Image Source: Morningstar.com

There are many ways to make money through stock investing. We can look at the macro trends but we risk being wrong (you know how politic is).

We can look at chart patterns and buy stocks with bullish chart patterns but there is a risk that there will be no buyers to take the shares off your hand at a higher price.

We can play on momentum and we also can speculate which companies are going to beat earnings this season and buy it before it does. 

Or we can simply, as Pat Dorsey, ex-director of Morningstar Equity Research puts it, buy wonderful companies at a reasonable price. And let these companies compound cash over a long period of time.

Not many money managers follow this strategy.

The plan is simple:

1. Identify a business that can generate above-average profits for many years (look for competitive advantages or economic moats [structural characteristics inherent to the business such as: intangible assets, switching costs, network effect, cost advantages).

Ask: What prevents a smart, well-financed competitor from moving in on this company’s turf?

2. Wait until the shares of those businesses trade for less than their intrinsic value (company’s value is equal to all the cash it will generate in the future [growth], estimate certainty of these cash flows [risk], amount of investment needed to run the business [return on capital] and amount of time the company can keep competitors at bay [moat]), and then buy.

• Price to sales ratio is useful for companies that are temporarily unprofitable or are posting lower profit margins than they could. If a company with better margins have lower price to sales ratio, you might have a cheap stock in your sights.
• Price to book ratio is most useful for financial services firms. Because the book value for these companies is closer to the actual tangible value of their business, be wary of extremely low book value because it may indicate that the book value may be questionable.
• For the price to earnings ratio, be aware of which “E” is being used in a PE ratio. The best “E” to use is our own. Look at how the companies have performed in good and bad times, think about if the future will be a lot better or worse than the past, and come up with your estimate of the “E” the company will earn in an average year.
• Price to cash flow can help us spot companies that give out a lot of cash relative to earnings. It is best for companies that get cash up front but it can overstate the profitability for companies with a lot of hard assets that depreciate and will need to be replaced one day. Eventually using up the cash. 
• Yield based valuations are useful as they can help us compare results directly with alternative investments such as bonds.

3. Hold those shares until either the business deteriorates (see signs of eroding moats), the shares become overvalued, or you find a better investment. This holding period should be measured in years, not months.

4. Repeat as necessary.

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The above was first published in January 2019 Week 1 VIM Club weekly insights.

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