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Balance Sheet signals to discover value

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1Balance Sheet signals to discover value Empty Balance Sheet signals to discover value Fri Jun 03, 2016 8:08 am

EquityChamp

EquityChamp
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Extracted from a writing of Gennaro Cuofano, Financial Analyst/Assistant Controller













Speculator vs. Investor
Before investing even one dime in stock is crucial to understand the difference between speculation and investment. Indeed, the speculator is the one who invests with a very short-term horizon, trying to predict the erratic future market fluctuations. Are you so smart to be able to predict how the trend will be in the future? The truth is that statistically you won’t be able to do that. The same Graham who was a market guru performed just 2.5% above the market return. Do you think you would be able to do better? If your answer is “yes” than you are deluding yourself. Anywhere today you find people telling you how they got rich quickly through daily trading. Although some of them really got reach through speculation, statistically the success rate is very low (around 3.5%, see Daily Trading Success Rate) . The investor instead is the one who has a much longer perspective and looks at the company’s balance sheet to base his decision. Warren Buffet suggests to apply as much due diligence to the stock you buy as you would do when buying something extremely important. Think for a second the time we spend on researching the new car to buy or the new smartphone. Why when it comes to stock investing we approach it almost with the “slot machine gamer” mindset?
Our brain is not wired to handle money
As it turns out our brains take quite other routes when it comes to money. Psychologically, our mind has not been wired for handling money. For such reason we struggle so much (see Our Brain is not wired to handle money). In addition, when it comes to stock it seems like we own nothing. In particular today, with the new sophisticated systems, anyone can buy stocks with one click. Thereby, before approaching the market ask yourself: Do I understand how this business works? Would I keep this stock for my entire life? Is the financial position of this company strong enough? These three simple questions can keep you away from troubles afterward. Speculating is neither good or bad but just what it is. Therefore, if you are classified as speculator keep always in mind that you are betting against the market at the same way the guy who bets horses, thus expect to lose all your money. If instead you are an investor, you can set your expectations, so that the capital will be safe and in addition you will receive a satisfactory return. What is a satisfactory return? Do not expect to become reach in one day, one year or ten. But if you are patient enough you might get rich, since your return will compound. In addition, by reinvesting your dividends you will have tax advantages. In conclusion, according to Graham, the speculator tries to anticipate and profit from market fluctuations. The investor instead looks for “suitable securities at suitable prices”. Are you a speculator or investor?
What advice would Benjamin Graham give you?
Assuming that you want to be an intelligent investor, Graham would tell you:
1. Do not look at market fluctuations. Instead, focus on understanding the business you are buying. In one case only the investor must look with eagle eye at Mr. Market. When Mr. Market overprices a stock that the intelligent investor owns; or if its market value irrationally exceeds its book value, then it is time for the intelligent investor to sell and benefit from market irrationality. Conversely, if a stock is extremely underpriced compared to its book value, the intelligent investor will “shop at a discount”. Why do we wait entire months for “black Friday” to have discounts on clothes and when it comes to stock investing we neglect those “discounts”? The best deals are found in times of irrationality; the intelligent investor knows that and he does not follow the crowd, neither buys what is fashionable at the time.
2. Do not waste your time at forecasting how the Market will perform in the future. You might get lucky once and make a lot of money. Although, this will lead to catastrophe. Why? Well, if you are like the average speculator, after jackpotting from your lucky forecast, you will convince yourself to be a “Market guru” and to have understood how the Market works. In this moment of ultimate delusion you will increase the stake, go “all in” and lose it all. You are warned, the intelligent investor “knows that he knows nothing” about future market movements. If you forget this basic principle, you will be easily deceived and doomed to failure.
3. Do not be fooled by the management. The intelligent investor knows that a good management is as important as analyzing the books. He must apply the same metrics used when valuing his returns when looking at the management’s performance over the years.
If the catalogue of “Do Not” is not enough, Graham would give you the catalogue of “Do”
1. Know what you are doing and know your business. In few words, stop spending hours of your day watching business channels and reading newspaper. Focus instead, on analyzing balance sheets and management of the organizations you want to invest in. In addition, analyze them at least with the same degree of due diligence you would use if you had to buy a new car or a new house.
2. Master your inner game. Build your emotional strength, and do not listen to the continuous flow of information that is produced to “make noise”. “Know thyself”, understand how you feel, which emotional reactions you have when investing. Only by studying yourself you can master the world around you. Change your perception of the world and suddenly the world will seem a different place.
3. Master your circle of competence. Focus 100% of your brain power on things you understand and let the rest go. Warrant Buffet has followed this principle all his life long. He never put a dime in tech stocks because he could not understand them. This does not imply that tech stocks must be always ignored by your investment; instead, ask yourself: do I understand how this business works?
Why should I follow Graham’s principles?                                                                                                                            
Well, there is no particular reason to implement those principles, beside the fact that everything you tried did not work. If you are stuck at investing, and you need a successful system, then there is no hurt in trying those principles.
How to keep emotions from sabotaging our success in investing.   
Each time you lose money investing, don’t fool yourself by thinking: “I am a special case”“none feels like I do”and “I have been such a failure all my life and I will always be”. This is a deception your brain is constructing to make you feel the “victim”. Biologically speaking it is true that each human being is different in some way; since our DNA has so many possible arrangements for any human being on earth. On the other hand, though, when it comes to psychological processes we are all the same. We all follow more or less the same thought patterns; although none will tell you what he is thinking; quite the opposite. In any case start to understand your thought patterns when investing and laugh at the voices that try to deceive you. But keep in mind:
MASTER YOUR INNER GAME, EVEN BEFORE YOU INVEST A DIME

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