Expanding on The First Principles of Equity Investment – Part I

Posted on May 30, 2011

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In an earlier post I have written about the first principles that drive my equity investment decisions. I have been asked to expand on those principles and so in this post am going to do exactly that for the first two principles.

Investors are Owners: Think Like One

If I were to own a company or want to feel engaged with the company that I work for, I would want it to be a good business. To me investing in the stock of a company is no different from owning or being part of a good business. This is not merely a philosophical stand; as a stock holder you are indeed a part owner of the company. Why would anybody want to own a business that is not good?

The foundations of what makes a good business are simple and same regardless of the size or the industry in which the business operates:

  1. an environment that attracts and retains the best talent available,
  2. products or services that are of high and consistent quality,
  3. ability to market effectively,
  4. prudent financial practices, and
  5. an ethical management that looks after the stakeholders’ interests

While the above-mentioned factors are almost self-evident, it is amazing how one or more are missing in most companies. The challenge for an investor is therefore to find such companies and having found them, commit to them. There are so few good companies that once you have found one you would be foolish to let it go.

Price versus Value

The price of a stock reflects the combination of two financial factors: the assets of the company and the potential of the company to generate future income. Of these, the former is easily determined, the latter almost impossible to predict with any degree of accuracy. It is the uncertainty of the latter factor that gives rise to varying estimates of what the value of a company is and hence the price of the stock. An investor is essentially trying to maximize his benefits by buying stocks that are priced lower than their inherent value. The assumption is (and it is a good assumption) that the market will eventually value the stock at its inherent value and hence an investor that paid a price lesser than inherent value will pocket the difference. While this sounds logical, it is the difficulty in arriving at an estimate of current price value differential that makes for winners and losers. The difficulty in determining the inherent value of a company drives investors to focus only on price. However, buying a stock simply because it is available cheap compared to its peers without any consideration to the company’s inherent value does not mean that the investor is picking a winner. An intelligent investor is the one that can buy a good business at a fair price.

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