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Principles for Successful Investing

Other than buying stocks that trade below their intrinsic value, what are the other principles of successful investing? The best investors treat public markets the same way anyone would treat private markets. The idea is the same, we are buying a share of ownership in a company that will, we hope, make a profit and grow. The ability to buy into most of the large and successful businesses in the world is no doubt a blessing if used properly, but the constant streaming of prices and quotes can also be a curse.

I bought stock in Apple in May 2017. At the time, the stock was trading at an incredibly cheap valuation. The enterprise value per share was slightly more than eleven times the trailing-twelve-month free cash flow. This is a bargain for such a large, profitable, durable business. I bought the stock at an adjusted price of about $36 per share. Today it trades at $163. I wish I could tell you I retired on that gain, but I did something stupid. I saw that Apple was getting into the streaming wars and I said, “I’m out.” In my defense, I still do not think that was a very smart decision, although I do love Ted Lasso. The lesson here is it is very hard to screw up a good business, and I should have taken longer than an afternoon to consider what getting into streaming would mean for the company. But I made up my mind, logged onto my broker’s website and put in the sell order. Since 2017, free cash flow per share has increased by over 150% and the EV/FCF multiple has doubled.

What does this mean to treat our public stock portfolio like a portfolio of private businesses? It means we plan to hold each company for many years, we measure performance through the underlying cash flows of our holdings, and we maintain a strong financial position. Together with the shrewd purchasing decisions outlined in my last post, these are the four main principles of successful investing. Like most difficult problems, investing can be simplified and distilled down to a few simple principles.

Being a long-term holder of a position does not mean we will never sell; it means we are as careful in our selling decisions as we are in our buying decisions. When we buy a position, we should plan to hold it either until the business deteriorates, the price of the shares becomes detached from the reality of the business, or we die. If the assumptions we made about the business being strong and durable become clearly incorrect, we should sell. If the shares are priced for only the rosiest of possible outcomes, we should sell. Other than that, we should hold. There are two main reasons to not trade frequently. The first is that we do not have an informational advantage on the market. If we limit our trading to the times when we are sure we are right, we reduce the risk of being wrong. The more we trade, the less likely it is that each trade is the right one. Second, there are major tax benefits to holding long-term. If we do not sell, we do not owe capital gains taxes. If we want to sell a holding to buy another position, we need to account for the tax consequences of that decision and that makes it much less likely that the new position will be worth it.

The industry standard for performance measurement is to use current market prices. In most cases this is correct, you should be incredibly wary of a professional money manager that asks you to ignore the market value of their holdings. However, when we evaluate our own performance, it is best to not use just market value. Market value only matters at two times; when you buy and when you sell. At all other times it is just a number. What always matters is the value of your holdings. Value is measured through the underlying income generated by your assets. If you were assessing the performance of a portfolio of private companies, you would look at the revenue, profit margins, and balance sheet. The fundamentals of the underlying business are what matters. If the stock price goes down but the business is fine, that is an opportunity buy more.

The last point is somewhat obvious but seems to be ignored by many. On both a personal level and a holding level, financing should be sound. This means we don’t buy stocks with money that we need to meet short-term liabilities, and don’t buy stocks on margin. If you have any consumer debt outstanding (credit cards, personal loans, or car loans) it most cases it is best to use savings to pay off this debt before buying stocks. For companies, this means that the capital structure is not overly leveraged. Larger companies can operate with more debt than people can but when the debt starts to strain management’s ability to invest in growing or maintaining the business, that is too much leverage. This is a somewhat subjective measure but usually an investment grade rating by one of the credit rating agencies is a good rule of thumb.

Like value investing in general, these investing principles are rather simple but difficult to carry out in practice. In addition to discipline and patience, these principles also take habit and conviction. When we already own a stock, it can be very difficult to assess performance objectively and continue to hold for the long term when the market disagrees with us. However, this patience will be rewarded if we do our initial research thoroughly and stick to these principles.

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