Some investors try to find a catch-all formula that guarantees investment success. For example, they may analyze a number of ratios, including return on equity, debt-to-equity and price-earnings, to "rate" specific companies and determine how much capital should be apportioned to them.
In my view, there is no magic formula that can guarantee investment success. Certainly, focusing on facts and figures can help investors avoid low-quality companies in favor of those that offer less risk and a greater chance of long-term success. But overall, investing is an art rather than a science. It cannot be broken down into formulas that take the place of qualitative analysis undertaken by an investor who has detailed industry knowledge and experience.
This viewpoint has previously been discussed by Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Vice-Chairman Charlie Munger (Trades, Portfolio), who said: “There isn’t a single formula. You need to know a lot about business and human nature and the numbers. It is unreasonable to expect that there is a magic system that will do it for you.”
A disciplined process
Rather than seeking a magic formula, I believe investors must first fully understand the industry in which a company operates. This requires detailed knowledge of its key drivers, risks and long-term growth opportunities. This will help them immeasurably in understanding which companies have the greatest competitive advantages over their peers and are, therefore, more likely to overcome tough operating conditions to generate high profit growth over the long run.
As mentioned, focusing on company fundamentals can help investors to unearth the most appealing stocks within an industry. However, valuing them based on facts and figures is subject to opinion on the part of the investor. Even ratios such as price-earnings or a discounted cash flow valuation require some interpretation.
In my view, valuing companies is a challenging part of investing. As a result, obtaining a margin of safety versus a stock’s intrinsic value is imperative to allow for potential mistakes. Investors who are patient enough to wait for a stock’s price to decline so that it trades substantially below its intrinsic value can further stack the investment odds in their favor.
Mistakes are commonplace
Of course, mistakes are not only made when valuing a company. Any investor can miss potential pitfalls facing a company when deciding to add it to their portfolio. As a result, diversifying a portfolio and taking a long-term view are essential to investment success. This allows investors the capacity to absorb losses from their mistakes.
Ultimately, stock market movements are highly unpredictable. This year, for example, the stock market has fallen by approximately 17% in spite of investor optimism at the start of the year. As a result, all investors must accept there are no guarantees of success when buying shares.
Investing can be a tough experience for which there is no magic bullet. But by sticking with simple principles, it is possible to take advantage of the stock market’s double-digit annualized total returns over recent decades that are likely to continue in the future.
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