3. Measure your success by the underlying operating performance of the business
You should hold small pieces of excellent businesses with the same tenacity you would if you owned the entire company. Over time, the operating results and the share price are inextricably linked. Years ago, at the height of the dot-com bubble, a reader of this column, angered by my insistence that fundamentals mattered, posed a question in a missive, “Don’t you know that the stock price has nothing to do with the underlying business?” he asked. He was serious.This sort of absolute mental absurdity is what causes asset pricing bubbles. Common sense tells you that if a company cannot continue to exist as a viable entity, the investors will eventually lose everything. How many grocery stores and small retailers have been crushed by Wal-Mart due to its superior operating skills? Were you a shareholder in those businesses, the fundamentals – supplier cost, profit margin, volume – were all extremely important. Without the ability to compete, you eventually closed your doors. For further proof, look at the venerable behemoths of the past that now lie in the junkyard of financial history: Pan Am, the Pennsylvania Railroad. K-Mart and Sears were headed in the same direction until the former was saved as a result of the involvement of famed hedge fund manager Eddie Lampert of ESL Investments and distressed-debt guru Marty Whitman at Third Avenue Funds.
4. Have a rational disposition toward price
There is one rule of mathematics that is unavoidable: the higher a price you pay for an asset in relation to its earnings, the lower your return. It’s that simple. The same stock that was a terrible investment at $40 per share may be a wonderful investment at $20 per share. In the hustle and bustle of Wall Street, many people forget this basic premise and, sadly, pay for it with their pocketbooks.Imagine you purchased a new home for $500,000 in an excellent neighborhood. A week later, someone knocks on your door and offers you $300,000 for the house. You would laugh in their face. Yet, in the stock market, you may be likely to panic and sell your proportional interest in the business simply because other people think it is worth less than you paid for it.
If you’ve done your homework, provided an ample margin of safety, and are encouraged about the long-term economics of the business, you should view price declines as a wonderful opportunity to acquire more of a good thing. If those statements aren’t true, then you shouldn’t have purchased the stock in the first place. Instead, people tend to get excited about stocks that rapidly increase in price; a completely irrational position for those that were hoping to build a large position in the business. Would you have a proclivity to purchase more cars if Ford and General Motors increased prices by 20 percent? Would you want to buy more gas if per-gallon prices doubled? Absolutely not! Why, then, should you view equity in a company differently?
5. Minimize frictional expenses
In the article Frictional Expense: The Hidden Investment Tax, you learned how frequent trading can substantially lower your long-term results due to commissions, fees, ask / bid spreads, and taxes. Combined with the knowledge that comes from understanding the time value of money, you realize that the results can be staggering.Imagine that you are 21 years old. You plan on retiring on your 65th birthday, giving you 44 financially productive years. Each year, you invest $10,000 for your future. If you managed to earn at 10 percent return, by the time you retired, you would have $6,526,408; certainly not chump change by anyone’s standards! Yet, if you had controlled frictional expenses, adding a mere 2 percent per annum, the resulting 12 percent return would have generated $12,118,125 by retirement. That’s nearly twice as much capital!
Although it seems counterintuitive, frequent activity is often the enemy of long-term superior results. As one great analyst once told me, “sometimes the client is paying us to tell them not to do anything.”
6. Keep your eyes open at all times
Like all great investors, famed mutual fund manager Peter Lynch was always on the lookout for the next opportunity. During his tenure at Fidelity, he made no secret of his investigative homework: traveling the country, examining companies, testing products, visiting management, and quizzing his family about their shopping trips. This led him to discover some of the greatest growth stories of his day long before Wall Street became aware they existed.The same holds true for your portfolio. By simply keeping your eyes open, you can stumble onto a profitable enterprise far easier than scanning the pages of Barrons or Fortune. Need help getting started? Check out Finding Investing Ideas: Practical Places to Discover Profitable Opportunities.
