Investing Formula

Introduction

It has been nearly a decade since I first invested in the stock market. I remember my first trade: I bought a speculative stock and sold it immediately for a trivial profit, just to familiarize myself with placing buy and sell orders.

At the time, I wasn’t able to tell the difference between investing and speculating. To me, investors were those who held stocks for a long period of time whereas speculators held stocks for a short period of time. This remains a common perception among most beginners in the Saudi stock market.

In the last six months of 2005, I made a 70% profit on my investment. I still remember one of my best trades during that time: I made 150% on a stock in one month; I was proud of that achievement. I thought that I was well prepared to enter the market because I had become familiar with many tools of technical analysis and had developed my own spreadsheet to import data from the web, analyze them and highlight buy and sell signals.

Later, I discovered that analysis relies on the analyst, not computer software. Furthermore, I discovered that the 70% that I had made in six months was nothing compared with the performance of the speculative stock that I sold for the sake of making a trivial profit; the price of that stock increased by more than 1000% during the same period. In fact, the Saudi stock market was booming at that time; everybody was investing in the stock market, and good returns could be achieved easily. Even the 150% gains, which were made in one month, had a smaller impact on the overall return on my portfolio because I had allocated one-fourth of the portfolio to that stock; thus, the overall return of the portfolio was 37.5% (assuming no effect of other investments).

The most important point of this story is that I failed to protect those gains, which were actually excellent. In February 2006, the Saudi stock market reached its peak, and then the market collapsed and I lost all my profits and a portion of my principal. The market declined again in 2008 because of the global financial crisis. The market reached its bottom of 4,130 in first half of 2009, falling from its peak (above 20,000), which was recorded in February 2006.

These were not the only investment mistakes I made. In 2009, shares were very cheap, and, although I should have invested in the market, I didn’t do so because I had lost confidence in myself and I didn’t want to experience the same nightmares that I’d had in 2006 and 2008. I started reviewing my own performance in 2010, trying to identify my mistakes and the core competencies I required in order to be a successful investor. The first and most important problem was my investment behavior. I was actually a bad investor who could make gains during a bull wave and then fail to protect them during a bear wave.

In 2011, I decided to change the rules of the investment game and act according to strategy instead of investing haphazardly. The results were excellent; in addition to the good results that I have achieved since that time, I began to develop more knowledge and more skills to help me manage my investments and recover all the significant losses incurred before 2011. Statistically, l had lost approximately 75% of my initial investment but had recovered all my losses in a few years.

It may be fortunate that I was subjected to those losses and hard lessons in my early days in the stock market. The most important lesson was the importance of investment behavior and its influence on the mental function of the investor. It is normal for beginners to make mistakes; however, because a bull trend will cover those mistakes, investors fail to learn from their errors. Indeed, decent people try to avoid mistakes, and if they do make mistakes, they correct them and learn how to prevent repeating those errors.

The accumulation of lessons can create an expert in his field. Experience can be defined as a series of different mistakes that an individual has learned from. Wisdom is learning from others’ mistakes. Ultimate stupidity is making a series of identical mistakes. Only a few investors learn from others’ mistakes, and they are, most properly, the stars of the stock markets.

I began an Executive Master of Business Administration degree in 2012. This program added another building block to the investment skills and competencies that I had developed over the last few years. Notably, the two most beneficial courses were Strategic Management and Strategic Marketing. These two courses opened new horizons and enabled me to understand the way businesses work and the importance of competitive advantages.

One of the courses in the program was investment analysis and portfolio management; the ideas presented in that course contradicted what I had learned from Security Analysis, Graham’s famous book. Later, I discovered that there are two investment schools with two nearly opposite directions and that I needed to select one of these two directions.

Graham’s school was basically driven by a deep understanding of corporate strategies, the fundamentals of business, economic cycles and human behavior. Graham’s most important contributions in the investment field were his books Security Analysis and The Intelligent Investor.

The ideas and concepts that I learned from Strategic Marketing and Strategic Management were nearly consistent with what I learned from Security Analysis. Furthermore, the other book (The Intelligent Investor) answered all the key questions regarding market price behavior and how I should respond to the fluctuation of market quotations.

I came to believe that the investor’s role in the stock market is preventing losses and reducing the possibility of losing money. As long as the investor is able to prevent losses, he will earn good returns. The possibility of losing money is reduced by avoiding the three big mistakes in the stock market. These three mistakes are bad selection, bad valuation and bad management. Conversely, achieving good investment results is conditional on good selection, good valuation and good investment management, the three foundations of the investing formula. To achieve good investment results, we must ensure that we completely fulfill these three measures; good investment results are the sustainable return that is achieved by bearing reasonable risk.

The investor should assess the possibility of making money and the possibility of losing money before making any investment decision. These two possibilities have an inverse relation: if the possibility of losing money is high, the possibility of making money is low and vice versa. We must consider that both possibilities are equal if and only if we are gambling. Moreover, a one hundred percent possibility of seeing gains (or losses) from a specific security is impossible.

To reduce the possibility of losing money (which increases the possibility of making money), we must buy only good assets at only good prices, and we must act in the manner of good investors. Risk remains if we buy good assets at inflated prices because the price could decline to reflect the true value of the stock, and we will eventually lose money. Risk also exists if we buy a good asset below its value because we may be influenced by the market decline and sell the asset at less than our purchase price. A skillful investor knows the low level of market prices; however, no one knows the future bottom of shares’ prices.

The ideas and concepts of this book are centered on the three investment fundamental skills: selection, valuation and management. I advocate selecting stocks based on certain selection criteria that will be explained in detail in this book. We learned the significance of buying stocks based on estimated intrinsic value; therefore, i put great effort into developing the different valuation techniques presented in this book. Furthermore, we highlight key concepts that will help an individual investor better manage his investment portfolio.

I don’t claim to have reached maturity; we continue to learn, and this book is one of our attempts to learn and to share our knowledge.

Ali M. Tohary

December 17, 2014

PART ONE: THE INVESTMENT WORLD

Chapter 1: Basic Concepts

I have met with many people who believe that a stock is something non-tangible that is not worth the money they must pay for it. Therefore, people tend to invest in something they can see and touch, such as real estate. It is quite difficult to explain the meaning of a stock, particularly to people who work for public companies and can see all sorts of assets in the companies for which they work. Such people see the stock market as a large casino in which groups of gamblers meet to play and make money by luck. Other people believe that hidden powers drive the market in a manner that benefits themselves at the expense of ordinary people.

Conversely, some think that investing in stock markets is a sophisticated business that requires an extensive list of qualifications. Such people may even believe that individuals should not invest directly in stock markets because the market is a place for giant financial institutions that have complete teams of financial analysts, economists and technical analysts. Moreover, giant institutions have their own communication channels through which they can access essential information not only at the company level but also at the level of the national economy.

I am not interested in finding support for either of these views. I tend to simplify things, look to the roots of any subject and try to understand its fundamentals. Investing in stock markets is a business like any other business that has advantages and disadvantages. Those who are interested in stock markets must acquire a minimum level of knowledge and skills to enable their success.

The dramatic changes in stock prices may be the primary cause of misconceptions in some people that lead them to extreme stances on the stock markets. The sensitivity of stock markets to economic and political developments and the dramatic changes in stock prices are normal attributes of stock markets that cannot be ignored or avoided. It is better for investors to adapt to these attributes and try to build investment strategies that consider all factors, including market sensitivity and price volatility. However, before we examine investment strategies in greater depth, we must develop a better understanding of a stock, the stock market and investors.

What Is a Stock?

A stock, in a simple definition, is a small piece of a business; stock owners (also known as stockholders or shareholders) own a tiny portion of the company’s assets and earnings. A shareholder has the right to receive a portion of the company’s cash distribution and is entitled to vote on substantial issues related to business operations.

The Coca-Cola Company is a good example to demonstrate the meaning of a stock. Coca-Cola is a well-known beverage company that owns more than 500 nonalcoholic beverage brands. According to the financial results for 2013, Coca-Cola generated $47 billion in sales and approximately $8.6 billion in profit; the net assets of the company are approximately $33 billion, and the company is worth more than $180 billion.

It is too difficult for one investor or even a small group of investors to own such a giant company; even if they have sufficient wealth, because investors tend not to put all their eggs in one basket. It is much easier if the ownership of this company is divided into small pieces so that an ordinary investor can acquire a stake in such a large corporation. We call these small pieces stocks (or shares or equities). The total outstanding shares issued by Coca-Cola are 4.41 billion; thus, small investors can own a small piece of the company for only $41.30. This piece of the business represents $1.95 from the profits and $7.52 from the net assets.

This is a simple explanation of the meaning of stocks that we should always remember. However, if shares truly represent something of value and they are worth the money paid by investors to buy them, why has the negative impression of stocks and stock markets spread so broadly? The answer is simple: not all stocks are worth the money paid by investors to own them. In theory, investors should search for good stocks and pay a fair value to acquire them. However, not all investors are actually interested in the stocks of high-quality companies or even attempt to understand the concept of fair value; these investors are interested more in price appreciation instead.

Types of Investors

One subject in the investment world that is always discussed extensively is classification of investors. It became common to classify investors into two main groups: investors and traders. There are numerous distinctions between these groups in terms of their time horizon, method of analysis and the manner in which people perceive investment. According to the supporters of this classification, investors are those who are interested in the business itself and its future growth; thus, they tend to understand fundamentals and financial performance. Moreover, investors tend to hold stocks for long periods and pay less attention to market price volatility. Traders, conversely, are those who buy shares for the sake of future price appreciation. Traders are more interested in understanding the price behavior of a stock than the fundamentals of companies. In general, traders tend to hold stocks for relatively short periods; therefore, traders are sensitive to price volatility.

I tend to classify investors in a different manner; however, before going into further detail, we should first define an investor. An investor is the one who sacrifices cash in the present for the sake of future gains. This definition does not differentiate between those who rely on core fundamentals to make investment decisions and those who rely on their intuition to select and value stocks. This definition does not differentiate between those who hold shares for decades and those who buy and sell within the same day; anybody who puts up money for the sake of future returns is an investor.

Classifying investors into groups is one of the factors that help to build a better understanding of how stock prices behave. Investing in stock markets is not always centered on the underlying value of a business; not all investors are interested in buying shares below fair value. Therefore, we can see some shares that are first-class traded at low prices compared with their intrinsic value; we can even see shares of worthless companies that are bought and sold at very high levels. This is an important observation that must be properly explained and understood. To explain it better, we must classify investors who buy and sell stocks into groups. I believe that there are four groups investing in stock markets:

Value Investors

These are the type of investors who buy and hold stocks for long periods of time, meaning years or even decades. Value investors are interested in identifying first-class assets in which to store and grow their money. Therefore, value investors rely on core fundamentals for their investments: business models and the future of their selected companies. Value investors enjoy cash dividends, which may even be as important to them as salaries are to employees. Value investors buy into good companies; good companies hire competent executives who work day and night to run the business efficiently and effectively to achieve their ultimate goal, which is maximizing shareholders’ wealth. Value investors’ strategy to maximize returns and minimize risk is to identify good businesses that show their stability and demonstrate high growth potential and then buy shares at relatively low prices. Value investors retain the stock for long periods, watching the stock’s financial performance. Value investors sell the stock if the future is no longer promising or if they identify a better opportunity. Value investors generally do not care about price movement because they have a better ability to bear market crashes. In fact, market crises generate new investment