11 Rules of Stock Picking

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By Motley Fool Staff

In honor of The Motley Fool's 10th anniversary, we're looking back on some of the best columns of the Fool's first decade. In January 1998, former Fool Randy Befumo wrote a classic series on his 11 rules of stock picking. More than simply a "How-to," these rules comprise a "Here's why" for understanding how to intelligently select stocks. The entire original series is well worth a careful read, but due to space reasons, we've whittled it down to just the highlights. Enjoy.

What is this crazy lil' thing called stock?

• Rule 1: When we buy stock, we are buying businesses. (Publicly traded businesses, yes, but businesses all the same.)

Beyond what I jokingly call the four dimensions of security analysis, there are some assumptions that you should be aware of before we plunge any deeper. The first is that very project we are engaging is how to value a publicly traded business. The words "stock" and "business" are interchangeable in my usage -- there is no methodology for valuing a stock that does not spring from the underlying business. "Investing in businesses makes the most sense when it is business-like," is our operative proverb.

Whether you are buying the whole business or just shares in the business, approaching the problem as if you were buying the entire enterprise (news - web sites) enforces the same discipline any true acquirer would use. If you were to really go out and acquire a business, you would pay careful attention to the price paid; you would want to know the underlying quality of the business; you would concentrate your purchases in areas where you have the most knowledge; and you would consider how long you intended to own the business. Simply, you would care about valuation, quality, depth of knowledge, and time -- my four dimensions of security analysis.

Valuation: the price paid in relation to the cash created

• Rule 2: When you buy a business, the price you pay should relate directly to the cash you expect the business to generate.

   

• Rule 3: Context, context, context. It is critical to understand a company's economic model on its own terms, in relation to industry peers, and in relation to the business environment as a whole.

   

• Rule 4: Valuation determines future returns.

As much as purely quantitative criteria outside of any business context alarm me, valuation is probably the most important parameter to consider when committing capital to a business. The reason for this is the underlying and indisputable logic for purchasing publicly traded businesses. Aside from any superficial psychological benefit to owning shares in various corporations, when you purchase a stock, you are buying that business because you believe the future value of the cash the business will generate will end up being worth more than the current value of the dollars you are paying.

A business exists to generate profits using whatever assets it has. After generating these profits, the business can decide to reinvest, make acquisitions, pay dividends, or repurchase portions of itself from other owners. The earnings you can reasonably assume to make over the lifetime of the business put in today's dollars is the value of a company at any given space in time. Current events and wild speculation may change the perceived amount of these cash flows, but in the end, the business is worth the cash it can generate with its assets, whether they be tangible, like a factory, or intangible, like a trade name.

While the valuation method used depends on the company you are valuing, the ultimate impact of that valuation is indisputable. The wider the gap between the current value and the intrinsic value, the higher the return. Current valuation defines future returns, with higher valuations decreasing future returns by a proportional amount. If you overpay for the future earnings, you will either lose money or suffer through mediocre returns until the point where the valuation becomes attractive relative to the intrinsic value. The shares of stock can only increase in value if there is a significant difference between their value today and the cash they are going to generate in the future. If there is no difference, or if the shares have actually overestimated the cash that will be generated, they cannot mount a sustainable increase in value unless you assume that all parties involved will remain irrational.

In the end, the higher the price you pay, the more likely your returns will either converge with the market returns for a significant period or fall below them if you not only overpay but also buy a low-quality business.

Quality: a measure of excellence

• Rule 5: Cheap crap is still crap.

   

• Rule 6: Excess returns come from buying moderate to high-quality businesses at low to moderate prices.

   

• Rule 7: Higher-risk excess returns come from shorting low-quality businesses when they attain high prices.
  

Much of the investing media is preternaturally intent on valuation. The price/earnings ratio and growth rates routinely grace the pages of even the most Podunk and picayune business section, but very little ink is spilt on the issue of business quality. This may be the result of "quality" being a much more esoteric and diffuse issue than valuation. Or it simply may be out of ignorance. While all you need to do valuation is the numbers and a calculator, determining the underlying quality of the enterprise actually requires that you know more than simple math. It requires that you understand what a business is and how it functions as a conceptual, capitalist construct.

Business quality is important because in the end, cheap is not enough. Investors who routinely buy shares because they trade at low price/earnings ratios or low price/sales ratios often find that the earnings are in a state of decline or the sales are quickly disappearing. Although various studies indicate that you can marginally beat the market if you buy a diversified basket of distressed securities at low valuations (Ã la Ben Graham), gigantic returns like those posted by the patron saint of investing, Warren Buffett (news - web sites), come from buying high-quality businesses at low to medium prices. Taking the last few puffs from a cigar butt you find in the street might seem like a good deal, but actually getting a case of premium cigars for a relatively moderate price is not only more sanitary, it creates more in the way of value.

The comparison between valuation and quality is quite straightforward. Just do the math on the valuation side and determine whether the stock has a low, moderate, or high valuation. On the quality side, do the math there as well, add in whatever bias you want for management savvy, trade brand value, or market dominance, and assess this as being low, moderate, or high as well. Then compare the two with an eye toward buying companies that carry low valuations that are of moderate or high quality or, if you are a little more of a risk taker, buying companies that have medium valuations that carry high quality. Conversely, a great short is a company of low business quality with a high valuation.

Depth of knowledge: the circle of competence

• Rule 8: Buy what you really understand.

   

• Rule 9: Don't buy what you marginally understand or what just floats your boat -- you will intermittently lose enough money to make this ultimately lead to below-market returns.

Valuation and quality form the length and width of the investment world. These two dimensions indicate in the end what the size of the investment return will be. Like everything else in life, our ability to use these tools successfully has finite limits. In fact, our ability to measure valuation or quality is actually fairly limited, despite the seeming precision that the numbers offer us. Although we always have the option of leaving an extra "margin of safety" in a purchase by being conservative in our assessments of the valuation and underlying quality to try to offset our human limitations, properly assessing another dimension of the investment process -- depth of knowledge -- is probably even more vital to avoiding mistakes.

Depth of knowledge is a straightforward concept despite the fact that it is erratically employed. Simply put, it is a measure of how well you understand the company's economic model -- the way it interacts with customers, suppliers, distributors, and investors as part of its daily operations. The maxim "Buy what you know" is insufficient -- it should really be "Buy what you understand." Heraclitus probably said it best when he quipped, "Much learning teaches little understanding." Actual concrete understanding of what a business is is fairly rare. More often than not, it degenerates into a superficial sense of what the products are and how exciting they might be, or an idiosyncratic consumer familiarity with the product inflated into a purported understanding of the company's economic model.

While knowledge is important, it should not be taken out of context with valuation and intrinsic business quality. The appearance of detailed knowledge about a company without a genuine understanding of how much cash the company will generate in the future can be as catastrophic an investment scenario as looking at valuation only and ignoring the company's underlying economic model. It is depth of knowledge combined with low valuation and high quality that make for outstanding investments. Any deviation from these three dimensions involves taking on the distasteful risk of losing money. This is not the end, however. When you combine this fully functional, three-dimensional investment model with an appropriate philosophical framework and add the concept of time, you can engage in full-fledged security analysis.

Time: the ultimate arbiter of returns

• Rule 10: Cite all past and future investment returns in a consistent unit of measure.

   

• Rule 11: Time heals many, but not all, self-inflicted valuation wounds.

Concentrating on valuation, quality, and depth of knowledge allows the investor to pick companies that are most likely to appreciate significantly in value. The returns an investor earns by owning the shares of a publicly traded company depend as much on the time the security is held as any of these other factors. The amount of time over which a price change occurs makes the difference between a stunning investment and a subpar investment. In order to invest successfully, individuals must understand the critical role that time plays in determining returns and they must develop reasonable expectations about what sort of returns to expect over a given period of time.

Say you have done your homework and bought shares of XYZ Corp. After some interval, you discover to your delight that the shares have doubled in price. A real home run, right? Not necessarily. Just as in physics, you want to be careful to keep all of the units of measure in a problem the same or else you will get bizarre results. Thinking about all of your investment returns in one unit of measure -- annualized returns -- is critical to making informed decisions about which investments have been and will be the most attractive. In our example of the 100% returns, if this 100% were earned over the course of a year, it is a staggering return. However, if it took you 10 years to double your money, you have only earned 7.1% annualized returns over the whole period.

Beyond the necessity of using a consistent unit of measure when discussing returns, time also has a much more powerful and salutary effect on the investment process. You see, time heals many investment errors that are related to valuation. While certainly time does not heal all of the damage, nor does time matter a fig if an investor loses patience, the amount of time you hold an asset does decrease the valuation risk inherent when you purchased the asset. What that means in English is that if you bought a great company but paid too dear a price, over time that valuation mistake is going to be overcome by the compounded earnings growth that the company delivers. This is why focusing on quality during the investment process is so critical -- if you buy quality, then time is your friend. If you buy crap, time doesn't matter a whit.

The more you concentrate on becoming a long-term owner in a quality business that you purchased at a low valuation and know quite a bit about, the more likely you are to tell your friends about the shares of a $50 or $60 stock you own where your cost basis is measured in pennies. Although much attention is placed on the stocks that double or triple in a year, going up 10 or 20 times in a decade is where stocks really create wealth. By following the 11 fairly simple rules laid out in this series, I think investors heartily increase their odds of doing just that.

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