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How to Buy and Sell Stocks

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

how-to-buy-and-sell-stocks

Research

I love researching stocks. I think a part of it is understanding that I'm not just learning about little pieces of paper, but rather individual businesses. I've long been fascinated with how businesses are run, and understanding a stock is understanding the underlying business, but it's also a lot more than that. Once you go down the rabbit hole of trying to predict how a business will do in the future, which is an immensely important part of the way I value businesses, you can't help but be curious about history, geopolitical forces and regional politics, environmental factors, and pretty much everything else that's going on in the world. In other words, investing research is a good excuse to learn about the way the world works.
Because of this, I love to read (or listen to) books about history, biographies of people who have shaped the world (and about the factions who have benefited from and who have suffered at the hands of immense change), economic policy, investing, and pretty much every sort of nonfiction under the sun.

Stock ideas can come from a wide variety of places: a website dedicated to stock analysis, a friend's suggestion, a YouTube video, or even a social media post. Some specific recommendations of places where I've gotten ideas are Seeking Alpha's trending articles, Morningstar's stock screener, The Motley Fool, and Marketwatch. Another really good way to generate ideas for investing is to take a look at what investing legends are buying. If Warren Buffett is buying a stock, and given that I'm a value investor, I'm inclined to be curious as to why he's buying. You can find publicly available information on portfolios of great investors and traders and draw inspiration from this. Be careful, though: there is always a lag time between the time when the investor purchased the stock and the time when the portfolio is publicly available, so what might have been a good idea a few months ago might not necessarily be a good idea right now (even if it's still a great company with the same story, the price might have gone up since everyone else started to realize this).

The Stock Story

Once you have the initial idea, you have to do research. It isn't enough to listen to one person and think you have your plan, but getting the idea is a great starting point for further research. If you have a stock picked out and you're interested in it, I've found it helpful to develop a narrative around the stock. This story doesn't need to be especially complicated; it can be as simple as "I think this stock is undervalued because of X, and is likely to go up Y% in Z time frame." If X, Y, or Z changes, it's a good idea to question whether the story has changed.

Valuation

The ultimate goal of valuation is to answer the question: what is this stock worth? Cutting to the core of the question, we can refine this: what is this business worth?, and we can then divide the total value of the business by the total number of shares outstanding (after all, a share is just a little slice of the entire business, not just a piece of paper or numbers on a screen being traded, as many people imagine). Finding out what any income-producing asset is worth can be accomplished in a number of ways, but there are really only three that I pay attention to:

  • Discounted Cash Flow
  • Comparing to other businesses in the same industry
  • The value of the underlying assets vs the liabilities

Clearly, comparing to what other businesses are selling for can be a valuable reference, but it does assume that the market has correctly priced the businesses in an industry on average. This can be useful, but it can also be a very bad mistake, such as when the market realizes that an entire sector has been badly overpriced (like during the dot-com crash of 2001-2002. It's a great reference, but probably not a great standalone tool.

Similarly, the underlying assets are great to know. In Buffett's early years, he would often pick "cigar butt" companies that were actually selling for less than the assets of the company were worth (he was even able to find a few with no debt!). Suffice it to say, those sorts of opportunities are much more rare nowadays, but taking hard assets into account can be really useful. If I'm comparing two companies, for example, and both have the exact same cash flows, but one has twice the underlying assets of the other, it's a really simple decision to make as to which one to buy. After all, if you had to liquidate all the assets of the company today, and the amount you could get is anywhere close to what the business is selling for, that can put a bit of a floor on how much money you are likely to lose in a worst case scenario.

I like to value companies based on DCF (Discounted Cash Flow) projections, at least most of the time, meaning I'll project out how much excess free cash they'll generate over the next few years (more on this below). If the company will generate more cash than the cost of the business within a reasonable time frame, it's a buy. It's not always super easy to determine what a reasonable time frame is, and this can change depending on how insanely overvalued (or cheap) the market is, but it's a good idea to insist on a return on your investment in a relatively short amount of time. Phil Town (another value investor who tends to articulate these concepts very well) has a really simple rule he calls a "ten-cap", based on an idea from Buffett that you should get your money back within 10 years at a minimum, and you can apply this ultra-simple rule to real estate, stock investing, or any other place where you're putting your money. Generally speaking, the riskier the investment is, the more money you should insist on getting sooner. This is the essence of the risk/reward ratio that's so very important to investors.

After reading and listening to dozens of books on investing, I'll give my endorsement for a book that Phil's daughter Danielle wrote called Invested. The reason this book is so compelling is that Danielle is just a regular person who is reticent to learn about investing, and speaks very plainly in layperson's terms in order to get across the concept of how to value a company. If you're not sure why hiding your money under your mattress isn't a great idea, this is also a great book for you.

Discounted Cash Flow Analysis

That leaves DCF (Discounted Cash Flow) analysis as the "meat and potatoes" (or, if you're' vegan, the "vegan meat and potatoes") of valuation. Back to our original question: how much is a company worth—or, even better: how much should I pay for this company? Buffett, who cut his investing teeth during a time when bonds were very much in favor, simplifies this nicely by likening a business to a bond that pays you back a percentage each year, and then you get the original purchase price of the bond back to the end of the term. If you have a 10% bond that lasts 10 years, you get 10% per year for the first 9 years, and then 110% during the final year. But what would you pay for such a bond? $200, the cost of the bond, is a tempting answer, but it's wrong. Why? Aesop: a bird in the hand is worth two in the bush. First, the value of money today is almost surely worth more than the same amount of money tomorrow to just about anyone, since having the money and being able to spend it if you need it (or want something) is better than not being able to spend it, all things being equal. Second, inflation is very likely to be in the cards for a long time in the future. If you bury $1000 under your mattress today, it will probably be worth more like $800 in a decade, depending on how high inflation goes over the next decade. Naturally, then, it is prudent to demand a return that's higher than the rate of inflation if you're letting someone borrow some money for ten years. The US Treasury yield is often called the risk-free return rate, and so that's a pretty good floor on the discount rate.
We're going to think about stocks in the same way, just like bonds (although the amount of cash they'll pay out on a regular basis will certainly be a lot more predictable). Since stocks are pretty much all riskier than a government-backed bond like a Treasury note, it's a good idea to make your discount rate higher than the current treasury yield rate (abysmally low in 2021, but at least it's greater than zero). And, since we know that we're going to insist on getting our money back relatively quickly from a stock, and that's generally based on free cash flows, not just profit (after all, a company can relatively easily reinvest its profits in itself, but if it's not generating excess free cash, it might not be reinvesting very wisely, whereas cash is simple to value), the discount rate depends very much on how risky the stock is. Now, I've seen several different people walk through DCF analysis and use beta (market volatility) to determine the discount rate. I'm not a huge fan of this approach, since I don't much care how volatile a stock is, provided I'm willing to hold it for several years—and I generally always am—but I do care whether the business will be successful in the long term. In other words, risk =/= volatility. Risk means a permanent loss of capital, not a short term fluctuation of a stock price.
Let's circle back one final time to our initial question, "how much is this business worth?" It is worth all of the future cash flows, discounted to the present day and the riskier the stock is, the higher the discount rate should be. Here's where having some experience playing poker might come in handy: If a stock is 70% likely to double tomorrow, but 30% likely to lose all its money tomorrow, is it a buy? Yes, in my view, provided you aren't risking something you can't afford to lose (how much of an individual business you want to own is something you'll have to decide yourself; I've generally settled on around 2%, but Munger, Buffett, and other prominent value investors will have a much larger percentage of their portfolio in one business at a given time). This is a lot like having pocket aces in Texas holdem during the initial deal. If someone else goes all in, should you call? Certainly, provided you are playing with money you can afford to lose. After all, your odds of winning are as high as they're ever going to get during an opening draw.
Of course, nothing in investing is so linear, and so, we have to try to make the process as simple as possible and try to guess how likely a business is to return the money within a given time frame. You can have very specific formulas for how to do this, and there are plenty to choose from, but, as Keynes put it, it's far better to be approximately right than precisely wrong. As long as you can have a rough idea as to how likely you are to get your expected return, you can use the discount rate to help with your valuation.

Margin of Safety

Benjamin Graham, the godfather of value investing, articulated a concept that has been utilized by virtually every great investor over the last century: the margin of safety. This concept is always a strong determining factor for me as to whether to buy or not, and a combination of the three methods of valuation can be useful in determining how much of a margin of safety to demand when buying a stock. This means that if you screw up by a fair amount, you're probably still going to do okay with an investment. The "underlying assets" case we mentioned before is a great example here: if the company is selling for less than the price of its assets (leaving debt aside for now), then it's surely a buy, since you could theoretically liquidate the company and immediately get your money back, and in the meantime, there is likely a strong upside. Howard Marks is fond of saying that if you take care of the downside, the upside tends to take care of itself... and even when it doesn't, as long as you've properly taken care of the downside, you're at least going to be following Buffett's first rule of investing: never lose money.

If the assets aren't tremendous, but you can value the company at X based on future cash flows, insisting on a 20% discount (or maybe even more) adds an extra cushion. We all admit that nobody knows the future, and all sorts of things can go wrong with a company, from government regulation to natural disaster, to unexpectedly poor management. Having an extra cushion is important, and you can insist on this. Remember: in baseball, you have to swing at every third strike, or you'll strike out, but in investing, you can take a swing when you're damn well ready.

Cost Basis

The easiest stocks to decide to buy are stocks I've already bought in the past, and the easiest way to check to see if a stock I've bought before is a good bargain right now is to take a look at cost basis in my portfolio. This is just the difference between what I bought the stock for, versus what it's trading for today. The reason I like checking the cost basis so much is that I've already done the initial research, so if a stock price has dropped below my cost basis, it's a buy (unless something material has changed with the company- the "story"). This is certainly where things can get emotionally interesting, since your judgment is often called into question if you see a stock you've bought going down in price well below where you bought it, but this is also where some real money can be made, if you're careful about allocating the money, and if you're sure the story is still consistent and correct.

When to Sell

The above gives you a pretty good idea of how to buy a stock, but what about selling? Well, the good news is that if you already know the stock's story, it should be pretty easy to figure out if it's overvalued. I personally think that if a stock is priced considerably higher than it's worth, it's always a sell, because I'm not super interested in technical analysis or speculation. I also tend to be better at finding stocks near their bottoms than trying to wait for a peak price, so I'll usually be really happy with a 30-40% return over the course of a year or so. If a stock was priced way too cheaply and has gone up 40%, but I think it's still undervalued, I might sell it anyway based on my personal bias, but taking a closer look at the current stock story is important here. Has the company improved dramatically, and is it now worth way more than the current price, even though it's gone up?

© 2021 Andrew Smith