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15 mantras to WIN the stock market

Last updated on: January 4, 2013 08:09 IST

15 mantras to WIN the stock market

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Morningstar.in

Morningstar's Chief Equity Strategist Paul Larson outlines the stock-investing principles that guide his investment strategy.

In the 1950s, acclaimed journalist Edward R Murrow hosted a popular radio programme called 'This I Believe' in the United States that lives on in various forms today. The programme asked people from all walks of life to write short essays regarding the principles that guide them. In the spirit of this programme, below are 15 things I believe.

1. Stocks represent ownership stakes in businesses and are not just pieces of paper to enable trading. Think like a business owner.

2. If stocks are ownership slices of a business, we should value stocks like we value businesses. A business is worth the discounted value of all future cash flow that it can generate.

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3. As Benjamin Graham wrote, in the short term, the market is a voting machine. Popularity rules the day. In the long term, the market is a weighing machine, gravitating toward a company's true intrinsic value. Buy on the cannons (when stocks are unpopular) and sell on the trumpets (when euphoria reigns).

4. There are two ways to make money in the stock market: 1) Own businesses that will grow in value over time. 2) Buy things below intrinsic value, and wait for the market to come around to recognise that value. Try to do both.


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5. Businesses that have strong and sustainable competitive advantages -- a wide economic moat -- will increase in value at a greater rate than those that do not. Wide-moat firms are also best suited for survival, possessing the high ground that will flood last, if at all, when a downturn hits. Focus on these firms.

6. Gaining an edge via better information is nearly impossible in this day and age. However, humans are fallible, and incentives are aligned with short-term measures for many market participants. Behavioural finance is legitimate, and an edge can still be had via a better long-term perspective.


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7. Staying within one's circle of competence is impor­tant. Do not be afraid to admit, 'I don't know' and/or that something is 'too hard'. To use a baseball metaphor, there are no called strikes in investing, so we can be patient and wait for the truly fat pitches before taking a swing.

8. Activity for activity's sake is harmful since frictional trading costs can greatly harm returns. We should aim to minimise commissions, taxes, and fees for 'helpers'.


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9. We should focus on the value of the securities we are considering just as much as the price. If we know the price but do not know the value, we know nothing. One becomes a better athlete by practicing, not watching the scoreboard.

10. Valuation matters. Paying too high a price for a stock can lead to disappointing returns, even if the underlying company subsequently performs wonder­fully. Look for situations where a company has to meet or exceed a low set of expectations priced in by the market.


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11. There is a dosage effect regarding portfolio diver­sity. Diversity is important to have, but too much can also dilute best ideas and excess returns. It can actu­ally be safer to have fewer baskets if it affords a much-closer watching of the eggs.

12. The greater the payoff odds (lower price/fair value ratio), the greater the weight a position should be in a portfolio, all else equal. Likewise, the greater the confi­dence in one's projections, the greater the position size should be, all else equal.


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13. The future is inherently uncertain, and one should always demand a margin of safety. The more uncertain a situation, the greater the margin of safety should be.

14. Always consider opportunity costs. We should not be afraid to sell a good opportunity to take advantage of a great opportunity. We can generate value by selling dollar bills trading for $0.90 to buy other dollar bills trading for $0.60.

15. Investing is a multidisciplinary exercise. Read widely. Look for wisdom in unconventional places, and always keep an eye out for opportunities.


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