective the S&P 500 lost approximately 50% of it’s value.
They knew exactly how much the actual business was worth and weathered the storm as other investors panicked.
Take a look at how McDonalds has performed since the bottom of the 2008 market crash. They’ve doubled in price but even more importantly their dividend, the cash that’s returned to shareholders increased from $2.05/share to $3.36/share
Let’s analyze Wendy’s/Arby’s who are competitors in the same industry. This company is not number one and they do not have the same rock solid business as McDonalds. By no means are they a horrible company, but they’re not an exceptional one either.
And make no mistake we only invest in exceptional businesses.
Prior to the stock market crash in 2008, Wendy’s & Arby’s traded for $9. Once the market crashed shares traded for under $3, that’s a 66% of it’s market value.
Remember, this is during the same time frame in which McDonald’s only lost 21% of it’s value.
When you buy large, dominant, and profitable businesses at great prices you don’t have to constantly worry about your investments. In fact you can rest assure your investments are productive assets multiplying your wealth at a significant pace. This is one of the core principles in the TSP advice we provide on a monthly basis.