Ten Golden Rules For Picking The Best Stocks To Buy by Lukas Neely, Endlessrise Investor
Are you fed up with trying to find the best stocks to buy?
How much time are you wasting trying to find the next great investment opportunity?
We’ve got a secret for you….
The following is our rough coverage of the 2021 Sohn Investment Conference, which is being held virtually and features Brad Gerstner, Bill Gurley, Octahedron's Ram Parameswaran, Glenernie's Andrew Nunneley, and Lux's Josh Wolfe. Q1 2021 hedge fund letters, conferences and more Keep checking back as we will be updating this post as the conference goes Read More
Don’t do it by yourself. It’s too hard!
With over 50,000 publicly traded companies in the world, trying to pick the best stocks to buy on your own is a sure way to frustration at best — Or even worse, you make the worst trading mistake ever….trading your precious time for money.
This is lost time and money that you’ll never get back, if you don’t know how to properly search for the best stocks.
If you’ve invested in the stock market before, you know how difficult it can be to find the best stocks to buy. However, this process must be done. Great investment returns won’t grow themselves. They need a solid foundation with which to blossom and grow.
A simple process that finds the best stocks to buy is the lifeblood of every great investor. The following rules are a simple process to help you find great investment opportunities fast.
Here Are The 10 Golden Rules For Finding The Best Stocks To Buy:
1) Have A System Or Process Of Investment (and try to follow it).
“By failing to prepare, you are preparing to fail.”
Whether you are a long-term investor like Warren Buffett or Seth Klarman, or even a shorter-term trader like Paul Tudor Jones, it’s vital that you establish a philosophy that’s similar to your personality and risk tolerance.
Here’s a simple question to ask yourself:
Do you have the temperament to see your investment decline by 50% without selling your position?
If yes, then value investing may suit you well. If no, then you may enjoy the philosophies or strategies of more active traders.
This simple question will help you determine which side of the line you stand.
Focus on establishing a rational, repeatable, proven investment process from a Super Investor you admire, and don’t deviate from it too much (unless you develop your own philosophy).
Remember: All these stock ideas from Super Investors won’t mean anything if you don’t understand their investment philosophy.
Study up on the Super Investors. Read about them and their past investments and decisions. And choose a Super Investor philosophy that suits you best.
I believe every investor should have a mentor. Pick one (or many), just make sure to stay within the boundaries of their proven philosophy.
2) Use Super Investors As A Starting Point To Determine Investment Opportunities.
“If I have seen a little further it is by standing on the shoulders of Giants.”
Let’s not kid ourselves here…technology is great. It’s paved the way for some incredible discoveries, and it helps to improve the quality of life to billions of people everyday.
However, when it comes to being distracted with tons of big data it can be a burden at times for an investor. The data set that’s available today is too large.
The Super Investor process bypasses all the noise. It allows you to focus on a select few companies, and pinpoint the areas that matter most to investment success.
This is a Secret of the investing world that many investors are not using enough.
Hidden beneath the mountainous documents and data of SEC filings, lies a treasure chest of incredible opportunities. You just have to dig them up, and find them through all the 13Fs, 13Ds, 13Gs and proxy statements.
If you are going to invest in stocks, it makes perfect sense to start with investments that have already been vetted by the world’s greatest investment minds and analyst teams. This is a “no-brainer”, however investors constantly want to make it difficult on themselves because we live in a world where simple is looked upon as lazy. Some call it lazy…I call it smart.
Using the Super Investors investment ideas allows you to follow a simple process that consistently finds you the best stocks to buy.
Start viewing “simple” as a job well done. You will have more time and energy, and your investing will take a giant leap forward.
This strategy doesn’t mean you disregard all logic, and stop the research process. Listen to Super Investors that you respect or share similar philosophies. It doesn’t mean you blindly accept them at face value and invest in their ideas no matter what. That would be incredibly irresponsible. You still need to finish the remainder of the golden rules to help decrease your risk.
It is important to note that investment funds generally report their end-of-quarter holdings with a 45 day delay. That’s why it is imperative that you align yourself with focused, long-term Super Investors that use very low turnover in their portfolio. And you want to pay particular attention to the top 10 positions. A Super Investors best ideas will be over-weighted in the 10 positions. This strategy will increase the likely-hood that the investment ideas are the best stocks to buy.
As you can see, this simple process allows an investor to narrow a universe of 50,000 stocks — into a couple hundred businesses that an investor can know very well.
How’s that for an investing hack?
At Endless Rise Investor, we follow a list of 30 value investors that fit our long-term philosophy. We couldn’t have asked for better analysts.
You can view our list of Super Investors on our homepage: http://EndlessRiseInvestor.com
(finding just 3-5 great investment opportunities every year through this process, gives an investor a superior advantage versus the rest of the market.)
3) Explain Why You Are Buying The Stock In One Paragraph.
“Acknowledging what you don’t know is the dawning of wisdom.”
If you can’t explain why you are buying the stock in one paragraph — Then Don’t Buy The Stock.
Throw it in the garbage bin, and move onto the next idea or opportunity. It’s not worth your time, and could cause psychological and emotional mistakes down the road if you don’t have the necessary conviction in your investment.
When you identify a potential opportunity, run it through your checklists and mental models to see if it passes some basic tests. After this quick analysis, you want to write down a few lines on why you want to buy the stock. In this paragraph, we want to focus on the big picture reasons for investment. Jot down potential sustainable competitive advantages of the business and a rough estimate of intrinsic value.
Remember to keep this analysis somewhere safe. You will want to review it periodically (every 6 months or so). Make adjustments or modifications to your analysis with new information that is coming in after the 6 month period. This will help you determine whether the business is on the right track or potentially deteriorating (at which point a decision may need to be made).
It is very important to stay within the confines of your circle of confidence. If you know the industry dynamics of railroads better than the technology space, then focus on railroads. It’s perfectly normal for you not to know everything about everything all the time.
Maybe you may understand the fundamentals of a particular business industry better than most. Or maybe you may have expert knowledge of a certain business model. Or maybe you don’t really want to know too much about the business, you just look for business that are trading at incredible discounts to liquidation value or intrinsic value. Whatever you do well, keep doing it.
A great deal of permanent losses have occurred when investors get curious, and venture outside their circle of competence. Expand your horizons, however do it slowly.
4) Determine A Range Of Values For The Business.
“The essential point is that Security Analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to protect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.”
Valuation by its very nature is more art than science. It’s not a static or straightforward endeavor, and it requires many assumptions. However, mastery of the data isn’t necessary. Contrary to popular belief, investors don’t have to be precise in the estimate of Intrinsic Value. The art of valuation, in-and-of itself, is imprecise. An investor that approaches valuation in a conservative manner will be a step above the rest. Abandon perfection and precision…and seek conservatism.
There are three main types of valuation techniques an investor should learn in order develop conviction in an investment when the world is falling down around you. The three techniques include:
1) Discounted Cash Flow Valuation (DCF) is a method of using future free cash flow (FCF) projections and discounting them to arrive at a present value. As you can imagine, they can be a significant amount of variable and assumptions that go into this valuation technique. However, DCF is one of the most precise types of analysis for valuation with predictable FCF. The only problem is…free cash flows aren’t very predictable.
Identifying sustainable competitive advantages in a business is the only way a business will be able to produce any type of free cash flow over a sustained period of time. This makes the analysis of competitive advantages essential in the calculation of DCF.
2) Conservative Liquidation Valuation was made popular with Benjamin Graham’s Net-Net calculation. This was a conservative, back of the envelope calculation of liquidation value.
Net-Net = (Current Assets – All Liabilities) / Shares Outstanding
This calculation alone, implies that Graham (the father of value investing) was unable to determine a business’s Intrinsic Value with any high degree of conviction. Another reason we want to use a range of values in our estimate of Intrinsic Value.
The tangible book value of the business can usually be used as a rough estimate of liquidation value too.
3) Sum-Of-The-Parts Valuation (SOTP) provides a breakdown analysis of each segment of the underlying business. Each segment is valued using conservative multiples to revenue, EBITDA or Net Income for the particular industry. Sometimes segments within a business can present hidden values, which can be spun-off and monetized to provide increased shareholder value.
This type of analysis is common in conglomerate type businesses.
A range of values can be calculated a number of different ways using these three main valuation techniques. If it makes sense, you can take the average of the three valuation techniques above to arrive at conservative estimate of intrinsic value. Or if the business is a high-quality, FCF producing business, you can use likely estimates for growth, FCF and discount rate, and take the average range of those calculations. Or maybe the business is headed for bankruptcy, a conservative estimate of liquidation value would make sense in this scenario.
*An investor could even weight certain assumptions if they believed certain scenarios were more likely than others.
“The two most important things are real asset values and the ability to generate after-tax free cash flow. ”
Remember: A stock isn’t just a piece of paper. A stock represents a ownership stake in a REAL business. That’s why valuation is so important.
So how do we handle valuing something that is inherently unpredictable and imprecise?
The ONLY way is conservatively! And preferably at a discount to assets.
5) Buy At A Discount To Those Values.
“When you buy businesses at steep discounts from real value, a lot of good things can happen.”
Ascertaining a conservative range of values is great, however it doesn’t do us any good if we don’t purchase at a discount to these values.
In relation to value, the price paid for your investment is the most important element. The lower the price paid, the higher your ROI (all else being equal).
Ascertaining the “real” intrinsic value of a business is no easy task.
However, going through the three valuation techniques in a conservative manner can yield insight into a potential investment opportunity, if a stock is trading well below any, or all three of the valuation techniques. This would give an investor a high degree of assurance that the Intrinsic Value of the business hovered somewhere well above current trading levels. Thereby confirming a margin of safety in investment.
If you aren’t a seasoned security analyst, it’s probably best to buy assets at a discount, rather than earnings. Earnings can fluctuate wildly in the short-term compared to asset values. If an investor attempts to buy earnings at a discount, he/she would need to know the underlying business fundamentals intimately to arrive at a conservative estimate of Intrinsic Value.
Ideally, investor should be investing in businesses that offer at least a 60% discount to Intrinsic Value (preferably lower). The further a stock moves away from its intrinsic value, the larger the margin of safety (all else being equal).
6) Be Contrarian (sometimes).
“Do not follow where the path may lead. Go, instead, where there is no path and leave a trail.”
Ralph Waldo Emerson
As an investor you can’t be afraid to buy stocks that others have left for dead. You will never be 100% certain in investing. If you believe your investment thesis still holds true, then you must have the courage in your convictions to let your decision play out. In order to control your flight response to combat fear and pain, give yourself room to buy more on the down side. If you believe you’ve found a great investment opportunity, don’t purchase the entire position right away.
For example, lets say I want to establish a $10,000 position in AAPL which equate to 10% of my overall portfolio. Because I am a horrible market timer, I will eestablisha core position of $5,000 (5% of portfolio) and add to my position if the stock continued to drift lower till I established my full $10,000 position (all else being equal).
It’s a technique to help investors average into great investments safety.
“Value investing is at its core the marriage of a contrarian streak and a calculator.”
When making contrarian investment decisions, it is vital that an investor control his/her emotions. Emotion must be left at the door when investing. Fear and greed are two powerful emotions that can wreck havoc to the decision making process, which then trickles down to your investment returns. They is nothing worse than being right with your investment thesis, and then selling out of your investment at the lows right before the subsequent recovery.
The market will always attempt to cause the most amount of pain the the most amount of people. Any time you find yourself leaning too far with the majority or the herd, it could be time to rethink your strategy.
Contrarian investors are always on the look-out for low-risk, high uncertainty investments. Mohnish Pabrai (Pabrai Funds) calls it “heads, I win…tails, I don’t lose too much.” Investors will be able to separate them selves from the rest of the crowd by consistently buying low-risk, high uncertainty contrarian investments with risk reward scenarios greater than 5:1,
7) Be Patient.
“If you are not willing to own a stock for 10 years, do not even think about owning it for 10 minutes.”
An investor should expect a convergence between Price and Intrinsic Value over the course of 2-3 years (sometimes more). I believe this is an acceptable time period for an individual to be patient, while you give your investment thesis time to play out. Sometimes the convergence gets there quicker, and sometimes it doesn’t get there at all.
If you succumb to the short-term whims of Mr. Market, you are severely handicapping yourself. Allowing at least 2-3 years for your investment to work, gives you an superior advantage over other market participants.
Personally, I have held positions for up to 7 years (and counting). Most worked out, some didn’t.
Stocks don’t go up immediately. Be ready for that to happen. In fact, be ready for the stock to go down in value after your initial purchase. It will put you in a better state of mind by expecting a drop in stock prices.
I always hope that a stock goes down after I purchase it. I know…I am sick.
Smart investors will be patient and give themselves room to purchase more at lower prices. If it was a great investment at $15 per share, then it should be an even better investment at $10 per share. That’s great investing. Most people don’t think like this though.
8) Always Seek Catalysts.
“Value investors are always on the lookout for catalysts. While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits.”
Catalysts help investors pinpoint potential events which will cause the business to grow and/or the stock to rise.
Cheap prices can sometimes be enough of a catalyst for share price appreciation, however we want a greater assurance for share price appreciation and margin of safety.
The presence of readily established catalysts helps to increase our margin of safety by potentially increasing the speed of return. Shareholders benefit in two ways after a stock is purchased at a discount from a business’s underlying value:
1) The stock begins to rise to converge with its underlying intrinsic value.
2) An event(s) occurs which causes the value to be realized instantly or over time by other market participants.
Although an investor will likely do extremely well over the long-term by purchasing businesses at deep discounts to their intrinsic values, we want further confirmation. An investor never wants to be completely held captive by the vagaries of of human nature and the often times irrational behavior of the markets.
Investors want to invest in in high quality business, at deep discounts to intrinsic value which have likely events in the horizon to bring about full value of that investment.
Investors call these events, catalysts.
Catalysts reduce risk and help investors by:
• Reducing their dependence on market forces for investment returns.
• Fast-tracking the time between price and value.
Here are a few catalysts that investors use to bring about full or partial value in an investment:
• Spin-Offs or Divestitures
• Major asset sales (includes merger-arbitrage)
• Stock Buybacks
• Dividend Initiation or Increase
• Activist Involvement
• Future growth of the underlying business
• Future growth of the industry
• Volatility Squeeze
• Business Turnaround
9) Be Cautious Of Leverage.
On Leverage: “If you’re smart you don’t need it, and if you’re dumb, you got no business using it.”
Leverage is a double edged sword.
As quickly as leverage can work well on the upside, it can turn at the flip of a switch. It can work amazingly well during the boom times. And it can be disastrous, and wipe you out on the downside if your not careful. Ideally, you never want to invest using leverage.
This goes for businesses too. The majority of investor failures occur from investing in businesses that were over-leveraged. As an investor, you never want to interrupt the power of compounding if you can help it.
Businesses with strong balance sheets can give investors the confidence to buy more of their favorite ideas when it seems the world is coming to an end.
Nothing kills a business faster excessive leverage.
Leverage brings added risk of permanent loss of capital to the individual and business alike. As an investor, its best to stay away from leverage. If you’re investing correctly, the power of compounding will make you extremely wealthy in short order.
10) The Best Stock To Buy May Be One You Already Own.
“Exactly when to sell – or buy – depends on the alternative opportunities that are available…It would be foolish to hold out for an extra fraction of a point of gain in a stock selling just below underlying value when the market offers many bargains.”
Every investment decision you make should be weighed against the investments in your current portfolio.
Only sell your current positions if the stock becomes incredibly expensive, or if you find a better high-quality investment with a greater divergence between price and intrinsic value. This will lower your risk profile, while increasing your potential rate of return at the same time.
“What lies behind us and what lies before us are tiny matters compared to what lies within us.”
Ralph Waldo Emerson
The sky’s the limit!
Investing is a fun, challenging, exciting, dynamic and lucrative endeavor.
And it can also be dangerous and time consuming too, if an investor doesn’t have a simple, repeatable system for finding the best stocks to buy.
We’ve laid out the Golden Rules for you to go find amazing investment opportunities.
You now have no more need for teams of ‘crack-shot’ analysts or high-priced newsletters or overpaid money managers.
Virtually every investment idea we make is cloned from another investor we admire or respect (and then vetted through our in-depth research process). And the best part of this business model is we still get the out-sized investment returns, while not having to pay management and return fees (or team of analysts).
Make it simple — Be a cloner. You can do it all by yourself.
And just in case you get lonely, you have Endless Rise Investor and the Super Investors beside you all the way to give you their best ideas.
What are you waiting for?
Go get ‘em!