Rule 1: Invest for Value (Buy Profitable Businesses at Reasonable Prices)

Value is perhaps the most important concept to understand as an investor (next to risk). Most people intuitively understand this in their everyday lives. Unfortunately, it is less understood in the arena of stock investing. What is value? Value, in this sense, is when you get a great deal on buying an asset. In the case of investing, it is when you are able to buy $1 worth of assets for $0.80 or less. When you are making the purchase of an item, like a house, or a car, or a television, and you put extra effort into finding an item of equal or greater quality but at a lower price, you have made a value purchase. It is the same in the stock market. When you purchase a share of a company, you are buying an ownership interest in an underlying business – an asset.

Almost any stock will have a story describing how the managers will try to make money, but if it’s a real business, it will have more than just that. It will have real products, real sales, real profits, and real business models. A successful business will generate cash flow and it will reinvest this cash flow for growth or it will pay this cash flow back to its shareholders in the form of dividends. When we find those unique opportunities to purchase successful businesses at prices well below their real or intrinsic value, we have made a value investment.

The tricky part is determining what the stock is actually worth. This is by no means an exact science (not even close) and there are many different techniques that people use with varying degrees of success. The reality is that two different people can be given the exact same information on a company and arrive at two different conclusions of what they think the company is actually worth, and neither one of them is necessarily right or wrong. So rather than trying to determine the exact intrinsic value of the company (stock) you are purchasing, focus more on fundamental principles. If a company is not profitable or is not breaking into profitability, then it is not an investment, it is a speculation.

If the company is trading at a premium price, risk increases. If that company is trading at a discounted price, risk decreases. The more solid companies you buy at attractive prices (that are making money), the better your portfolio will perform over time. The more you buy speculative ventures, which are innately impossible to value, the worse your portfolio will do over time. You may need to utilize the services of a qualified and competent advisor, but that is no substitute for maintaining your own independent thought.

If the company is trading at a premium price, risk increases. If that company is trading at a discounted price, risk decreases. The more solid companies you buy at attractive prices (that are making money), the better your portfolio will perform over time. The more you buy speculative ventures, which are innately impossible to value, the worse your portfolio will do over time. You may need to utilize the services of a qualified and competent advisor, but that is no substitute for maintaining your own independent thought.

Rule 2: Be Patient and Allow Your Investments to Grow

As human beings, most of us possess a desire for immediate gratification. This is in large part why online ‘trader’ programs and strategies have been met with such popularity as of late. The term ‘day trader’ is appealing because it essentially suggests that profits can be attained on a ‘daily’ basis. All of the worthwhile things in our lives however, were not developed on a short-term basis, but instead they required years to grow and develop and eventually begin to yield rewards. This is true with relationships, with friends; it is true with building a family, a career, and skills we wish to develop. With each of these assets, as with the act of growing a tree, at one point, we took the initial step of planting a seed and over time, with effort and care, the assets developed strong roots and began to grow. Most rationale people would never expect instant gratification with any of the most important assets in their lives and nor should they from their investments.

When we invest, we do not just buy ideas, we do not buy hype, and we do not buy promises. When we invest, we buy a piece of an operating business for the most attractive price possible. When the business grows, we expect the value of our investment to grow with it. Anyone who has ever built a business knows that success does not come overnight.

The business must be given time to grow and so must the investment. Back in 2002, we recommended a quality company, Hammond Power (HPS.A:TSX). The recommendation met all of the requirements of an investment, in that it was a profitable and growing business that we purchased at a very attractive price. Largely unknown by the investment community, the company’s stock price remained relatively unchanged for over two years after we recommended it to clients. Over time, with continued success in the operating business, the company gradually became better known by investors and the stock began to skyrocket. From a recommendation price of $0.65 in 2002, our investment grew to $13.10 by 2007. It took several for our seeds to grow roots and begin to blossom, but our patience was rewarded with a 1,915% return. Had restlessness dictated our actions, we may have been prone to dispose of the investment during the period of inactivity, the result of which would have been a zero return. Well a return of this magnitude is not common, generating excellent returns well being patient is not an isolated event, but often a typical scenario for us, as it is for many other fundamental investors (including Warren Buffet). For those that are uncomfortable with a 3 to 5 year time horizon, I ask this: Would you rather make money by being patient, or would you rather lose money by being restless?

Rule 3: Invest with Your Mind, Not Your Emotions

Warren Buffet, who is the undisputed greatest investor in the world and often referred to as ‘the smartest man in the room,’ provided a very interesting take on the key ingredient to successful investing. He said, “Success in investing doesn’t correlate with I.Q. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

This should hopefully come as welcome advice from those that once thought investment success required brilliance. Indeed, more often than not, we are our own worst enemies when it comes to investing. Emotion is the single biggest detriment to long-term investment success in the stock market. When stock market prices are climbing, meaning the underlying businesses are becoming more expensive, emotion encourages most people to become greedy. The opposite is true in a declining market, when prices are falling, and in many cases some of the underlying businesses are selling for discounted prices, most people become more fearful and consider leaving the markets. Ironically, this is the period where the best mid to long-term investments can be discovered.

The lesson to be learned here is – control the emotions of fear and greed. Understand that the market moves up and down and don’t become too excited or too depressed in either event. Let us remember the Crash of 2008. By mid-2008, stock market activity was at a climax. On the financial news, we were inundated with references to legendary levels of liquidity, M&A activity, and opportunity. The result was irrational exuberance where like in the tech boom, people thought that the rules had changed and they became willing to pay any price for overvalued assets. Then the crash came and in the second half of the year, sentiment took a 180 degree shift with the overall market losing nearly 50% in the matter of months.

It was at the trough of the market that many of our clients were asking us if they should liquidate their portfolios and stay away from the markets until certainty returned. The problem is that liquidating out of fear, and at the trough of the market, forces you to lock in your losses. The intention is always to re-enter the market during better times. Unfortunately, this timing never works the way it is intended. When we fast forward to the market recovery, the vast majority of the gains were made between March and May, with the market largely moving sideways since. Investors that had elected to lock in their profits during the market’s lowest point, in October of 2008, would not likely have gotten back into the market in time to benefit from the recovery. A quote we are quite fond of is that “success in the market is derived from time in the market and not timing the market.” Another from Warren Buffet is “if you cannot stomach your investments suffering a temporary decline of 50% or more, you have no business investing in the stock market.”

Rule 4: Diversify Your Investments

Diversification is a tool that every investor has been touted. Although the benefits have undoubtedly been explained to you at some point, it is important enough that I will explain it again. Capital has to be spread around amongst different investments types, amongst different industries, and amongst different individual companies (stocks).

How a portfolio is diversified depends a lot on the individual and the relative importance of their investment portfolio. You can afford to take more risks (and diversify less) if you are young and without dependents. When you are older and become more dependent on your investments, your risk tolerance declines and your need for diversification increases. From experienced investors to novices, just about everybody in this day and age understands that stock market analysis is anything but an exact science. Even the greatest analyst on the planet cannot know unequivocally what will happen to a single stock or the stock market in the future. Even in the case that the analysis of a single stock is flawless, the analysis cannot predict with absolute certainty whether or not an individual company will succeed or fail.

True diversification should start at the asset class level (stocks, bonds, cash, real estate, etc). Unfortunately diversifying outside of stocks, while necessary for most, is beyond the scope of this commentary. Our focus here will be the discussion of how many individual companies, or stocks, should be in your active portfolio. At KeyStone, we focus on two areas of the market where we believe investors can generate superior returns – high-growth small-cap stocks and dividend growth stocks. For our clients, we typically suggest holding eight to ten individual companies in each of these portfolios. Holding less exposes you to excess risk of poor performance from an individual stock. Holding more makes your active portfolio too difficult to manage. Let’s take a sample portfolio of eight stocks with the following one year returns: A(-40%); B(-20%); C(0%); D(0%); E(20%); F(25%); G(50%); and H(85%). These example returns are being used purely for illustrative purposes, but they do represent a somewhat realistic return spectrum.

If you were to diversify equally into all eight of these stocks, you would have made an average return of 15% for the year. On the other hand, if you were to select just one of these stocks (not knowing which would outperform), you would have a 50% chance of either making nothing at all or even losing money. If you were to select just 3 of the stocks, there is a reasonable chance that you would have selected A, B, and C, which would have yielded an average return of -20%. Of course, by selecting 3 stocks you could have been lucky and picked F, G, and H, yielding you an average return of 53%. The problem with concentrating into one to 3 stocks is that you are now depending on luck to guide your returns. “Hindsight is 20/20, but foresight is legally blind.” You don’t know at the beginning of the year which companies will be the losers and which will be the winners, so in order to give yourself the best chance of generating a reasonable return, you have to diversify your holdings. Anything less brings us from the realm of investment to the realm of speculation.

Rule 5: Maintain Reasonable and Achievable Expectations

Many people buy and sell stocks with an expectation of becoming wealthy within a short time span. Unfortunately, this is more of a pipe dream than a reasonable expectation. By now, you should be familiar with Warren Buffet and his reputation as “the world’s greatest investor.” He has amassed a fortune of $50 billion over a 40 year career as a buyer and seller of businesses. Yet all of his success has been generated with an average annual return of only about 22% per year. To the truly experienced investor, this return is phenomenal. To the average speculator, this return might actually appear meagre. Yet no money manager on record can boast of a higher average investment return over a long-term (over ten years) time horizon. The truth is that those that might tend to scoff at the return and consider it unimpressive have not even come close to consistently generating anything comparable.

A big problem with maintaining overly high expectations is that most people tend to gravitate to high-risk investments in order to achieve them. In the Canadian investment market, this typically means overly high allocations to the very cyclical resource sectors of Mining and Oil & Gas. While these sectors have their place in a well diversified portfolio, overly high allocations almost always result in disaster. In the search for unrealistic returns, many investors go a step further and over allocate towards junior resource and junior high-tech. With only a few exceptions, these types of companies typically do not make any money and are pure speculations. As with the temptation of gambling, many so called investors are attracted to the prospect of the infamous “10 bagger” (a stock that multiplies in value 10 times), but as with gambling, nearly every participate that allows greed to dictate decision ends up nearly penniless.

Lest we remember the lessons from the tech boom of the late 1990s and early 2000s – long standing wisdom that insisted real companies should actually make money was thrown to the wayside as the investment community became absolutely enamoured with the prospects of generating nearly unlimited returns. Lest we also remember how quickly it took for those paper profits to disappear and how quickly those ambitions for unrealistic returns morphed into hatred for stock market investing. We have seen this again more recently with the stock market crash of 2008. Between 2002 and 2007, many speculative junior mining issues enjoyed excellent returns in the absence of actually generating any real economic value. During this period, many of those who bought and sold stock in junior mining companies undoubtedly saw a few years of triple digit returns. In the end however, after the bell sounded, these individuals were quickly left in the exact same position as those that were once seduced by the tech boom – with stock that in some cases had declined by up to 95% or more.

While the speculative sectors, along with the rest of the market, have since seen somewhat of resurgence, they are still almost all trading at depressed prices relative to the pre-2008 levels and almost all of those that participated in that market remain in the red over the course of this market cycle.

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