Introduction to Successful Investing
Peter Lynch’s comment, from the first page of his excellent book, One Up on Wall Street, probably did more to inspire me to learn, and convince me I could do it myself, than much of what came after I read it. My experience in the years following proved to me that he was right. This blog, if it has any purpose at all, is to convince you of that fact. And, I’ll tell you how to do it.
What is Investing?
Contrary to what you may have come to believe about investing, it is not gambling on the stock market with your hard-earned money. Investing is buying affordable shares of well-managed companies at a reasonable price and enjoying the growth in your share of ownership of those companies as they prosper.
There are only ten, rudimentary terms you have to understand for this methodology to make sense.
There are only two things you need to learn about a company and its stock:
• Is the company a good company?
• If it is, can you buy it at a reasonable price?
There are only two things you need to know to determine if it’s a well-managed company.
• Is the growth of its revenues and its profits strong and stable?
• Can its current management sustain its successful track record?
Both of these issues can be determined by looking at graphs of readily available data that you can plot yourself or, far more easily, using software that reads, plots, and analyzes that data for you in an instant.
If you can tell the difference between a line that slopes up and one that slopes down and if you can tell the difference between a line that is straight and one that is crooked, you know nearly all of what you need to know about the quality of your investment candidate!
Once you’ve determined that the company is a good candidate—and only then—you can determine a reasonable price for its stock.
There are only two things you need to learn about the price of the stock:
• Is the reward adequate?
• Is the risk reasonable?
Because the short-term ups and downs of the market are impossible to predict, and because the earnings of a company are what drive the price in the long term, price and earnings data is forecast five years in the future. Using the historical price and earnings data of the previous five to ten years, it is possible to arrive at a reasonable estimate of the highest and lowest price at which the stock might be expected to sell five years out.
It is simple math to derive the forecast annual rate of return of the investment from the current price and the forecast high price. You will look for a reture of approximately 15 percent annually, which would double your money every five years.
From the current price and the forecast low price, it’s also simple math to compare what you might lose, should the price go down to the forecast low price, with how much you stand to gain should it go up to its forecast high price. The resulting ratio, comparing risk to reward, provides us with an Upside/Downside ratio or a Risk Index. So long as the reward is at least three times the risk, we would consider the risk to be reasonable.
How it Works in Practice
Assume you can purchase the shares of a good company at a reasonable multiple of its earnings. For example, ABC Company last year earned $1.00 for every share of stock that was issued to investors.
If you determined that a multiple (P/E) of 20 times earnings, those shares would cost you $20 each.
If that company can grow its earnings 15% each year, by the time five years has gone by, it will be earning about $2.00 per share by then. (Well-managed companies can readily do this.)
Should you wish to do so, you may sell those shares for the same, reasonable multiple of its earnings (20), which means that you will receive $40 for every share you own. You will have doubled your money.
Should you decide, however, to continue holding onto those shares for another five years, assuming the rate of growth continues, you would then be able to sell them for $80 each. And, in another five years, $160 each. This is the “magic of compounding” and is what—along with having the discipline to add to your investments on a regular basis—enables you to increase your wealth spectacularly, simply by holding onto what you already own and not pulling out and spending your earnings.
In a nutshell, that’s all there is to it. If you agree that this is simple logic and makes perfect sense, then you’re well on your way to being a successful investor.
Please tell me if there’s something in this explanation that doesn’t meet your test of common sense.