It is February 2022, I am investing in stocks for almost 5 years now. In that period I have made some money but nothing exceptional. Looking back, I could see many stocks how, in that period, their prices went up 1000% or even 2000%, and there were periods when I had them in my portfolio but I have sold them too early thinking that they were too expensive. In few cases I was right but mostly they continued performing very well and went to extreme price levels. So, these days, I ask my self, what made these stocks or companies so good that they performed so well? That is what this article is about.
What gives a value to a businesses
Maybe we should start with the question: what makes a business valuable? Or what determines its value? Why we are willing to pay for a business? The answer to that question is not simple. Many will say: the value of a business is determined by net cash flow it generates in a year. But when we look at the stocks which are at extreme prices, their net cash flow is mostly negative or they are trading at very high EV/FCF prices. So why do investors are willing to buy them? They buy them because they believe that they will generate very high cash flows in the future. So if you want to hold shares of a such business, you need to find a stock with positive story attached to it, a business having plans for very high growth.
Spotting a good business
Now we know what kind of business to buy, however knowing that is not enough, the challenge is: how to find these good businesses? And maybe: how to spot them early when they are still toddlers and at cheap prices? The ways of finding, as I see it, are few. First, getting internal news about the business. In most cases, when the positive news arrive and are available to the public, the price is already at very high prices, so we need to get that positive news at early stage. Second, we could understand that there is something new about the business, by the abnormal share price movements. When there is something new about a business, there are always some group of investors who get these details early and they start buying shares in huge quantities. That creates an abnormal moves in the share price. If you are good technical analyst, you could spot them by working on the charts.
Holding for a long term
Buying an exceptional business is not an easy move, mostly their prices are at very high levels and many investors prefer to keep away from them. Let say you have bought one. At this point you enter into a, for many people, a painful period. You have to hold that position for a sustainable period of time when almost all ratios and indicators are telling you that you hold an extremely overpriced business. For example, I remember Amazon.com at one point was at P/E of 380 and you have to go and buy it, then hold when it goes to P/E 450. Also the share price moves up and down a lot, by a lot I really mean “a lot”. To do all that, you need to believe in the story of the business, that it will over-perform and continue growing. That craziness crates the whole difference.
It depends a lot on the business and the sector it operates in. There are business which operate in very bad sectors, good example are airlines and auto producers. These companies could grow for years and at some point they reach their limits, it is the time when making and exit could be very logical act.
Businesses operating in good sectors could perform very well for many years. Examples are Apple, Microsoft, Google, Visa, Moody’s, etc. For such companies, the time to exit comes when they have challenges in the management, stop innovating, could not keep pace with the market(like IBM) or there is a new player in the sector which comes with better product(s). Best example is how Nokia was replaced by Apple in just 2-3 years. Also a good example is how Yahoo, one time at the top, with the many wrong decision by the management, have lost their position and lost their leading place to companies like Google. One day I will write an article on “business management” and how a good business could be turned to a trash by a bad management. Also many businesses, even that they continue investing, their profits may stop growing due to a huge competition in the sector. You could spot them by checking the revenues and net profits. If the operating profit is going down when the revenues are still growing, it is an indication that there is too much competition in the sector. A good example is the danish company Vestas Wind, they are still a good company but due to the huge competition, the profits continue to go down.
To perform well in the stock markets, with the knowledge I have at February 2022, my method of investing is:
- read about business and sectors, try to understand them, their business models, how they work, what affects them;
- make constant scan of the business which have long term growth potential;
- check the price levels of the stocks you follow at least ones per week, determine critical levels;
- for the stocks in the portfolio, set sell price or so called stop-lost price. I know that, more things could happen then I could anticipate. If there is something bad about the company, it will first hit the share price then the news will appear in the public media. So I always have a stop-lost price, it saves lives;
- to kill the monkey inside, I have some cash for trading, not more
that 5% of the portfolio. It also help me to act fast and with
confidence, when the time to sell one of my positions arrive;