Buying Stocks Means Buying Companies#
What are you buying when you buy stocks? Are you buying a company's equity or a tradable ticket in the stock market? In fact, stocks have both equity and ticket attributes. These two attributes correspond to two ways of making money.
If you consider stocks as part of a company, that is, equity, then you can earn a portion of the company's annual net profit based on the proportion of your investment to the total market value. If you consider stocks as a medium of exchange, that is, a ticket, then you can buy them at a low price from others and sell them at a high price to another person. Your profit comes from the high price at which the buyer purchases the stocks, and it has little to do with the company's operations.
In the stock market, people make money using both of these methods, but the second method requires you to find buyers and guess whether they are willing to buy your stocks at a high price. Whether you can find a buyer or whether they are willing to buy is uncertain. As the saying goes, human hearts are unpredictable. I can't accurately guess what my girlfriend is thinking, let alone the thoughts of the buyer who wants to buy my stocks at a high price.
So, how do you make money relying on equity?
Our profit = (selling price of stocks - buying price of stocks) x number of shares held, and the stock price = P/E ratio x earnings per share, where earnings per share = net profit of the company / total shares. Therefore, the stock price = P/E ratio x net profit of the company / total shares.
When buying stocks, we certainly hope that the stock price will rise in the future. In a situation where the total number of shares usually remains constant, for the stock price to rise, at least one of the two variables that determine the stock price, the P/E ratio and the net profit of the company, must increase.
Let's start with the P/E ratio.
The P/E ratio can also be calculated as the current market value of the company divided by its profit. For example, if the current market value of a company is 10 billion and its profit for the year is 200 million, then the P/E ratio is 50, which means investors believe that the market value is 50 times the profit. Is a P/E ratio of 50 considered reasonable? Sometimes it is, sometimes it isn't. Some people think it is reasonable, while others think it is not. Therefore, the P/E ratio reflects the overall sentiment of all participants in the market. When they are optimistic, they believe that a higher P/E ratio is better, and when they are pessimistic, they believe that a lower P/E ratio is better. The P/E ratio, influenced by these alternating emotions, is unpredictable. Spending time on unpredictable things is a waste of life.
Therefore, it is illogical to expect the stock price to rise by relying on an increase in the P/E ratio after buying stocks. It is a matter of luck.
So, what's left to consider is the net profit of the company.
If you can predict the future net profit of a company, then you can consider buying its stocks at a reasonable price. Can the net profit of a company be predicted?
Yes, it can.
Circle of Competence#
Let's say you are an employee. Although you have never started a company, you can consider yourself as a company. By selling your labor and providing services to your boss, you earn a salary. You know how much money you can earn each month, how much bonus you will receive at the end of the year, and roughly estimate how much you can spend in a year. Therefore, you can accurately calculate how much money you will have at the end of each year, and the money you save is your net profit.
Why can you calculate your net profit for a year? Because you understand yourself, know your income and expenses each year, and know how you make money.
The same applies to predicting the net profit of a company. As long as you can understand how a company makes money and what its unique competitive advantage is, you can predict its future profits. This is much more logical than predicting the emotions of others, and logical things can be made simple by cultivating certain abilities.
This brings us to a key term: competence. Emphasize that you need to have the ability to understand a company.
In addition, you need to know where the boundaries of your competence lie. If you have the ability to understand the consumer industry, do you also have the ability to understand the technology industry? Not necessarily.
There are thousands of companies listed in the stock market. Do we need to understand all of them? No, and it's not possible. Our energy and competence are limited. It is enough to focus on a few selected companies.
This brings us to another core concept of value investing: the circle of competence. It refers to the areas that you truly understand, the areas that match your skills and expertise.
However, it is important to distinguish between understanding and thinking you understand. This is the guarantee of your future returns. As Warren Buffett once said, the size of your circle of competence is not important, but knowing its boundaries is vital.
Stick to and cultivate your circle of competence. What are the benefits? It allows you to have an advantage in understanding certain information. For example, based on your understanding of a company's business model and unique competitive advantage, you can predict its future profits for the next few years. The limitation of the circle of competence also reduces the number of stocks you can choose from, thereby reducing the possibility of making poor investment decisions.
For example, Bill Gates is a good friend of Warren Buffett for many years, but Buffett has never bought Microsoft's stock because he cannot determine whether Microsoft will continue to make money decades later, which means Microsoft is outside his circle of competence. Jeff Bezos, the founder of Amazon, is also a friend of Buffett, but Buffett has not invested in Amazon either. This is a manifestation of Buffett's adherence to the principle of sticking to his circle of competence and truly practicing what he preaches.
Margin of Safety#
When you find a company with an excellent business model and a unique competitive advantage, such as Maotai and Tencent, should you buy their stocks immediately? Of course not. Just like buying things, not losing money is the bottom line. It's good to have good quality at a reasonable price, and it's even better to take advantage of a good deal. Therefore, if the stock price is too high, you should not buy it.
If you know that a watermelon is worth 5 yuan per kilogram, and someone is selling it for 2.5 yuan per kilogram, would you buy it? Definitely.
But what about buying stocks? According to the concept of buying stocks as buying companies within your circle of competence, how do you know how much a company is worth?
After understanding the company, you can use the discounted cash flow method to calculate the intrinsic value of the company. I will explain this method in detail in the next article. For now, let's assume that you can roughly estimate the intrinsic value of the company.
If the intrinsic value of a stock is 5 yuan per share, and someone is willing to sell it to you for 2.5 yuan per share, would you buy it? Definitely. The price difference of 5-2.5=2.5 yuan is usually called the margin of safety, which is the difference between the intrinsic value of the asset and the price you buy it for.
Don't underestimate the margin of safety. It is one of the core concepts of value investing and a magic weapon to ensure that you make continuous profits, because buying at a high price can result in permanent losses.
In addition to the desire to take advantage, what are the reasons why we must consider the margin of safety when buying stocks?
Combining the previous discussion, investing means using cash to buy stocks of companies within your circle of competence. However, people make mistakes from time to time, and unexpected disasters often occur in the capital market. In such cases, the margin of safety ensures that you minimize or avoid losses when you make mistakes in assessing companies, overestimate corporate profits, or encounter economic crises or black swan events.
In addition, considering the margin of safety, the buying price will be relatively discounted compared to the intrinsic value. In other words, the price you buy is reasonable or relatively low. Driven by the instinct of seeking profit, capital flows into assets with strong profitability (remember that you are buying stocks of companies whose profits are expected to grow), pushing up the prices of assets and narrowing the gap between your buying price and the intrinsic value. There is a high possibility that the stock will rise to a level that scares you. Your task is to sell when the stock is overvalued and earn a higher return. Therefore, the margin of safety is also the source of excess returns.
You may ask, are there really stocks in the stock market that are priced below their intrinsic value? Why would someone be willing to sell them to you at a low price? Isn't that foolish behavior?
It may not happen in a fruit shop or a vegetable market, but it does happen in the stock market, and it can happen at any time. This brings us to an important assumption of value investing: Mr. Market. The aunt selling vegetables will not sell them to you at a loss, but Mr. Market will.
Mr. Market#
Imagine that you are trading stocks with a person named Mr. Market. Every day, Mr. Market will propose a price at which he is willing to buy your stocks or sell his stocks to you.
Mr. Market's mood is very unstable. Therefore, on some days, Mr. Market is very happy and only sees the bright side, so he will quote a high price. On other days, Mr. Market is quite depressed and only sees the difficulties, so he will quote a low price.
In addition, Mr. Market has a lovely characteristic. He doesn't mind being ignored. If what Mr. Market says is ignored, he will come back tomorrow with a new quote.
The useful thing about Mr. Market is the prices in his pocket, not his wisdom. If Mr. Market seems abnormal, you can ignore him or take advantage of this weakness. But if you let him control you completely, the consequences will be unimaginable.
This is a fable about Mr. Market mentioned by Benjamin Graham, the grandfather of value investing, in his book "The Intelligent Investor" (1949). Mr. Market is always ready to trade with you, to buy the stocks you hold and sell you the stocks he holds. He is not a specific person, but the collective behavior of the masses.
Mr. Market is crazy. His behavior is unpredictable and cannot be followed. You can only take advantage of extreme situations. Mr. Market, composed of the masses, embodies human greed and fear to the fullest. His emotions swing between excessive optimism and extreme pessimism.
When he is in a good mood, he will offer a high price to buy the stocks you hold. If his offer price is much higher than the intrinsic value of the stocks, you can consider selling to him and make a good profit. When he is in a bad mood, he will sell the stocks he holds to you at a low price. If his offer price is lower than the intrinsic value of the stocks and there is enough margin of safety, you can happily buy them and take advantage of his generosity.
But what about situations other than these extreme cases? Ignore his quotes and focus on the company you are buying, just as the exciting part of a basketball game is the performance of the players on the court, not the changing scores on the scoreboard.
If you still don't know who Mr. Market is, when you become anxious and confused by the fluctuations in stock prices, and when you are in intermittent ecstasy and pain, just open the front camera of your phone and you will see the true face of Mr. Market.
Conclusion#
- Buying stocks means buying companies.
- Buy stocks of companies within your circle of competence.
- Consider the margin of safety and buy stocks of companies within your circle of competence at a certain discount.
- Due to the madness of Mr. Market, you have the opportunity to buy stocks of companies within your circle of competence with a certain margin of safety. Beyond the extreme quotes of Mr. Market, you should focus on the company itself, not the fluctuating prices on the chart.
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References#
- Tang Chao. Practical Value Investing. China Economic Publishing House, 2019.
- Understanding and Not Understanding
- Circle of competence - Wikipedia
- How to explain "Margin of Safety" with vivid examples? - Zhihu