Cale Smith, MBA
August 29, 2009
Q. What should I be looking for when I invest in stocks?
A. I’ll continue my answer to last week’s question with a quote from the world’s greatest investor, Warren Buffett:
“What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected.’ You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
That brings me to the first of five recommendations when it comes to successfully investing in stocks.
1 – Buy businesses you understand. Stay within your circle. You need to put the work in to research a company prior to buying shares. But if you don’t truly understand the economics of the business, reading annual reports will likely be pointless. If you are disciplined enough to stay clear of companies you don’t really understand, you’ll avoid one of the most common investing mistakes.
2 – Focus on the moat. In the same way a moat protects a castle from invaders, a company’s competitive advantage leads to long-term excess profitability. If there is no moat around a business, competitors will eventually breach the walls and the company’s profitability will suffer. So will its shares.
3 – Insist on a margin of safety. Your goal should be to buy stocks for less than they are really worth. The difference between the stock market’s price and your own estimate of value is called the margin of safety. As value investors often put it, you want to buy dollar bills trading for fifty cents.
4 – Buy and hold. The costs of short-term trading commissions and taxes can seriously impact your long-term returns. If you buy great companies at low prices, you’ll rarely want to sell.
5 – Do your own homework. There are few places with more conflicts of interest than Wall Street. Don’t ask a barber if you need a haircut, and be very skeptical of Wall Street advice when it comes to investing in stocks.