The Art of Investing
By Renato Marques
Investing is the act of putting money, effort, time, etc. into something to make a profit or get an advantage, or the money, effort, time. Investing in your knowledge is your one way ticket to success in everything you do regardless of how many times failure may seem apparent.
The first thing we must all know about investment is that: “Investing is not risky. Risk is not having the right education and knowledge to invest.”
You must study and understand the language of investment in depth and what is involved before attempting any investment. That takes many years of dedication. It’s just like speaking a new language. If you don’t learn, practice and gain experience, you won’t be able to achieve good results and will keep wondering what is happening around you. Excellence takes time, patience, training and a lot of commitment. That applies to everything else you do.
Being able to have the vision and making fast decisions, can only be achieved with a high level of confidence and a mind set that’s geared towards manifesting success. All abilities and skills can be learned with the proper development of discipline, commitment and burning desire to accomplish something.
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I’ll share a basic understanding so you can get started in moving towards your investment goals and dreams.
All investments are based on probability of success. Technical analyses, market and economic conditions, financial news and reports, can calculate and increase your margin to 85% or 90%. The three major investments and most profitable are Forex, Stock and Property.
The investment style developed is incredibly important because of the way investing works. Both risk and return are connect to style. By anticipating that the economy will grow or slump, the decisions to buy or sell can be made effectively. Fundamental and technical analyses involves evaluating all the factors that affect an investment’s performance. For the stock market, it would mean looking at all of the company’s financial information, earnings reports, and it may also entail meetings with company executives, employees, suppliers, customers and competitors.
Analyse management, really understand what’s driving the company and where growth is coming from. Stocks are based on companies and companies are based on performance so the idea is to buy a share as cheap as possible and sell it as high as possible. The Forex is fundamentally different than the stock market as the prices tend to return to its start point or normal range over a certain period of time. Currencies are controlled by many factors and obviously is a comparison between two separate countries against each other.
The key is to identify when the price is outside of its normal range and trade it back to its range where the prices tend to be most of the time. The technical analyses of each individual pair is a combination of: Economic data release, understanding the impact of unemployment claim, employment change, unemployment rate, manufacturing production, building permits, existing and new house sales, trade balance, cash rate, bank statements, services PMI, GDP, PPI, CPI, as they all have a high impact on the economy and create volatility on the price action at specific time. All this factors must be deeply analysed and combined with the charts conditions before any decision is made.
See our page on 11 Inspiring Business and Investment Books, for a much deeper understanding about investment.
Property investment is based on location and demand when it comes to make the most of the sales profit. Some basic rules must be applied but it may vary depending on the locations to be invested.
- Improving the property general condition to maximize the value, is to effectively expand the available areas and create new spaces at the best possible specification and standards on market demand. Aiming to minimise cost of material and labour when possible without compromising the standards initially planned for the project.
- Understand what buyers in the area want and the area standard of living. It’s all about renovating to the preferences of the majority of the potential buyers or renters in the area to the broadest possible preferences.
- Have a precise plan for renovation and expansion and when considering changes mid project, always base on what return to expect to gain on the additional investment. Identify what the cost will be and weight it up with how much additional benefit (resale price) it may provide.
- Always get a building report to the advantage of the investment as a guide for potential problems and for budgeting purposes.
- Take all the time needed for the project management and organisation in an efficient manner as extended delays can easily happen costing more money.
- Always be based on the numbers calculated on the due diligence and facts before investing at any particular property.
The most attractive and rewarding investment is the Forex market in a short term depending on the strategies used for each particular trade and time of the day. Stocks and properties can be planed in a mid/longer term in different scales. They are all the best ways of investing depending on the strategy and goals. Investment has always been a feared business but only by those who do not understand the nature of investment and what is involved. Risk aversion is a common state of mind for the majority of the population based on paradigms. It’s a complex concept but successful investors know how to change and overcome the fear barrier enabling them to avoid mistakes and identify risks.
Being an investor requires in first place a vast level of knowledge and deep domain expertise in the areas to be invested. Vision, courage, patience, control, mind-set, psychology and confidence must all come together when making of an investment a profitable venture. Studying and analysing the markets on a daily basis is the key for understanding your investments and growing in experience. That must be an ongoing practice for success.
It’s the ability to change and re-adapt to all kinds of situation in the market that determines the size and consistency of the profits. Only successful investors and Entrepreneurs commit to this level and that’s why the names are well deserved. Deep domain expertise is what it takes to achieve any financial or personal goal. Everybody wants to be financially successful but only a few are willing to become a master of investment.
See our page on 11 Inspiring Business and Investment Books, for a much deeper understanding about investment.
To make money work for you, you need to follow these 3 basic steps:
1. Understand Valuations
When you’re looking at assets or activities to invest, you need to be able to gauge and forecast future lifetime earning potentials. Not only should you evaluate the assets you are looking at, but also other assets you currently have. Take everything into account including your personal life or anything else that might be affected by your purchase.
There are calculators easily found online to help you calculate the value of websites or businesses.
2. Know How To Finance
The second thing is you need to know how to finance the acquisition of the assets you are evaluating. There’s so many different, creative ways to fund your project like kickstarters, crowdfunding, and loans.
You can use websites like kickstarter.com or
gofundme.com. You can find possible angel investors, venture capitalists… you can use small business loans or credit cards. It all depends on your situation.
3. Asset Creation
Third is to be able to create assets out of thin air. Most assets are created by starting a small business. If you have a small business, sometimes you don’t need to buy certain assets, you can just invest into your own business to create it for a lot cheaper.
If you look at the Forbes list, most business owners started out with small businesses.
That’s because by investing their time and money into their business, it actually produced assets that they used for leverage to grow even more.
One thing you need to watch out for that I’ve seen happen all the time with entrepreneurs is that most people bite off more than they can chew.
Best approach is to take sort of a step-stone approach.
First start off with working with a 5-figure business, then move on to 6 figures, then 7 figures, and so on. If 5 figures is too much, you can start out even smaller.
The big idea is that if you’re not experienced, you need to start out small so you won’t be overwhelmed.
While this guide can be helpful, it only outlines some of the pitfalls to try to avoid. Also, when investing in microcaps you will find that most companies have some aspects of at least one of these. These negatives need to be evaluated in the context of all the attributes of a company to determine if the positives outweigh the negatives.
Poor Share Structure
Some companies have very poor share structures. The worst kind is usually when you have convertible debt which converts at a discount to the market for the stock. That can create what is known as a death spiral. First, the holder converts some of the debt at a discount to market prices and sells it at a profit. The selling puts pressure on the stock price causing it to drop. Next, the holder converts more of the debt at a discount to the now lower stock price and in turn sells it at a profit. The cycle continues until the debt holder converts and sells all of the debt. A big problem with this arrangement is that each time the debt holder converts, he or she gets more shares for the dollar because the stock price drops. What can happen in this situation is that a company with a decent share structure can see their share quantity balloon. Convertible preferred stock can also be structured with a death spiral. Never invest in a company with death spiral financing because it is a quick way to see your investment dollars fall into the abyss.
Just because a company doesn’t have death spiral financing doesn’t mean they have a good share structure. Always investigate the total diluted share count for each company. In addition to the outstanding common shares, one needs to examine any preferred stock (especially convertible), convertible debt, options, and warrants. With that information you have a view into what the total share count might look like in the future and can factor that into your analysis. For example, if the share count is going to double over time, the future per share earnings potential might not look as good as it seems on first glance. Also look at the company’s history of share issuance. If don’t like it when a company has a history of handing out options like candy. Give more attention to a company that treats their shares like gold.
Weak Balance Sheet
The first thing to look at on a balance sheet is the tangible book value per share. When it is negative you have to be careful. Let’s say you have a company that has a stock price of $1/share and is expected to earn $0.12/share in the next year. If the tangible book value is slightly negative, let’s say -$0.02/share, that is a cause for caution. When it is say -$1/share, that is usually a cause for great concern.
A negative tangible book value isn’t the only thing to cause caution on a balance sheet. Debt coming due soon can be a cause for concern especially if it will be difficult to refinance that debt. If a company cannot renew their debt or otherwise pay it off, there usually are some pretty negative consequences. It’s wise to examine a company’s debt to see how big it is, the interest rate on the debt, and when the debt comes due?
Along with debt, one also needs to look at a company’s cash position. If they don’t have enough cash to operate and don’t have access to debt (e.g. a line of credit), they may have to raise money which will mean dilution of your holdings. Usually when a company raises money by selling stock it is below market prices for the stock which will cause a drop in the stock price. Try to avoid companies that need financing.
There is much more to analyzing a balance sheet than mentioned here. Some poor balance sheets can be OK where as others are not. It is an art you have to learn.
Poor Quality of Earnings
Sometimes companies have great earnings but they are of poor quality. For example, maybe they have significant revenue but they can’t collect their bills fast enough. This will show up in a metric called DSO or Days Sales Outstanding. When analysing a company you may want to ignore the nuance of credit sales versus overall sales and just use overall sales as credit sales levels are rarely disclosed. When the DSO calculation gets above 90 days you need to look very carefully. Repeated numbers that high can indicate that the customers are of poor credit quality. Try to calculate DSO on a quarterly basis.
Sometimes recent earnings are not sustainable which also falls into poor quality of earnings. For example, maybe there was a factor that temporarily increased gross margin. Maybe there was some sort of one time gain that boosted earnings such as winning a lawsuit. Maybe the company is just about to start paying taxes whereas they haven’t in the past. Perhaps there was a large piece of revenue that came in that isn’t repeatable. Earnings could grow dramatically when the large order is fulfilled, but then sink afterwords.
Customer concentration can also fall into this category. For example, if ACME Widget is receiving 80% of their revenue from one customer, there is a huge problem if that customer goes away. Customer concentration doesn’t necessarily scare me away but it often will reduce the size of the position I’m willing to take on.
The main way to investigate the quality of earnings is to read the footnotes in filings and the details in PRs. What one has to do is to factor the quality of earnings into the valuation model for the company. Just because some earnings are not repeatable doesn’t mean the company is a bad investment. It is just a part of the entire analysis that one has to do.
Low Gross Margins
The problem of low gross margin (GM) businesses is that one small mistake or problem can often turn a profitable business into an unprofitable business. Those problems can come in a variety of ways. Some examples include increasing input costs, pricing pressure from competitors, and loss of scale from decreased revenue.
While it is hard to be precise, as mentioned before a high GM business is one with a GM greater than 50% and a very low GM business is one that is less that 20%. Also, one thing to consider is that sometimes businesses can grow their GM as they increase scale. Thus, the current GM isn’t always indicative of what to expect going forward.
Lack of Moat
Companies lacking a moat can be a problem because they can rapidly go from producing good results to bad results as it is difficult for them to differentiate. Mostly all they can do to compete is to be a low cost producer or provide greater service.
A good shortcut for knowing if a company is in a commodity business and thus has little to no moat is if they have low gross margins. Highly differentiated businesses usually have high gross margins although that isn’t always the case.
There are three general categories for these companies addressed below including commodities, commodity product, and intellectual property risk.
Try to avoid companies in the commodity space or companies that service this space. That means companies in the oil, gas, and minerals businesses. To win in this space you have to be right about the commodity price and the business. It is hard enough to be right about the business that you don’t need to add commodity price risk. In a pure commodity business, even being a low cost producer is no guarantee of profitability as we have seen recently in the oil industry. There are times where you will have to go out on a limb and invest in a company in the commodity space but they are becoming increasingly rare. There are people that specialize in this space that are very good but it isn’t for me.
There are companies that have products or services that are commodities. Here is about oil and gas per se, but products that really aren’t differentiated. For example, imagine a company that sells construction nails or a company that sells cheese. Unless they have a special type of nail or a special flavor of cheese, they are unlikely to be able to have any kind of pricing power. Services sometimes fall into this category too. However, services often can be very sticky which means that there is some level of pain involved in the customer switching to another provider.
Intellectual Property Risk
Intellectual property risk is probably most drastic in pharmaceutical patents although it does come up elsewhere. A company with a great product that is about to come off patent can suddenly be up against a slew of competitors. Also, sometimes you see a company that has a great product but hasn’t done anything to protect it. Perhaps the idea isn’t patentable. Sometimes, the best way to protect a product is with trade secrets.
There can also be risks that a company is violating a competitor’s present or future patent. This is often hard to investigate but it is something to watch especially when there are similar products in the market.
A great product that isn’t protected will find itself up against competition eventually. In microcaps sometimes this is OK because it is such a niche market. However, any product of even moderate scale will soon find a competitor and that can be very damaging to margins.
Excessive Management Compensation/Lack of Alignment with Shareholders
Let’s go back to ACME Widget. Let’s say that they have annual revenue of $3M and have $300K of net income. However, the CEO has a salary of $750K and has a history of granting himself significant blocks of options. Furthermore, this CEO has never purchased shares on the open market and only owns shares that he acquired through option grants. This CEO is not someone that is likely to have shareholders’ interest in mind and appears to be treating the company as a piggy bank. It’s wiser to have a CEO that owns a lot of stock and pays himself a reasonable salary of say $175K or less. A CEO that makes money when the stock goes up is more likely to focus on doing the right things and is more likely to treat shareholders fairly.
Overly Promotional Management
One of the job’s of management of a public company is to maximize the value of the stock. I’m a firm believer that the first step in that process is to produce good results. While management should be a cheerleader for the company, sometimes there are management teams where it appears they think that is their first job. If I see outlandish projections, that usually is a sign that management isn’t focusing on job one (results) and often is more focused on selling stock. If the story that management is telling sounds too good to be true, it often is.
When you hear a story that sounds outlandish, one thing to do is to check past management projections. If they have a history of making their projections it’s much more credible than if they miss their projections. Again, don’t mind management telling the story because that is part of their job. It is just that if they become too promotional, that is a sign to be careful. The worst situation is when you uncover a company that is part of a pump and dump.
Business Models with Major Uncontrollable Risks
There are some businesses that have some major risk that they can’t control that just scares me away. For example, maybe the business is a pawn shop business and the government is looking to increase regulation. Sometimes businesses like this are a value trap. They look highly profitable but with one quick change their profitability decreases. Another major risk can be an industry that is declining in size. It’s better to swim with the current on a growing industry than swim against the current with a shrinking industry.
Cyclic industries also fall into this category. Some industries go through major boom/bust cycles. I will certainly invest in cyclic industries but I much prefer if the industry isn’t cyclic.
Reading the risk section in annual filings (see Risk Factors in the 10-K for US companies) is a good place to read to check for major risks like this that you might not see on the surface.
Proper due diligence requires that you examine both the positives and the negatives about a company or any particular investment. This document provides a framework to look for some of the negative items. Next time you are looking at a new investment, be sure to check the company against these pitfalls. Also, please share any other pitfalls you would like to add to this list by posting a comment below.