I’ve been investing in the stock market for a while, and I was just thinking the other day about how my strategy has changed over the years.
The early years
I first started investing in when I was still in high school, probably around 15 years old. I paper traded for a while using quotations in the daily newspaper, and then opened a brokerage account. My strategy at that time was based on technical analysis (TA)—essentially betting that I could predict future movements in the price of shares based on past movements.
The theory of TA is that markets move based on emotional buying and selling by traders. Thus, if a configuration appearing on a stock chart preceded an increasing stock price, that configuration likely to lead to similar gains the next time it appeared since traders will have similar emotional mindsets.
Though I made money, I gave up on that strategy quickly because the commissions were too high relative to my account size to do trading and TA didn’t have a rational enough basis to be intellectually satisfying. Stocks represent ownership of a business, so it seemed odd to me that I was trading on the basis of squiggles on a chart rather than, say, anything to do with the actual business.
In my second year of university, I made my next foray into stocks. This time, I had a discount broker, so commissions were much more reasonable. What’s more, instead of squinting at pictures, I cared much more about the actual companies I was buying. I primarily focused on mining stocks, reading The Northern Miner weekly.
At around that time, diamonds were discovered in Canada’s Northwest Territory. Probably 20 companies started drilling in the region, and that formed the basis of my new strategy.
There were few roads in the Northwest Territory, and none to the location of the diamond discovery. Instead, the companies would wait for winter, then build temporary roads over the frozen lakes and tundra to get their drilling equipment in. This restriction led to an interesting cycle in these diamond mining stocks.
In early winter, the roads would be built and the drills hauled in. In late winter and spring, the most enticing targets would be drilled. In summer and fall, the results of the drilling would be be released.
The thing is, speculative mining stocks are largely driven on the basis of drilling results. When results are about to be released, the stocks often go up in anticipation. Conversely, when no results are due for a while, the stocks tend to stagnate.
So, my strategy was to buy in the early winter, months before people even started thinking about drilling results. Then, I’d sell just before the results were released. It didn’t matter to me whether the results were good or bad. I just wanted to sell my shares at a high price the shares to anyone who wanted to make a last minute bet on the results. Doing this, I’d typical make two or three times my initial investment.
Not cheap. Caring about value
This strategy worked well for several years until the speculative fervour for diamonds died down. But by then, I was ready to move on anyway—I became less interesting in gaming stock prices, and more interested in investing.
My value phase lasted for probably fifteen years. The strategy with value investing is simple. Stocks represent ownership in companies. So, figure out what that ownership is worth, and pay less than what the stock is worth.
For instance, suppose that a debt-free company owns a building worth $40 million and has a million shares outstanding. Then each share must be worth at least $40. So, if you can pick up shares for $20, you’re probably going to do well over time.
Of course, it is a bit more complicated than that. The value of a company isn’t usually that tied to its underlying assets. In fact, in real life, asset values pretty well only come into consideration when you’re looking at a liquidation. Instead, the value of a company is mostly based on how much cash it throws off as an operating business.
Thus, as a value investor, I migrated from focusing a bit on earnings and a lot on assets to not much on assets, and a lot on cash generation.
But if you care a lot about cash generation, the thing that really matters is how sustainable that cash generation is. Your business might make $100 million in earnings one year, but it won’t be worth much if the next year its earnings plummet due to competition. Though that might seem unlikely, there are entire industries that historically have this dynamic (resources, airlines, semiconductors etc.)
So, recently, I been focused on earnings growth and competitive advantage. The key questions to this investing approach are, 1) how fast is the company growing its income stream and 2) is it extremely likely to continue to grow that income stream for the indefinite future?
Because of compounding, if you can identify a company that can sustainable grow its earnings for two decades, that company has a huge amount of value and often that value isn’t fully reflected in stock prices. Such companies require only one decision—to buy—and can slowly make you rich.
The Bottom Line
So, that is my strategy now. Interestingly, sustainability is the probably the key attribute that Warren Buffett has gravitated towards as well. I think he’s gone that way because such stocks are often undervalued and he can buy in quantities that are significantfor Berkshire Hathaway. If it works for him, perhaps it will work for me, too.
And if not, I’m sure my investing strategy will continue to evolve.