Day 26: How to invest in the stock market intelligently

Day 10 of my 35 Day Challenge

Have you ever thought about investing in the stock market? Many  of us have. But most of us also have been hesitating to actually invest. I mean all of us have witnessed financial crises, economic crashes and burst bubbles, or we at least heard of them. And most of us probably don’t trust our own financial abilities enough to actually manage our investments on our own.

Have you ever felt like it would be so much easier to just hand over your money to an expert and let him deal with it? Well, don’t. They usually charge way to much for their expertise and they often get it wrong.

However, there is a way of investing intelligently! A way that doesn’t leave you at risk of losing everything and that shows you the factors you should look out for , when judging the profitability of a share!

In 1949 Benjamin Graham showed us with his book “The intelligent Investor”,that taking a long-term, more risk-averse approach to the stock market actually works. Since then people like Warren Buffet have made a fortune with Graham’s approach.

In this post i will share a few things that i’ve learned reading “the intelligent Investor” and a few things i’ve learned from other books. I will show you

• who Mr.Market is
• how to beat Mr. Market and why you should probably just ignore him anyway, and 
• a formula that will help you to judge shares way better

Who is Mr.Market ?

Benjamin Graham described the stock market as a crazy Person called Mr.Market. Mr. Market probably has a bipolar disorder and he really wants to sell you shares in is company. Some days he is incredible optimistic, tends to overestimate himself and he wants to sell at a high price. On other days he becomes depressed and thinks his company isn’t worth much, and he sells at a lower price.

How do you beat Mr.Market?

Well, it’s not that hard to beat him. You just have to use his temperament to your advantage. Buy stocks when he’s feeling down so you can get them cheap and when he’s feeling better, you can offer to sell them back to him for a higher price. So as an intelligent investor you focus on the pricing. You only buy stocks when it’s price is below the company’s intrinsic value. That means, that you only buy if you think that there is a probable margin between what you pay and what you will earn as the  company grows. Imagine you’re buying expensive shoes, they’re only worth it if they last a while. If the quality isn’t that great and they don’t last long, you might as well buy cheaper shoes that last you for the same amount of time.

If you want to to beat Mr.Market and invest intelligently you should pay close attention now:

• always analyze the long-term development and business principles of the companies in which you are considering to invest, before you buy any stock – How much a company is really worth in the long run depends directly on how well it performs. So look at their financial structure, at their management and it’s quality and whether it pays steady dividends
• Don’t look at short-term earnings. Look at the big picture instead by checking  the company’s financial history
• Never put all your eggs in one basket! It’s very important to diversify your investment – And never put all your money on one stock, doesn’t matter how promising it looks. That’s gambling! Diversifying helps you to ensure, that you won’t lose all your money at once.
• Understand that you probably won’t get extraordinary profits, but safe and steady revenues
• Prepare yourself for the up’s and down’s of the unpredictable stock market – look at the history of the stock market, there always have been up’s and down’s. Economic crises, like the Wall Street crash in 1929 can happen. You have to make sure that you can take a big hit like that and survive. That’s why it’s so important to diversify your investments. Invest in stocks, bonds, ETF’s, real estate and what not. If you just have stocks, make sure to have stocks in different industries. 
• Prepare yourself mentally for a crisis –  you can’t predict a crisis, but it can happen. And when it does it’s important not to run around like a headless chicken. After a crisis or a crash the market always recovers. So don’t sell out of panic. Don’t sell when everyone is selling
• Check the company’s history – look at the correlation between the stock price and the company’s earnings and dividends over the past ten years. Then consider the inflation rate, in order to see how much you’d really earn. If you calculate a 8 % return on the investment within one year, but inflation is at a 5 % rate, you’ll earn a return of only 3 %. So make sure it’s worth the effort.
• Invest in at least 20 different companies to reduce risk.
• Look at investment funds with a long history of success and copy them
• Check your investment portfolio and the companies you invest in regularly. – Is the companies management still run well? How is the financial situation? When you realize that one of your companies is overrated, and its stock prices are growing without any relation to it’s intrinsic value, better sell before it crashes.

What is the magic formula and how to you use it?

Ensure that the price of the stocks you buy is below the company’s real value and sell them when the price is above it. To do so look at the earnings yield. It shows if the price of a share is a good deal. The earnings yield is calculated by dividing the previous year’s earning per share ( how much the company made, divided by the number of shares it issued) by the current share price. This way you will know how much return you can expect from your investment.

So if a company’s earnings per share where at €0.76 last year and it’s stock is currently trading at €10.00, then the formula gives us an earnings yield of €0.76 divided by €10.00 , which equals 7,6 %.

That’s not enough, though. You need an additional calculation to see if a company is actually profitable. So we have to look at the return on capital (ROC).

ROC is calculated by dividing the after-tax profit by the book value of invested capital (the total amount of money invested by the company’s shareholders, bondholders, and so on). This reveals how effective a company is at transforming investment into profit.

So for example, if you just spent €300,000 setting up a shop and made a profit of € 100,000 in the first year, your ROC for that year would be at 33,33%, which is great. Anything above 25% shows, that a company is doing good. 

If you buy shares of companies that have a high return on capital at low prices, you’ll also buy into companies that are currently undervalued by Mr.Market. 

Use both of those calculations to create the magic formula. Start by making a list of the 3,500 biggest companies available for trading on one of the major stock exchanges and rank those companies on a scale between 1 and 3,500 based on their ROC. The company with the highest return takes the top spot. 

Then rank those companies according to their earnings yield –  highest earning yield is at the top. 

Now you only have to combine both of them! If a company is ranked Nr.1 on ROC, but 236 on earnings yield, it’s score is 237 ( one plus 236). The companies with the lowest combined ranking should be the ones you’re buying. This formula best pays off over a long period of time like 17 years, where it can return up to 30% .But it’s not made for short-term profits. Within a year the stock market outperforms the formula most of the time.  And only use it on big companies, and have at least 20 to 30 large company stocks at a time.

If you want to read more about the magic formula, read “The Little Book That Still Beats The Market” by Joel Greenblatt. 

I hope you enjoyed reading my post and that you learned something 🙂 

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Thank  you for reading 🙂