This article is a summary of what I've learned from one of my favourite resources for learning about investing.
If you want to watch the original material you can find it on buffettsbooks.com
This article will be structured in the same way as the original material to help with easy referencing. This article is as much for me as a reference as it is for you, the reader, to get a concise summary of the courses. This by no means is a replacement for watching the courses yourself and doing practice excercises. I would highly recommend following along with it if you want the full benefit.
This lesson discussed the differences between value trading and value investing.
Value trading is described as buying something that maintains its value and then trying to sell that later to someone for more money. Value investing involves buying assets which both increase in value as well as put money in your pocket. A liability on the other hand will decrease in value and/or take money out of your pocket.
A house is not an asset by this definition since it only maintains its value (it may increase in price purely due to inflation) and takes money out of your pocket. In New Zealand this sentence is considered a sin because many people swear by propery investing but this is really just speculation. The house is still the same (or even worse if not maintained) after 10 years as when you bought it.
You can make a house an asset by buying it at a reasonable price, renting it out and ensuring that a combination of capital gains and rental income covers your expenses for holding that asset over the long term. So in other words, over the long term (maybe after 20 years or so) this will start putting money into your pocket in the form of surplus rental income once the mortgage is paid down significantly. You could also structure the debt using various techniques to ensure a positive cash flow from the outset. I won't say more on this here since the article is not primarily focused on property investing.
Businesses bring in revenue, pay expenses, what's left is the net income. Usually at this point a business will pay taxes on that net income and then the owner of the business can either invest this income back into the business or take it out.
A large business is exactly the same except that it has a board of directors which represent the shareholders, and all the employees including the CEO work for the shareholders because they own the business.
The value of a business is largely dependent on what people will pay for it. The more you pay for a business, the lower your return will be. If you bought a business for $1 and it made $1 of net income for the year, you would have made a 100% return. Double or halve the purchase price and you halve or double the return.
This is one of the three financial statements which describes the assets and liabilities of the business.
In the previous lesson we were essentially discussing the income statement where the main output figure is net income. In this case, equity is the main output figure being assets minus liabilities.
If you evenly divide a company into pieces called shares the equity in that piece would be called book value.
The closer the purchase price is to the equity, the safer the investment because more of your investment could be recovered just by selling the assets of the business.
A share is an equal sized piece of a company. If you own one share, you own that portion of the business. Since you really do own part of the business, you also own the equity in the business and have a right to the net income of the business.
Each share has a book value (equity) and earnings (net income) which are simply terms for the same main outputs of the financial statements but on a per share basis.
The price to earnings ratio describes what the market price for a share is compared to its earnings. If a company has a P/E of 5 that means "for every $5 I pay buying this business, I expect to earn $1 a year later".
Whether you buy the whole business or just one share, the proportions are the same so always run the numbers using ratios and percentages rather that nominal figures.
Warren Buffett has four rules in investing.
Firstly, the company has to be stable and understandable otherwise it's simply not possible to predict the future of the company.
Secondly, the company must have long term prospects because buying and holding a company will save you fees, taxes and time over your investing career
Third, the business must be managed by vigiliant leaders. The only way to assess this is to look at debt levels and how well the company reinvests its income if it decides to not to pay it out to the owners.
Finally, the business must be undervalued because over paying for even the best business will result in poor returns.
A quick way to screen a company when looking for an investment is the following: P/E * P/BV < 22.5
Take the P/E ratio (return) and the price to book value ratio (P/BV which represents safety) and multiply them together ensuring the result is less than 22.5. This is equivalent to a P/E of less than 15 and a P/BV of less than 1.5.
Remember that the market is just there offering you prices every day and doesn't represent the value of the company.
Be patient (this is a slow and boring process) and think critically (if it was really as easy as copying your neighbours stock picks, everyone would be doing it).
A bond is an IOU from a company or government organisation used to raise money (debt) which they will pay back after a term all the while paying a coupon at a regular interval.
Apart from interest rates changing bonds also have failure risk of the issuing organisation as well as inflation.
The reason why bonds are considered a safer investment compared to preferred or common stock is because they are paid back first in the event of a liquidation.
Bods will also increase in value whenever interest rates decrease usually in economic downturns when central banks are trying to stimulate the economy.
Bonds are most of the time inversely correlated with stocks which helps to smooth out the ups and downs.
Every bond has a par value which is the original amount provided by the investor and also the amount to be returned to the investor at the end of the term.
The coupon rate is a percentage of the par value which is reedeemed in fixed dollar amounts, for example $50 every year on a $1000 par value bond is a 5% coupon rate. From the date of issuance until the inital value is returned, that same $50 will be paid every year regardless.
During the term the investor may decide to sell the bond at which time the market price may differ from the par value primarily due to interest rates offering better or worse options to the market.
As a bond approaches maturity, it will return to its par value but the futher it is away from this date, the more coupons that are yet to be paid and the more time interest rates have an opportunity to influence the market price of that bond.