Greetings, Seeking Alpha Readers! For my first article, I will mainly focus on criteria for making sound investment decisions, and the power of compounding. My hope is that all of my readers (especially my younger audiences), will take away this message: Invest in quality businesses for the long run, and let the power of compounding work for you.
The premise of this article is simple, the earlier one starts investing the higher the chance of financial success. Financial success can be a lot of things, but let's just define it as growing capital or building wealth. For many of us, there are two ways in which we can build wealth: Through investments, or through salaries (earned wealth). Our salaries usually serve as our 'float' capital to invest, and it's relatively simple to achieve, "get a job". Investments on the other hand seem complicated and obscure to the average person, but they need not be. I will layout three important but not exhaustive criteria if one wishes for success in the investment world.
For future articles I will apply this criteria to the evaluation of individual companies. So, without further ado, let's get down to the business of investing in businesses.
Criteria #1: Investing in businesses whether public or private, should always have a thesis or argument. If you can't write down the reason why you're investing in a business, stop there and forget about it. Astute Seeking Alpha readers should note that, "My neighbor gave me a stock tip" doesn't count as a reason. The thesis should contain the company's durable competitive advantage in the marketplace. Your thesis should answer these questions: Is this company's competitive advantage subject to competitive pressures? If so, how many competitors? Is the product easily replicated? Any barriers to entry in the given industry? If you can answer those questions, you should have a good qualitative feel of your company.
Criteria #2: Investments in businesses should always be based on sound valuation techniques. I'm not going to get into the details of various models, but I will list a few for your reference: DCF valuation, DDM (dividend discount model), Ratio Analysis, % of sales method. These four models serve as a good starting point for valuing businesses. The idea here is to apply at least two models to value a business, and if applied correctly, the value of your business should fall within a reasonable range. Then the range of valuations should be plotted on a football field diagram, as shown below:
This diagram is an excerpt from one of my corporate finance assignments, and is for illustrative purposes only.
Also, always make sure to sensitivity test your assumptions, as this will help to refine your ranges of valuation. For example, in the above diagram, my ranges for each method were generated by varying my discount rate +/- 1%.
To wrap up the second criteria, always use more than one valuation technique, and always sensitivity test your assumptions to the 'worst and best case'. This will give you an idea of the variability of your valuation. Finally, pick your 'best estimate' or 'base case' scenario and compare that to the market valuation. As a rule of thumb, according to "The Intelligent Investor", you should look for a 30% margin of safety to your base case valuation. At the end of the day, use common sense. If your valuation does provide a safety margin, but at that level the business is still trading at a huge premium to its 'average' valuation, ie Coca Cola's (NYSE:KO) valuation in 1998 @50x earnings, stay away.
Criteria #3: Investments in businesses should always be made for the long run. I think this point is the most understood and misunderstood point at the same time. Why? Investing in the long run makes sense to people in theory, but when it comes to equities we lose it. Consider this, suppose you bought a house to live in for the better part of your life. I think we can all agree that you would make that investment for two reasons:
a) You need a place to live
b) You believe the price of the home will appreciate over time; if not, you would just rent.
I'd bet that most people don't get a quote on the home the day after the purchase. However, with equities we make a purchase and then check the price the next morning hoping it goes up. The difference in sentiment can be explained by a lack of conviction for the stock purchase. If you're leaving your equity purchases up to chance, then you might as well go to a casino and bet it all on red. At this point, if you've read criteria 1 and 2, and you were able to find a business that meets those criteria, you should be delighted to hold that business for at least five years. Or you could pick Mr. Buffett's favorite holding period: forever.
I know the idea of compounding is well drilled in your head, so I will illustrate its power with one simple example. If you invest $100/month starting at age 20, and assume a nominal 6% return and 2% inflation, the present value (in 2015 dollars), of your savings by age 65 is over 100,000 dollars! Just for perspective, you can easily spend $100/month at Starbucks, or you can invest, your call.
To conclude, if this investment criteria is followed and applied correctly, then financial success will follow. Young people have the advantage of a longer compounding period, so start saving now! For my older, ahem, (more experienced) audience, hopefully you've already started saving and investing for your future.
Please comment, and critical feedback is encouraged :)
Disclosure: I am/we are long KO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Always do your own due diligence when evaluating a business. The author assumes no liability for investment results based on the ideas presented in this article.