Wednesday, August 4, 2010

Must-Reads That Will Radically Change Your View

¹²Must-Reads That Will Radically Change Your View Of The Stock Market

By Dan Ferris | 4 August 2010

Most people view the stock market like a lottery game. They make short-term bets on businesses they know little or nothing about and generally lose money. But there's another way to practically guarantee you'll make money in stocks. It requires you to stop obsessing about the market's day-to-day fluctuations and learn something about the businesses you're buying and selling.

You can learn about this method in a number of ways. But I think a great introduction is to read three short books, and one important chapter of another book. By the time you've read all four selections, a light bulb ought to switch on in your head. You should be convinced there's a better way to buy stocks than making random guesses about short-term share price movements.

Last fall at the annual Stansberry Alliance meeting, I was asked for a single book recommendation. I enthusiastically recommended Joe Ponzio's F Wall Street, which I had just finished a few hours earlier. F Wall Street teaches you to think about the value of a business first and forget about the price of its stock until you understand the value well enough. That's what all the best investors say. Look past the noise. Look past the short term. Forget about market risk. F– Wall Street! Focus on value. Be a business analyst, not a market follower.

I probably shouldn't tell you any of this. If you gained expertise in valuing businesses, you'd almost never buy stocks. Most public companies are simply too hard to value. Those that aren't too hard to value spend most of their lives overvalued by Mr. Market. When I tell my readers I'm having trouble finding "cheap stocks," it goes without saying I mean "cheap stocks I understand well enough to value". Ponzio also provides a reasonable valuation shortcut method "for 'armchair' investors who see the value in stocks, want to stick with large, stable companies, and don't want to invest hundreds of hours of research each year."

The book treats a hard subject in a straightforward, easy to understand manner.

Ponzio's final chapter is on patience, another hugely important concept. As I'll show my Extreme Value readers in the August issue (which comes out this week), mastering time is the most important factor in any investment plan. If you can't learn to be patient, you simply cannot make money in stocks. If you can be patient enough, success is virtually guaranteed. If you want to sign up for Extreme Value in time to get the August issue delivered to your inbox this week, click here. [[Note: I do not subscribe to Extreme Value and have no idea of its worth.: normxxx]]

Overall, F Wall Street is well-written and highly readable. It's also worth re-reading. I keep it at arm's length at all times when I'm at home. Most financial books stink. This one is great. Read it and learn from it.

Another valuable investing book is Joel Greenblatt's classic, The Little Book That Beats The Market. Using a simple story that's a joy to read, Greenblatt teaches the reader the ideas behind his Magic Formula investing concept. Magic Formula investing is a simple idea that says you should buy the best businesses when they're trading at suitably cheap prices. Greenblatt offers simple metrics and guidelines so you can learn to identify a good business and know when it's cheap enough. Greenblatt's book, too, is worth re-reading. It's next to Ponzio's book on my shelf.

Another book I often recommend is Frank Singer's little 27-page masterpiece, How To Value A Business. Singer's booklet provides a simple formula for valuing a business, which requires that you estimate the probability of a company's earnings occurring. Think about that. Most people take the earnings for granted. They don't bother wondering about the likelihood of earnings occurring. There are many highly cyclical businesses out there. Once you get real about the likelihood of a given level of earnings happening again, you start realizing a lot of stocks are just too risky to fool with.

Singer's book also prompts you to think about three different types of value, Liquidation Value, Stock Value (which is really IPO value), and Ongoing Business Value. Liquidation value is not the subject of the book. Nor is Stock Value. Singer admits there seems to be no sense or logic to IPO valuations.

Singer provides you with basic tools to understand the value of an ongoing business. He also shows you how ongoing business value can be much higher for a strategic acquirer than for an investor like you or me. A strategic acquirer is another company in the same business. Businesses are worth more to strategic buyers because the key inputs, the earnings, and the probability of the earnings occurring are higher for the strategic buyer. He buys the business because he thinks he can wring more profit out of it. And he thinks higher profits are highly certain. So he pays more. Like Ponzio and Greenblatt, Singer's book contains good examples and anecdotes.

The other must-read I recommend most consistently is Chapter 20 of Benjamin Graham's The Intelligent Investor. The chapter is called "Margin of Safety as the Central Concept of investment". I recommend you re-read it once a month. It's that important.

Once you learn about value, you have to keep in mind business values are inherently imprecise. You can't pinpoint them. You can only estimate them within a given range. Margin of safety is simply the margin for error investors need because it's impossible to pinpoint business value.

For example, if you think a company's stock is worth $100 a share and you buy it for $95 a share, you don't have a real margin of safety. If that $100 company is a World Dominator and you buy it for $75 a share, you're getting a margin of safety. Say the company is a riskier business, not a World Dominator. In that case, you'll want a bigger margin of safety. You might want to wait until it sells for $60 or even $50 a share.

Warren Buffett once said something like this: You want to build a bridge to withstand 30,000 pound trucks, then you want to drive 10,000 pound trucks on it. You don't want to drive too many 29,000 pounders across it. If most investors learned to value a business, they might exit the stock market altogether. My guess is most stock investors who learn to value a business become very picky about the stocks they'll own. They buy less often, sell less often, and hold longer.

And they make more money.

Dan Ferris And Sean Goldsmith

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