This article is part of Morningstar.co.uk's Equity Investing Week.
Investing in equities means buying shares in a publicly-listed company, which essentially amounts to owning a part of that company. Although the words "financial statements" and "accounting" send cold shivers down many people's spines, this is the language of business--a language investors need to know before buying into a company's equity. The beauty is you don't need to be a banker to understand the basics of the three most fundamental and important financial statements: the income statement, the balance sheet and the statement of cash flows.
Once you think you've found a superior company, you need to work out whether it's attractively priced--you don't want to buy shares in a good company at an expensive price. Discounted cash flow can help you calculate the intrinsic value of a company and compare that to its current market value.
The leg work involved in researching individual companies often puts would-be investors off and the risks associated with putting all your eggs in one (or a few) baskets can also push investors towards equity funds rather than individual equities. Still, if you want to add specific equities to your investment portfolio, we've developed a strategy at Morningstar that has five parts:
Look for Wide-Moat Companies
Companies with wide economic moats reside in profitable industries and have long-term structural advantages versus competitors. These companies have predictable earnings, returns on capital higher than the cost of capital, and long-term staying power.
The beauty of a wide-moat company is that the odds are pretty high that the actual intrinsic value of the firm will increase over time, leading to higher shareholder value. In other words, time is on your side with these companies. By contrast, companies with no economic moat generally destroy shareholder value over time--when you buy a no-moat company, you're making a speculative bet that the stock will bounce up just long enough for you to sell it. That's a very tough game to play, and generally only seasoned pros should attempt it.
We suggest maintaining a watch list of wide-moat companies that you consistently monitor for any opportunities. Morningstar Equity Research identifies companies with wide, narrow and no moats.
Always Have a Margin of Safety
Instead of buying shares based on what everyone else is doing, buy a stock only when it's selling at a decent margin of safety to your estimate of its fair value. Don't even think about the overall direction of the stock market, because that's impossible to predict with any consistency. By doing this, you'll need to exercise a lot of discipline and wrestle with the fear of missing out on a market rally. Patience is indeed a virtue when using this approach because often it may take many months, or longer, before a suitable opportunity presents itself.
Obviously, to determine whether a particular stock is trading with a sufficient margin of safety, you must have some sort of an estimate of what you think the stock is worth. Also, you must determine how much of a margin of safety you'll require before buying a stock. If the firm is not very risky, you could be content with a 15%-20% discount to its fair value. If the firm is riskier than average, you may demand a 30%-40% discount. Ultimately, it's your decision.
By requiring a margin of safety, you've given yourself some "error cushion," just in case your estimate was too high. By purchasing wide-moat companies, chances are high that the firm will increase in value over time. Thus, even if your estimates were way off, the company--and its share price--will likely appreciate in value, eventually catching up to your fair value estimate. In effect, by buying wide-moat companies, you have another margin of safety built into your investment.
Don't Be Afraid to Hold Cash
Holding cash is like holding an option--the option to take advantage of volatility in the market. The value of this option rises when market volatility rises. Thus, when the volatile stock market provides you an opportunity to buy wide-moat companies at bargain prices, you'll be ready with cash in hand to take advantage of the irrationality.
Many market participants often neglect this important aspect of investing and stay fully invested at all times. For instance, many professionals getting paid to invest other people's money feel they are actually required to stay fully invested even if there's a lack of suitable opportunities. Thus, when the market drops, they often can't do anything but watch (or worse, sell out near the bottom).
Don't Be Afraid to Hold Relatively Few Stocks
There are very few good ideas in any given year--Warren Buffett has said he's happy to have even one. For the rest of us (i.e., those without the need to invest several billion pounds to make a difference in their portfolios), there may be five or six good ideas a year. In any event, if you feel the need to hold more than 20 stocks, you probably aren't using the Morningstar approach--more than likely you're speculating and trying to diversify away the risks of your speculations by holding lots of different names. We caution you, however, that it's risky to hold a concentrated portfolio (few positions) unless you do three things:
1. Buy only wide-moat companies, which will increase in intrinsic value over time;
2. Buy them only at a significant discount to fair value (a margin of safety);
3. Have a time horizon of at least three years on each pick you make. It may take this long (or longer) for the market to recognise the value of a company.
If you aren't willing to follow these three rules on each and every stock you buy, then you probably need more diversification in your portfolio.
Don't Trade Very Often
If you're using this approach, you won't need to trade very often because you'll hold only wide-moat companies. By definition, a wide-moat company has long-term advantages and creates shareholder value year-in and year-out. Because a wide-moat firm creates value each year, its fair value tends to increase over time.
These are the only types of stocks in which a buy-and-hold strategy works well, because the odds are in your favour that the actual underlying value will continue increasing over time. As we mentioned earlier, when you buy a company with no moat, you are making a bet that it will bounce up just long enough for you to sell it.
Think of it this way: Investing is nothing more than a game of probabilities. No matter how diligent you are, your fair value estimate for a stock will never be exactly right. It's really just an estimate of what a stock is worth under the most likely scenario for future earnings growth and profitability. Thus, there's always less than a 100% probability that you'll be right about a stock pick. Given that the odds are below 100%, there's little point in trading from one stock to another frequently; your odds of being "right" on the new pick are probably only a little higher than the odds of being "wrong" on the current pick.
Add to this the costs of trading--including taxes, bid-ask spreads and commissions--and the odds of generating higher returns by trading frequently are worse than simply buying great stocks at good prices and holding them for three years or more.
