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What you need to know in order to
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If you haven’t already, I advise pouring yourself a strong
cup of coffee to make it through today’s letter.
That’s because I’m going to, as briefly as possible, discuss
a concept that’s somewhat boring.
But it’s vital to understand this concept if you hope to
have any success with your investments. Understanding this concept will lead
you down the road to asking the right questions about where, when and how you
invest. It will give you a crystal clear understanding of the difference
between investing and speculation.
It won’t guarantee
success by any mean, but it will put you on the right path.
Investing without understanding this concept is like running
a 110 meter high hurdles race while wearing a blindfold and clown
shoes.
This concept is a prism that filters out every unimportant
external distraction.
I’m talking about the notion of “intrinsic value.”
For the record, I’m not talking about the philosophical idea
of intrinsic value, which is an idea that’s been debated since Plato’s time.
That’s certainly a topic worth consideration, and you can read all about it
by clicking
here.
But I’m talking about intrinsic value as it pertains to
investments and assets – which are quite differently valued than the
“intrinsic good” of the human experience.
The idea of financial intrinsic value can be summed up in a
few simple questions:
What is the real
worth of this investment or asset? If it’s a business does it produce
profits? If it’s an asset does it provide interest or serve some
purpose?
Most fundamental analysis is in some way used to try to find
the answers to these questions. The idea of looking at a Price to Earnings
ratio gives a one-dimensional snapshot of what you’re paying for a company’s
intrinsic value for a moment in time.
The interest rate advertised for your local bank’s savings
account gives you a look at the value of depositing your money there.
These types of “snapshots” are certainly useful, but they
only give you an answer for that brief moment. Savings account interest rates
can change daily. PE ratios change by the second.
At the very least,
you need to understand the underlying value of the investments and assets
you’re buying – even if it’s just a snapshot. If you don’t do this type of
basic research, then you are no longer an investor. You’re a speculator. A
speculator buys an asset because he believes it will go up in price.
An investor understands how and why he’ll see a return on
his capital. If it’s a business, he understands it. He knows how much cash
and debt the business holds. He understands how it generates profits. He
understands the products, the means of distribution, the market, and the
likelihood that it will continue to succeed. For instance: I own shares of
Exxon (NYSE: XOM).
I understand to the barrel how much energy resources Exxon
owns. I understand their profit margins. I know how much cash and debt they
have. I understand exactly how they get their product to market, and I also
happen to be a customer.
How am I getting a return on my capital? At the very least I
know Exxon has the cash on hand to pay dividends for a long, long time. I’m
not waiting for an aberration in the oil market to make Exxon’s shares
skyrocket. I own Exxon because it has the most oil of any publicly traded
company, and there’s no realistic alternative to oil in the marketplace. Oil
prices will likely continue to rise over my lifetime, and Exxon will remain
profitable.
If it’s an asset, an investor completely understands the
interest the asset generates or the service it performs in their portfolio.
For instance: I buy gold and silver as an insurance policy protecting my net
worth from the incidence of currency crisis. I don’t expect to “get rich”
owning physical gold and silver. I don’t expect it to pay me dividends or to
fuel my car either. I know exactly why I’m holding gold and silver, and I
know exactly when I plan on selling the bulk of it.
I don’t own diamonds or micro-cap technology stocks –
because I see no intrinsic value for diamonds at current prices (they’re just
shiny rocks that are made of one of the most common elements in the universe)
and I don’t have the time or ability to accurately value technology
stocks.
If I did purchase diamonds or technology stocks, it would be
a sheer speculation that they’ll go up in price. A hopeful guess.
Guesswork shouldn’t be any part of your investment thesis.
You need to know exactly what you’re investing in, how you’ll get paid back,
or what service the investment is providing.
Understand these ideas, and you’re already ahead of 90% of
other individual investors – not a bad place to start.
Good investing,
Kevin McElroy
Editor
Resource Prospector