I invest long-term with the following 4 principles always in the front of my mind:
1. Stay Rational
Easier said than done when you are investing real money. Money you can't afford to lose tends to be 'hot' or emotional. Pro gamblers try to avoid sitting down with more than they can lose but anyone investing all of their own hard-earned money is always sitting down with more than they can lose. Fear of losing more than you can afford to lose tends to make the mind go irrational. You start guessing. You can't tell the difference between a good idea and a bad idea. Investing decisions are not life and death decisions (unless you've embezzled $100 million or so) but still, remaining rational in the face of intense emotions is an art that is learned in the trenches. They don't teach this at business school because they can't generate real emotions in a classroom setting. Staying rational is an art that the best investors in the world have learned. They have the ability to separate their emotions, block them off and operate on pure reason. If A, then B. If B, then C. Therefore, if A, then C. Using our rational mind is a huge advantage in a marketplace that dominated from time to time by irrationality.
2. Buy Fear, Sell Greed
When prices are set by the most fearful or the most greedy investors, those who are fully in the sway of emotion, its clear that the market prices are often far from rational. The big players in the market - mutual fund managers, pension fund managers, insurance fund managers and bank fund managers - are not the most cold-blooded rational creatures on the planet. Many of them got their jobs by political pull or a streak of good luck rather than any particular investing expertise. Their jobs depend on raising money rather than making it. They follow 'tried and true' investing strategies like diversification and rebalancing, strategies that guarantee mediocrity and market returns and which trickle off the tongue of the fund salesmen and administrators sweet as honey. But they know in their gut that they don't know what they are doing and when a stock begins to crash they stampede like the cattle they are because they know they can't get out quickly enough. Their only salvation lies in getting out before the rest of the herd. Losses don't matter. Only losses that are greater than the rest of the herd matter. Staying in the middle of the herd means safety. Lose money, but don't lose more than most and you'll be okay. And so the fear rises faster as the stock price slides that they will be the ones at the edge of the herd when they get to the cliff. My job is to buy from them as late in the stampede as I can manage. I buy fear. I fade greed.
3. Margin Of Safety
The three most important words in investing are margin of safety but there is a catch - you have to know the value of the business in order to know if its got a margin of safety. There are 3 main techniques I like to use to find the value of a business. 1) MOS analysis: Estimate the total pile of cash this business will earn in the future and discount it back to today with a reasonably conservative rate of return. I use 15%. (Note that the estimate of future cash is only necessary out 10-15 years because the current value of money you might get 20 years from now is near zero.) We have to be able to make a fairly solid estimate of that cash flow and we can't do that unless the business is a special type of business - a business that has products that don't have to change much. We call that a durable competitive advantage. Its akin to some sort of monopoly. If the business doesn't have that quality then how are you going to be able to estimate cash flow that far into the future with any hope of accuracy? And if you can't, how do you get to a value? That's why our universe of acceptable Rule #1 companies is small, not large. There aren't that many businesses that meet our requirement of Moat. Without moat there is no hope of estimating value accurately. And without knowing the value, a true margin of safety is not possible. 2) Payback Time analysis: Same issue but this time we just figure out how long it will be before we get our money back. If the time is short enough, we may be able to buy this business, take our money off the table and play with house money. That works too because risk goes to zero. Being able to calculate Payback Time means being able to buy more businesses than we can with a pure MOS analysis. 3) Owner Book Value or Tangible Book Value: Ben Graham made a career out of buying businesses at a fraction of tangible book value. Since he could only make an educated guess about which businesses would fail he bought a lot of them - about 200 or so - at a time to better his odds. Its a strategy we may become more familiar with if America continues its guns and butter economics to the point of total bankruptcy.
4. Drive Down Basis
This is the unsung hero of the Rule #1 saga: If you can lower your basis with cash flow from dividends (or buybacks or derivatives) your risk of being wrong goes down proportionately. If I buy KO at $65, sell puts and calls as appropriate and take the dividend in cash, within five years I can drive my basis down to $46. In that time, the dividend will rise from $2 to $3.20. My ROI on basis becomes $3.20/$46. About 7%. In tenth year the dividend is at $5.20, my basis is $25 and the return on cash goes to 21%. And each year thereafter the basis goes down as the cash comes in and the return on remaining cash goes up. When my basis goes to zero, where is my market risk? If I start spending the money to live on instead of reinvesting it, then the basis stays the same but the return still goes up because KO increases its dividend every year by 10%. In essence, I've created for my retirement a kind of special bond - one that is backed by one of the best companies in the world and yet pays out based on an ever increasing coupon rate, one that within ten years is over 20% a year and rising. No retiree with his money in that sort of a long bond will ever have to fear the effects of inflation on a fixed income because his income is rising faster than any sustainable inflation rate and his money is denominated in shares, not currency.
Keep these four things in mind the next time you are tempted to get emotional, follow the crowd into the hot stock, take a guess at the margin of safety price or spurn long-term investments.
Now go play.