Behind every share is a business and we invest in businesses, not in shares.
So goes the mantra of the investing greats such as Warren Buffett and Benjamin Graham. That advice forms the basis of my own investing strategy. Trying to understand the businesses, of which my shares represent a small slice of ownership, is fundamental to my investing.
However, my investing returns increased when I combined that business-perspective philosophy with a strategy for embracing the sentiment-driven gyrations of the stock market. We invest in businesses, yes, but we hold shares, so it makes sense to try to understand share-price behaviour too, which can often seem illogical.
Doing our own research to identify attractive stock market-listed businesses is a good start. Rather than simply buying and holding such investments, my conviction is that we can improve investment outcomes by following these five tactics.
1) Buy good value
Buying a good business with great forward prospects is fundamental to a decent investment. However, pay too much and the investment can unravel; we may lose money through a falling share price, even if the underlying business is growing.
Yet it can be a mistake to lead with price in a search for potential investments. Cheap businesses are often cheap for a reason. Usually, it’s because forward prospects are poor. ‘Cheap’ is not ‘value’, although many investors seem to fall at that hurdle — I’ve bitten the dust myself on that one!
Good value starts with good quality. Lead a search for investments with ‘quality’, then look for a price that makes good investment sense. That’s what experts like Neil Woodford and Warren Buffett do. You won’t find them rifling through the metaphorical short-dated bins outside the 99p shop. These guys shop at Marks and Spencer’s and Waitrose. Even last century, our super-successful investing predecessor Jesse Livermore urged us to go with the strongest and best firms.
When we do this, we deal with valuations in the mid-range, not with ultra-low P/E ratings and discounts to asset value, and not with mega-multiples of earnings at the other end of the scale. It took me a long time to grasp this important point about what good value really is, as recognised by many of the most successful and best-known investors.
2) Buy a rising share price
Generally, we buy shares because we think they’ll go up. Our opinions usually form through research and evaluation of a firm’s forward prospects. If the shares go down, we are wrong.
We can argue that our research is sound, but if a share we own falls and stays down then we’ve lost money. Despite researching hard and thinking until it hurts, it’s easy to be wrong. It pays to wait before buying, until the market agrees with our analysis and lifts the share price.
When we have an attractive valuation and good forward prospects, waiting for confirmation from the market can save ‘dead’ time, and it can help us avoid committing to firms where our opinions prove wrong and the shares go down.
3) Follow trends
Capital appreciation in our share investments comes from a price rise after buying. Trends often develop when a share-price mirrors underlying business progress. Regardless of how well, or poorly, such price rises synchronise with trading improvements, the important thing is being aboard when the shares move up. Equally, it’s undesirable to hold a share that’s not moving, or which is moving down.
The enduring presence of trends in financial markets constitutes advantage for the mobile private investor. Following trends, backed by research and business evaluation, is what made well-known investors such as Jesse Livermore, Martin Zweig and Richard Farleigh rich.
It makes sense to time participation in the part-ownership of great companies according to the trends displayed by their share prices. If the valuation and prospects of a firm are sound, it’s a good idea to buy when an upward trend develops and to sell when the trend reverses or when there is no trend at all.
4) Run winners
To follow trends, we need to run our winners. Many do the opposite and cut positions that show a profit. Big gains come from running winners, and if we allow the dynamics of the trend to dictate when to sell, we can maximize gains — sell when the upward trend falters, or reverses.
I used to sell when a valuation became ‘too high’. That’s folly. Financial information often lags prospects on the ground. The stock market looks forward and is a smarter beast than we sometimes give it credit for. In his excellent book Taming The Lion, Richard Farleigh cautions that share prices and other markets often go further than we think possible. That one insight alone has made me thousands since reading his book.
5) Cut losers
Remember point number two: buy a rising share price? If we buy a share and the trend then reverses, our opinion is wrong, plain and simple, no matter how much work we’ve put into the research.
A share price moving down is exactly the opposite outcome to what we expected. Jesse Livermore, Richard Farleigh and Martin Zweig all preserved their capital by cutting such losing positions. Many investors appear to do the opposite, buying more shares after they fall, thus risking the same mistake again. The valuation might seem compelling as a share price falls, but it’s a good idea to use market movements as confirmation that an opinion is correct. An adverse market movement is confirmation that an opinion is incorrect. Remember, the stock market can be smarter than we think!
