8/20/2012 2:45 PM ET
What matters in investing
STOCKS 104: Though some professionals make their living by creating a liquid market for stocks, actively ‘day trading’ is simply not how most good investing is done by individuals.
Different people have different notions of what stock investing is all about. Before we go any further, we want to put things into focus and set you on the right path.
Investing does not equal trading
Your perception of stock investing may involve frantic, highly caffeinated traders sweating in front of a half-dozen computer screens with cell phones pressed to their ears.
Feel free to dump these images from your mind, because solid stock investing is not about trading, the fastest computers or up-to-the-second information. Though some professionals make their living by creating a liquid market for stocks, active "day trading" is simply not how most good investing is done by individuals.
Beyond having to expend an incredible amount of effort to track stocks on an hour-by-hour basis, day traders have three powerful factors working against them. First, trading commissions can rack up quickly, eroding returns. Second, there are other trading costs in terms of the bid/ask spread, or the small spread between what buyers are bidding and sellers are asking at any moment. These more hidden frictional costs may represent a fraction of a stock's price, but they can add up. Finally, frequent traders tend not to be tax-efficient, and paying more in taxes can greatly diminish returns.
Just as someone can be a great driver without being a mechanical engineer, you can be a great investor without having a clue about how the trades actually get executed in the market. How your orders flow from one computer system to the other is of little consequence.
Just remember that investing is like a chess game, where thought, patience and the ability to peer into the future are rewarded. Making the right moves is much more important than moving quickly.
Investing means owning businesses
If mechanics mean little, what does matter? Do charts of stock prices hold the answers? We've said it once, and we'll say it again and again: When you buy stocks, you are buying ownership interests in companies. Stocks are not just pieces of paper to be traded.
So if you are buying businesses, it makes sense to think like a business owner. This means learning how to read financial statements, considering how companies actually make money, spotting trends and figuring out which businesses have the best competitive positions. It also means coming up with appropriate prices to pay for the businesses you want to buy. Notice that none of this requires lightning-fast reflexes!
You should also buy stocks like you would any other large purchase: with lots of research, care and the intention to hold the asset as long as it makes sense to do so. Some people will spend an entire weekend driving to different stores to save $60 on a television, but they put hardly any thought into the thousands of dollars they could create for themselves by purchasing the right stocks (or avoiding the wrong ones). Again, investing is an intellectual exercise, but one that can have a large reward.
You buy stocks, not the market
We've all seen the prognosticators on television, predicting where the market is headed. One thing to remember when listening to these market mavens is that stock investing is about buying individual stocks, not the market as a whole. If you pick the right stocks, you can make money no matter what the broader market does.
Another reason to heavily discount what the prognosticators say is that correctly anticipating market movements is hard. There are simply too many moving parts and unknowns to get it right every time. Better to concentrate on a relatively few companies of interest to you.
We established in the previous lesson that stocks are volatile. Why is that? Does the value of any given business really change up to 50% year to year? The fact is, "Mr. Market" tends to be a bit of an extremist in the short term, overreacting to both good and bad news. We will talk more about this phenomenon later, but it is nevertheless a factor to bear in mind as we proceed.
Competitive positioning is most important
Future profits drive stock prices over the long term, so it makes sense to focus on how a business is going to generate earnings. At Morningstar, we believe competitive positioning, or the ability of a business to keep competitors at bay, is the most important determining factor of future profits.
Despite where the financial media may spend most of its energy, competitive positioning is more important than the economic outlook, more important than the near-term flow of news and even more important than management quality at a company.
It may be helpful to think of the investing process as if you were planning a trip across the ocean. You cannot do anything about the weather or the tides (the current economic conditions). You can try to wait out bad weather that might sink your ship, but then you would be sacrificing time, a precious resource in investing.
The main thing you can control is which ship to board. Think of the seaworthiness of a ship as the competitive positioning of a business, and the horsepower of the engine as its cash flow. Some ships have thick, reinforced metal hulls, while others have rotting wood. Clearly, you would pick the ships that are the most seaworthy (with the best competitive positioning) and have the most horsepower (cash flow).
Though the ship's captain (company management) certainly matters, the quality of the ship is more important. On a solid vessel, as long as the captain does not mess up, there is not much difference between a good and a great captain. Meanwhile, there is nothing the best skipper can do if the boat's engine is broken and the boat is constantly taking on water.
To relate this to stocks, business economics trumps management skill.
It's also worth noting that all ships will experience waves (volatility). And though it is true that a rising tide lifts all ships, the tides have nothing to do with the quality of the boats on the sea.
The bottom line
It is very easy for new stock investors to get started on the wrong track by focusing only on the mechanics of trading or the direction of the overall market. To get yourself in the proper mind-set, tune out the noise and focus on studying individual businesses and their ability to create profits. In the coming lessons, we will begin to build the skills you will need to become a successful buyer of businesses.
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