Congratulations! You are well on your way to becoming a market-beater. You now have 10 building blocks to add to your investing foundation.
You’ve learned all about risk vs. reward, price vs. value, public vs. private companies, stocks and the stock market, index funds, compound interest and hopefully a lot more!
If you just started with us, welcome! Hop on the train!
The next building blocks will provide a sturdier foundation for you to become that market-beater and achieve your financial goals faster (it will still take a while, just not as long). Let’s jump right in and get to it…
Block 12: Business
As stock market investors, we are buyers of tiny portions (or big portions, you never know) of businesses. Therefore, we should have a pretty good understanding of business.
If you’ve ever started a lemonade stand, that’s just about as good as getting your MBA (ouch, I just disqualified myself from ever having an MBA (Masters in Business Administration) read past this section)). Joking aside, businesses sell goods that consumers or other businesses or governments buy. Essentially, businesses solve problems, make life better for consumers, and provide crucial products and services.
Back to that lemonade stand. If the goal is to make money you need to be intentional about your decisions. If, however, your goal is to make your neighborhood a happier place, you don’t have to worry too much about these next things.
So before you start selling the lemonade you need to go to the store to get cups, maybe straws, some lemons, possibly a cooler, and a pitcher. Let’s say all those items cost you $50 and you think you can make 100 cups of lemonade from the supplies. So how much should you sell a cup of lemonade for?
Well, to break even, you can sell a cup for 50 cents. Because:
(# of cups of lemonade* price of lemonade = revenue or sales)
100 cups * 50 cents = $50
(revenue – expenses (or costs) = profit))
$50 in sales – $50 in costs = $0 in profit
So you should probably charge more than 50 cents. But if you charge too much, say $20, the mailman will probably turn the corner and continue on his way.
If, however, your lemonade has the potential to make people better looking, then you might be able to sell it for $20. That is called pricing power. It is when a business can demand a higher price because of something special. For instance, a Ferrari costs more than a Honda Civic because there are additional benefits like social signaling, the ability to drive faster, or comfier seats (doubtful that this is a big factor in the Ferrari-buying process though).
Businesses with strong brands can demand higher prices. iPhones cost $1,000. Tiffany’s jewelry is not cheap. Whole Foods can sell $5 mangoes. But a high price is not always indicative of a strong brand. Amazon and Netflix provide their services for low prices compared to alternatives. Compared to most on-line retailers Amazon is inexpensive and compared to most cable subscriptions Netflix is also affordable. However, the same principle remains; strong brands can demand higher prices. People would probably be willing to pay $15/month for Netflix. By the time some of you are reading this, Netflix is probably charging that. So why would Amazon and Netflix sell their goods and services at a lower price than people would pay?
For one, both of these companies service big markets so it is a good idea gain market share. Market share, surprisingly, is just share of the market (revenue divided by the total market revenue). These companies can grab more market share and then eventually raise prices to make themselves more profitable.
Back to the lemonade stand. Let’s say you start doing scientific research to make your concoction tastier. And you also want to start lemonade stands in other towns. And you want to advertise on a local television station. And you want to hire your friend to be “Head Lemon Squeezer.” All of those operations take money. But that is business. In a nutshell, how can you sell more lemonade or how can you charge more for it? While at the same time, limiting the costs that those strategies and operations require.
Understanding business at a fundamental level is crucial to becoming a market-beating investor. Next, we are going to go over the language of business and how you can figure it out…
Block 13: Accounting
Accounting is the language of business. It is how investors figure out how a business is doing financially. There are three accounting statements that public companies have to file quarterly and annually.
The three are the balance sheet, the income statement, and the cash flow statement. Without any accounting knowledge, these numbers might as well be hieroglyphics but they actually tell a story if you know what you’re looking for. We’ll go over them individually but if you want a more in-depth explanation, click here.
The main equation is: Assets = Liabilities + Equity
To keep with the lemonade example, assets would be the lemons (inventory), the cups (supplies), or the stand (property). Liabilities are any debts you owe. If you had used a credit card to buy the supplies then that would be recorded under this section. If you have no debts, then the equity (ownership) will equal the assets, meaning you own all of the assets.
As an investor, the main thing to look for here is debt, usually demarcated by “long term debt.” For instance, if you bought all the lemonade supplies with your credit card, then you will be charged 16% interest as that is the standard rate. If you don’t sell a lot of lemonade, you won’t be able to make the payment and, either, get bailed out or go bankrupt. So preferably look for a business with more equity (sometimes called shareholder’s equity) than liabilities, but some industries allow companies to handle more debt. Like utilities, since their revenue is so predictable and the industry is very regulated they can afford to take on debt to magnify their returns.
The main equation here is:
Revenue – Cost of Goods Sold – Operating Expenses – Interest Expenses – Taxes
= Net Income
That seems like a lot and it kind of is but let’s break it down. We know revenue, it is sales of lemonade (# of cups sold * price). Cost of goods sold would be the supplies that directly go into the lemonade (i.e. lemons, cups, sugar, ice cubes). Operating expenses are the costs of the scientific research on the lemons, the advertising and the new hire. Interest expenses are the fees associated with debt (just like the credit card interest rate). Taxes are well, taxes. And then finally we have net income or net profit. This is the income statement.
Here you should look for gross margins (revenue – cost of goods sold)/revenue)) to increase over time. Also you should look for revenue to be increasing over time. It is a good idea to calculate the year-over-year growth. Then check the net margins (net income/revenue). Make sure these are not decreasing rapidly. Essentially you want to make sure the business is performing well. Is it able to increase prices and sell more while not letting costs get out of control. Of course, there is more complexity as you learn more and more but this is a great starting point.
So now try pulling up a company’s income statement and start doing some of those calculations. It will lead to more questions like: is 12% good revenue growth or are 25% gross margins considered poor? Here is where it is a little gray because it depends again on the industry.
Costco and Walmart have very low margins but high revenues because their businesses don’t have a lot of pricing power because there businesses are built on selling for the lowest prices. If Apple grows 10% it will be a lot more impressive than if a small software company does the same because of the absolute dollar value. This is where it just takes some time to read over enough income statements where you start recognizing patterns. As time goes, we will build out a rolodex to differentiate industries and you can access that here to widen your circle of competence.
Cash Flow Statement
The main equation you need to know here is:
Operating cash flow (or cash from operations) – Capital Expenditures (or property, plant and equipment) = free cash flow.
There are three sections of the cash flow statement: operations, investing, and financing. As you may have guessed, the cash flow statement details where the cash went during the reporting period (yearly or quarterly). So cash from operations could be items like inventory (extra lemonade cups). Cash from investing could be money that went toward building a new lemonade stand. And financing is something like taking out a loan.
What you’re looking for here though is that the company is cash-flow positive. That means that when you subtract capital expenditures from operating cash flow, the free cash flow is a positive number. This just means that the company is not losing cash. If, on the other hand, this number is negative; be careful. Check the balance sheet to see if the company has enough cash on hand to fund operations for a while longer. This is called the burn rate.
Let’s say a company’s free cash flow was $-10 million for a quarter. The company’s burn rate would be 40 million a year because $10 million * 4 quarters. If you check the cash under the assets section of the balance sheet and the company only has $40 million in the bank, then it is in trouble. It will either have to raise more money, taking on debt or dilute shareholders by offering up more shares.
Let us explain what we meant by the second half of that last sentence. Diluting shareholders. So a company can actually offer up more shares to raise cash. Just like in the IPO, it offered up shares, it can do that again on the open market. The only thing is that current shareholder’s shares are less valuable. If you owned 1 share of a company with 1 million shares and it offers up another million, your piece of the pie just got halved. So shareholders generally do not appreciate that. And that is why it is important to keep tabs on the cash.
Block 14: Economics
Now that we’ve covered business and accounting fairly in-depth, we can talk about economics. We’ve talked a lot about business, but businesses and consumers function within an economy. Even the best businesses can struggle if the economy is bad. So, as investors, we cannot neglect learning about the economy. However, focusing solely on figuring out the economy is difficult because there are so many moving parts. A lot of investors spend all of their time trying to guess where the economy is headed so that they can profit from related investments. They view it as a big puzzle that can be figured out by poring over mounds of data. We believe, on the other hand, focusing on individual businesses is a better use of an investor’s time because there are fewer moving parts to figure out. Let us explain.
There are three main factors why it is so difficult to focus solely on the economy as an investor.
First, nowadays economies are global. Trade in China affects the US and manufacturing in Taiwan has an impact on New Delhi. Globalization at its finest. Figuring out the impact of all these countries’ economic decisions is tough business in our eyes. Plus, you have the effect of global currencies as well. Some of you might be smart enough to figure it out, but not us.
Second, a large portion of the economy is affected by interest rates. Interest rates are the rates that the Federal Reserve (also known as the FED, a government agency authorized to move interest rates up and down) charges banks to borrow money. This rate then gets passed on to consumers and businesses in the form of loans and savings rates. If the FED moves interest rates up, it becomes more expensive to borrow money. And vice versa. Therefore, when the economy is doing poorly, the FED will cut rates to foster businesses and consumers to borrow and spend money to stimulate the economy. The thing is it is also tough to guess where interest rates will be in the future. No one has a crystal ball and people can form economic models to postulate where the economy will be and from there, guess where interest rates will be. However, again, there are so many factors. We would rather put our money where we have a better chance of being right.
Third, even if you have nailed the global impacts and interest rates, you still have to make an investment to profit from those predictions. In other words, even if you are a genius and are correct, what is the trade you will make to profit? Will you buy the US dollar or will you bet against banks or will you buy gold? The options are essentially limitless and who’s to say that the price of your investment will move in tandem with your hypothesis? There are many examples where economists think the markets will tank based on the data but then the exact opposite thing happens.
Instead of dealing with all of that, we choose to focus on what we can control, which is analyzing and thinking about businesses.
Block 15: Psychology
Now onto arguably the most important block: psychology. Wait I thought this was investing, what does psychology have to do with that?
A whole lot actually. Investing is very emotional. As you know, the stock market goes up and down a lot, which is called volatility. But how come? Well, because people are involved! I’m only slightly kidding. The lure of money can make people very emotional. When everyone is “getting rich” from the stock market, UBER drivers suddenly start giving you stock tips and your great-grandma asks you if she should start investing. On the other hand, when the market is down 50%, like in 2008, the words “stock market” are treated like profanity and no one wants to talk about it.
These are just facts. Notice the world around you and you might just see it. People, the same people who love to analyze economics, try to “time the market.” (what are we doing? first we’ve excluded MBAs and now economists!). Anyway, they use their fancy models to predict when the market will crash and then when they should buy in again. The same principle remains; there are so many factors at play! Our view is that it is a fool’s errand to try to time the market. For every one person it works out for, 886 go crazy from it (psa - not a reliable stat, but reliable in spirit).
So what should you do if you can’t time the market? Well, we say just stay invested and worry about what you can control. Immensely easier said than done though. It is tempting to pull your money out and wait for the market to go down and then put it all back in but here’s the thing: what is too high and what is too low? It is all based off of anchoring. And this is our first encounter with what is called a psychological bias. We are excited to explore more of these with you…
Block 16: Anchoring Bias
Welcome to psychological biases. A bias is something that prevents you from making an optimal decision. Have you ever tried to fix something and it just wasn’t working out but then you continued working on it for the sole reason that you had already put so much time into it? If so, you are familiar with biases. We all have them so let’s try our best to put a stop to ‘em!
The first investing bias we will look at is the anchoring bias. Pretend an investor buys two shares of stock, each worth $100. One Benjamin Franklin into Company A, the other in Company B. Company A’s price soon increases to $120. Hey, not bad! A 20% return! During the same period, Company B goes to $80, a negative 20% return. Ouch! What should our investor do?
Well, if he is like most people he will sell the profits of Company A and put the proceeds into Company B since it is “cheaper” and will lower the cost basis (the price you pay). However, our investor is falling prey to a little know bias called “anchoring.”
Anchoring is fixating to the price you paid or will pay for a stock. Selling a stock that went up and buying one that went down is like cutting your flowers and watering your weeds if you’re a gardener. Usually there is a business-related reason the stock increased and likewise for why a stock went down. If there is no business result associated then our imaginary investor may have made the right decision.
Here’s another example. An up-and-coming fast-growing company IPO’s at $10 per share and soon rockets to $25. Wow! That’s crazy. However, when you evaluate the stock you think it is a pretty great company and a solid investment even with the meteoric rise. You go ahead and buy some shares. You tell your friend and he exclaims, “What are you doing? The stock has more than doubled!!” He has fallen prey to the anchoring bias. He is anchoring to the $10 IPO price. You, instead, made the optimal decision and evaluated the investment based on the current situation and where it can go in the future. That is the key to combatting anchoring. Look to the future. And not the past. (p.s. we will talk more about how you can evaluate the investment and make your own decisions later…)
Block 17: Hindsight Bias
The second bias is hindsight bias, also known as the “Hindsight is 20/20” Bias. Looking back, we all could have been zillionaires if we only invested in Amazon and Netflix at their IPOs and held them until now. But of course, hindsight is 20/20. Could you have foreseen Netflix’s digital transformation or Amazon’s cloud services and Prime offerings? No, it would have been impossible. So don’t dwell on the fact that you missed out on those spectacular gains; look around you and find the “next” Amazon-like investment. There is no use dwelling on the past and wishing you could go back; use that energy instead to find the next great companies. They are out there…
Also, a lot of people fall prey to the hindsight bias when the market crashes. They say, “I knew I should’ve taken all my money out!” Well, if they actually knew, they would’ve done it! All we can do is make decisions with the current information we have. If your analysis tells you that the rise in the market is likely unsustainable and you sell, you have to live with the decision. You may have made the right decision but the outcome could have worked against you. Such is life. Oh well. We look to the future…
Block 18: Overconfidence Bias
Pride is an insidious thing. After all, pride goeth before a fall. When the market is doing well, everyone looks like Warren Buffett. Everything investors touch turns into gold. But like Warren Buffett is fond of saying, “You can only tell who is swimming naked when the tide goes out.” That is a strange way of saying that a market crash reveals who has fallen prey to the pride bias.
The markets, as we have, established are fairly emotional. It is almost as if the market is a big pendulum swinging between fear and greed. When the market goes down, fear is abundant. But when markets are hot, greed is plentiful. However, as investors, we are to be wary of either extreme. When we feel that there is a lot of greed, we should check our own greed levels. And when we notice a lot of fear, we should ask ourselves, “What is more important to me; my comfort level or investing to make tomorrow better than today?”
Be aware of either extreme. It can be difficult to tell when you are experiencing an extreme because most people only realize it when it’s too late. This is not to say that you should take all your money off the table when you sense some greed in the air. As we said, that is timing the market and it has been proven to be an arduous task. All we are trying to say is that it might not be a good idea to double down on sketchy biotech stocks when the market is hot. That is gambling, not investing.
Block 19: Sunk Cost Bias
This last bias is the one where you keep fixing that thing because you’ve already put so much time into it. Sure, perseverance pays off but sometimes it’s a better idea to change your course. If the only reason you are persevering is because you can’t get over the time and effort you put in, then you are falling prey to sunk cost bias.
This can play out in a couple ways as an investor. For one, you could be researching a stock and let’s say you spend 10 hours researching it, then you find something wrong with the company. Are you okay moving on and not worrying about that “wasted 10 hours?” Those 10 hours are a “sunk-cost”, meaning they should have no bearing on your decision; the decision should be based on the quality of the company.
Second, a lot of people hold onto bad companies simply because they own them in their portfolios. Placing a higher value on something just because you own it is called the endowment effect. It’s a real thing! The fact that you bought shares in a company should be irrelevant. The question you should ask yourself is: would I still buy this company now? If the answer is no, move on…And moving on we are…Ever higher!