Legendary stock market investor Warren Buffet laid the ground rules for investment philosophy when he set two rules for investing. Rule Number 1 of investing according to Buffet is never losing money and Rule Number 2 is Don’t forget Rule Number 1.
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But that is easier said than done, especially for a retail investor or a novice investor. In order not to lose money in the stock market is to pick up stocks which are close to the bottom. No fund manager, not even Warren Buffet has been consistently able to pick the bottom. But what differentiates a professional to a rookie is the ability to patiently wait and stick to their well-defined set of rules. It is not important to pick the bottom to make money, but as far as the price is right all that is needed to sit on the investment and patiently watch it grow. As the saying goes in the stock market it is not the brain that brings home the profit but its stomach to hold through the times.
Peter Lynch, one of the most successful professional fund managers in the world said ‘My best stocks have been the third, the fourth the fifth year I’ve owned them. It’s not the third week, the fourth week. People want their money very rapidly, it doesn’t happen.’ The statement holds true for all impatient retail investor who dumps their stock in less than a month because it does not move as anticipated.
One reason that shares are sold by novice investor is that they do not have a strong premise behind buying it. It is either bought on some friends tip or on an ‘expert’s advice’. There is no solid reasoning and a well laid out process behind buying the stock and waiting to check if the premise holds.
Ben Graham known as the father of investing and Warren Buffett’s guru put it well when he said that investors should purchase stocks like they purchase groceries, not like they purchase perfumes. Unfortunately, the opposite is true for most of us.
Also Read: Facts You May Not Know About Warren Buffett
In order to avoid such mistakes and follow Buffett’s rules, one must have a set of guiding principles that have to be followed come what may. A similar set of guiding principle needs to be in place for selling the stocks.
One way of selecting the guiding principle is to follow the guiding principles of the professionals.
There are various ways in which a fund manager identifies a company for investment. While most fund managers swear by Warren Buffett and want to adopt his style of investing, stock markets rarely give that kind of opportunity to pick up stocks which are available at throwaway valuations. Nonetheless, a variation on Buffett’s approach to investing is adopted by most. A set of rules are clearly defined upfront and the fund managers wait for the opportunity to pick up the stock when the set of rules are satisfied.
Value Investing: Buffett’s philosophy of investment is generally termed as value investing. In such type of investing the fund manager searches for a stock that is trading at a price below its intrinsic value. The intrinsic value of a company is its actual value based on a given set of formulas taking into consideration both the tangible and intangible factors. The fund manager calculates the intrinsic value of the company and waits for the stock price to fall below it. This way he knows he has bought the stock cheap and all he has to do is wait for the price to reflect the true value of the company. The fund manager may buy more if the stock falls as he is convinced of the story and feels that the drop is an even better opportunity. By doing this he follows Buffett’s rule of not losing money. There are various strategies of picking up companies that fall in the value investing category. Fund managers and analysts play around with various financial parameters, but the underlying principle in all cases is to identify stocks that are fundamentally cheaper than the current market price.
Growth stock investing: In an economy like India which is in its growth phase, there are more companies that are available that are contributing to the growth. It is rare that such stocks are available at a discount to the intrinsic value. All shrewd investors are keen on owning such stocks that are expected to continue on the growth path. Many strategies are used by professionals to identify growth stocks. One of the most common use one is called the CANSLIM method developed by William O’Neil. This is a combination of qualitative, quantitative and technical analysis of picking up stocks. It essentially catches stocks which are already on a growth path and are have a strong probability of continuing on the same. Other ways used by fund managers are looking for companies that have just completed a major expansion or are launching a new product range or are acquiring a company that can change the landscape. Commodity companies that benefit from increased demand and prices of the underlying commodity also fall under this category.
Betting on turnaround companies: A strategy for the brave hearts but one where the risk-reward is huge is to bet on turnaround companies. A company might have been making losses on account of various reasons – poor external environment, low prices of its products, high raw material prices, over leverage or simply poor management quality. A change in external or internal environment is captured by the fund manager who anticipates that going forward the company would immensely benefit from a changing scenario. In Indian context companies and sectors where the government extends help as in the case of steel and sugar sector recently, tend to do well. In this type of strategy, the upside potential is huge, but chances of it breaking Buffett’s rule is higher as the odds are still stacked against the company.
Irrespective of the strategy adopted by an investor it is important to stick to it and adhering to it under all circumstances. If an investor has to prevent his capital from losses he has to be slow and sure in picking up his investment. Spacing his buying over a longer period of time is one way of ensuring that he is closer to the price before stock market forces catch up and take the stock to new heights.