If one is trading for rapid profits .....

If one is trading for rapid profits, one must concentrate in those stocks that will give one the action one seeks.

Safety in the trading should come not from the selection of "safe" stocks # :

• a slow mover or 
• a cheap issue or 
• worse yet, a group of such shares.   

Real Safety

Safety should be by concentration in the one outstanding, fast-trading leader that is jumping in the right direction.

There is more safety and more profit in so timing one's buying in the one outstanding, fast-trading leader type of issue that when one gets a report on the purchase,  the bid is then already in excess of what one has paid.

One cannot afford to be wrong in such a fast-moving issue and one is sure to be

• much more certain about one's opinion before one acts to get in than in the case of a slow issue, and 
• likewise much more watchful to get out quickly if the stock doesn't act as anticipated or reverses its action.  

Here is the real safety.

Here also is a chance to build a backlog of profit which is partly a safety fund against future errors.



Use of Margin

In the same way, a sizable position in an issue, even on margin if that is what the individual's situation calls for, is relatively safer than the imagined security of having something paid for and locked up.

One is more careful establishing the margin position and one watches it more carefully.



Final Message

In short, know you are right and go ahead.  If in doubt, stay out.




Additional Notes:

# The issue which is "safe" because it is low and cheap is ordinarily a poor mover, usually creeping or backing and filling without getting much of anywhere while the sensational trading moves are practically all in shares which have broken out of the accumulation stage.

# With regards to these "safe" stocks, it is likely to be most exasperating during a rising market when other shares are scoring rapid advances; and during a period of decline when one is long, then the slow action of the safe stock will lull one into a sense of false security.

"High Priced" versus "Low Priced" stocks

High Priced stocks may be undervalued

Frequently the highest per share prices represent the lowest total valuation for a company when price is multiplied by shares outstanding and compared with total earning power and other figures.


Why high priced stocks can be favourable?

I generally favour issues selling at high prices per share.

They are more often to be in the rapid-growth stage.

They are likely to have a better-grade following.

Think possible profits on percentage basis

One should regard one's possible profits more on a percentage basis than on an absolute dollar basis.

A move to $10 from $5, is $5, but certainly no one would think a move to $130 from $125, meant the same thing.

Traders will not see anything dangerous in the doubling of a low-priced share to 10, from 5, though they will avoid, fear, and occasionally, even sell short a stock that moves to 175 from 125, or $50, when an issue in that class actually would have to rise to $250 to double.

It is quite useful to have a logarithmic chart just as a reminder. 

A "log" chart shows such movements in proper scale and tends to temper the judgement.



High-Priced stocks very occasionally can be available at low prices

Very occasionally, once in a good many years, normally high-priced stocks can be bought for low prices. 

This is so obviously advantageous, if one has the cash at the time and the foresight.



Low Priced stocks with small capitalizations

Sometimes one can buy low-priced stocks of companies that also have small capitalizations, and realise some very amazing profits.  

However, it should be realised that the possibilities of selecting one of the few a make good, and selecting it at the right time, are quite slight.



Low-Priced stocks with large capitalizations

Low -priced shares with huge capitalizations are usually quite undesirable.

Always write down the reasons, pro and con, before making a purchase or a sale

Tip to the Investors:  Always Write it Down

Writing down your reasons for making an investment should save you in your investing.

What you expect to make?
What you expect to risk?
The reasons why?

Always write down the reasons, pro and con, before making a purchase or a sale.

• Major successes in some investors were invariably preceded by a type of written analysis.  
• Sudden emotional decisions have generally being disappointments.
• Writing things down before you do them can keep you out of trouble.  
• It can bring you peace of mind after you have made your decision.
• It also gives you tangible material for reference to evaluate the whys and wherefores of your profits or losses.

Quality Not Quantity

I have seen many analyses, some involving many pages of information.

In practice, quantity doesn't make quality.  

There is invariably one ruling reason why a particular security transaction can be expected to show profit.

• Writing it down will help you find it.
• It will help you judge whether it is really as important as your first inclination suggests.

Are you buying just because something "acts well"?

Is it a technical reason - 

• a coming increase in earnings or dividend not yet discounted in the market price, 
• a change of management,
• a promising new product, 
• an expected improvement in the market's valuation of earnings?

In any given case you will find that one factor will almost certainly be more important than all the rest put together.



Reward/Risk Ratio

Writing it down will help you estimate what you expect to make and it is important that this be worthwhile.

Of course, you will want to decide how much you can afford to lose.

There will be a level at which you will decide that things have not worked out and where you will sell.

Your risk is the difference between your cost and this sell point; it ought to be substantially less than your hopes for profit.

You certainly want to feel that the odds as you see them are in your favour.



Much More Difficult:  When to Sell

All this self-interrogation will help you immeasurably in the much more difficult decision:  when to close a commitment.

When you open a commitment, whether it is a purchase or a short sale, you are, so to speak, on your home ground.  Unless everything suits you, you don't play.

But when you are called upon to close a commitment, then you have to make decisions, whether you see the answer clearly or not (analogy:  being stuck on a railway crossing with the train approaching).

• You don't know what to do -but you have to do something.  
• Go backward, go forward - or jump out.

If you know clearly why you bought a stock it will help you to know when to sell it.  

• The major factor which you recognized when you bought a security will either work out or not work out.  
• Once you can say definitely that it has worked or not worked, the security should be sold.

One of the greatest causes of loss in security transactions is to open a commitment for a particular reason, and then fail to close it when the reason proves to be invalid.

• Write it down and you will be less likely to find yourself making irrelevant excuses for holding a security long after it should have been sold.
• Better still, a stock well bought is far more than half the battle.

Careful Investors look for Signs of Quality Management

One of the main factors determining the success of a corporation is the competence of management.

Buy into companies with "good management."


But in practice, how do you know?

• Ideally you begin by meeting management.  However, the door is open to very few and the ability to assess it is just as limited.
• The practical approach is to begin by looking at the record.

Practical Approach:  Looking at the Record

If a company's earnings are increasing, this is one piece of evidence pointing to good management.

• However, the results must be measured against others in the same industry.  
• Otherwise, a management which swims with a favourable tide may get more credit than it deserves.  

Often a superior management fighting bad conditions is unjustly criticized.


Type of Management Counts

Is the company in question headed by an old-fashioned entrepreneur who has made management a one-man show?

Or does it have good management in echelon depth which can survive the retirement or death of its chief executive?


Officers' shareholdings

One aspect of management worth noting is the extent to which the officers own their own shares.

Broadly speaking, it is advantageous for the officers to have a stake in ownership.

It makes a difference whether they own the stock

• because they want it or 
• because they are stuck with it.

You should consider whether they

• acquired it through inheritance, 
• bought it on option, or 
• bought it in the open market.  

Likewise, where possible, consider the purchase date and price paid.



Close Watch Pays Off

One of the many ways of making money in securities, is through a close watch on management.

Watch and understand the changes where companies have been in difficulty, their stocks depressed and general dissatisfaction expressed and where a new management comes in and invariably begins by sweeping out the accounting cobwebs.

• Everything is marked down or written off so that the new management is not held accountable for the mistakes of the old.  
• Very often dividends which were imprudently paid are cut or passed.  
• Thus an investor at this juncture often gets in at the bottom or the beginning of a new cycle.
• A recent example:  TESCO London.

Conclusion:

Attempting to evaluate management, even though you cannot get all the answers, is worth all the effort it entails.



Related post:

Management Compensation
https://myinvestingnotes.blogspot.com/2010/04/buffett-1994-in-setting-compensation-we.html

"Come Back" Fallacy

One quote often mentioned on many occasions is that "Stocks recover if held long enough."

The stock market is full of examples of stocks of investment grade that have never "come back."  Some have vanished entirely.




"Come Back" Fallacy

There are examples of many stocks that were prime investments in the past or were darlings of investors in the past.   They are now selling at a fraction of the prices they once commanded.  They have never "come back."

It should be realized that even when stocks do come back, the original investor benefits very little if it takes the stocks a long time (20 to 30 years) to do so.  During that period,

• his life, needs and desires have changed,
• the value of money has changed, and 
• in the meantime, other opportunities have slipped by.

The Better Approach

So, it is much better to accept a loss, if you can, while it is still moderate - say 10% or so. 

If the stock really runs away from you, usually it is better to take a substantial loss and start anew than to be tied hopelessly to something which you wouldn't buy if you had the cash.

"To buy low and sell high." Keep 2 important things in mind.

One common stock market "fallacy" is the way to make the most profit is "to buy low and sell high."

It is a beautiful idea if you can do it. 

The truth is, no one knows what is low or high.


Some examples:

• In the recent severe bear market in 2007, many people who saw their stocks decimated a great deal thought they were low.  They never dreamed they would go even lower.

• By the same token, once the stocks started to go up in 2009, many people said, "I wont be caught again; I won't buy them unless they are really cheap."  Of course, they have never been at those low levels since.  They never became "really cheap."

• I have seen people sell stocks which they thought were high, based on what they had been previously, and the stocks went higher and higher.  Then news became public that justified the rise, and what had seemed high previously didn't look high any more in the light of new developments.  

• The same works in reverse.  Perhaps a stock seems low in relation to its dividend.  It goes lower and lower.  Then the dividend is passed or cut and the supposed "bargain" is no bargain at all.

Keep 2 important points in mind


At some point, stocks are genuinely "low" or "genuinely "high."  You may be successful in knowing what that point is if you keep two things in mind.


1.   First, remember that stocks invariably become "undervalued" or "overvalued."

• They overshoot their logical goals or levels

2.  Next, be sure you feel you have a special reason for expecting a turn or change especially when you are trying to buy low.  

• You surely don't want to own a stock that is cheap enough - but stays cheap.  
• So you must feel that you can see improvement or recovery reasonably soon ahead.

Conclusions:

"Buy low, sell high" is one of those wonderful market fallacies or ideas which may work out well for those who can learn the ropes. 

It can be a rather expensive idea if it is just applied as a generalization.

How "safe is your money? Think about money from the standpoint of what you think it will buy now and later.

"Money is (always) safe"

Money is only good for what it will buy.

Its purchasing power has been decreasing steadily over the ages.

It certainly isn't safe in the sense intended by the hoarder or the frightened widow.




"Keep your money working"

This is just as much of a fallacy in its way as thinking that "Money is (always) safe."




Middle Path

You would do best steering a middle course.

Think about money from the standpoint of what you think it will buy now and later.

If you feel it will buy more later, hang on to it.

If you feel it will buy less,

• spend it for something you are intending to buy; or 
• invest it if you think investments will be more costly later.

Think of money as you do of anything else that fluctuates.

Switching Capital: Replace 10% of your diversified investments annually

These are three grim factors that can damage your investment performance:

• the wrong industry, 
• a weak management and 
• over-market pricing of transient growth or profits - 

Are you fast enough to switch capital?

Capital is like a rabbit - it darts away at the first sign of danger!

Are you certain you watch your capital closely enough to flee from smoke before it becomes fire?

To do this successfully you must not only be alert to change but ready and willing to act.




Keep your eyes on the businesses

It is up to you as an investor to

• watch the progress of your companies and 
• switch your investments if your managements fail to keep up with the changing time.  

It takes superior management to adopt to change.  

It takes superior management to build worthy successors to follow in their footsteps.




Replace 10% of your diversified investments annually

Investors should make a conscious effort to do some switching in their portfolios. 

I think at a minimum they could switch 10% of a list of diversified investments annually.

If you own 20 stocks, surely replacing 2 can only help in keeping your investment in step with constantly changing investment factors.

Additional notes:

Newsletters of the First National City Bank of New York.

It tabulated the changes which occurred among the hundred largest U.S. manufacturers between 1919 and 1963.

These largest corporations are not always the most profitable.

Sheer size gave no guarantee of profitability or permanence.

While almost invariably at some stage in their growth, these companies were attractive investments, there was danger if you overstay your market.

1919 list:   100 largest U.S. manufacturers

1963 list:   Only 49 left

Comparison of just these two dates ignored the turnover.  In the interim numerous firms entered and left the group.

Many companies produced a single spurt of growth which could not be sustained.

Many factors were responsible.  An unfavourable change in the outlook for their industries was the major cause.

It boiled down to the always prime factor of management.

The greatest changes were in transportation companies.  It was asking too much to profit from selling horses and buggies in a gasoline age.

The National City letter concluded that to achieve success and hold it, 

• corporations must secure a primary position in growing markets, and, 
• they must be adoptable enough to shift into new fields and open up and to fill new needs.

It is up to you as an investor to watch the progress of your companies and switch your investments if your managements fail to keep up with the changing times.

None Since 96!  (Morgan Guaranty survey of stocks in Dow Averages since 1896)

A Morgan Guaranty survey compared the stocks that had been part of the Dow Averages since 1896.

Continual evolution, shifting investor preferences and the alterations in the actual composition of business activity resulted in not a single issue remaining on the list for the entire 68-year period.

Only American Tobacco and General Electric were on the 1912 and 1964 list, but both were on and off several times.

One of the least reliable guides to investing is popularity.  

• The transportation industry at that period contributed many once-popular investments that had vanished and had all but done so.  
• The carnage in streetcar lines and other utilities had been enormous.  
• Likewise in early automobile leaders.

Investors should make a conscious effort to do some switching in their portfolio.

The three reasons that can damage your investment performance are the wrong industry, a weak second echelon in management and over-market pricing of transient growth or profits.

The intelligent and safe way to handle capital is to concentrate.

Diversification

The beginner in investing needs diversification until he learns the ropes.

Diversification is an admission of not knowing what to do and an effort to strike an average.



Concentration is the intelligent and safe way

The intelligent and safe way to handle capital is to concentrate.

If things are not clear, do nothing. 

When something comes up, follow it to the LIMIT.

If it is not worth following to the limit, it is not worth following at all.



How to start?

Always start with a large cash reserve.

Next, begin in one issue in a small way. 

If it does not develop, close out and get back to cash. 

But if it does do what is expected of it, expand your position in this one issue on a scale up. 

After, but not before, it has safely drawn away from your highest purchase price, then you might consider a second issue.




Greatest Safety:  Putting all your eggs in one basket and watching the basket

The greatest safety lies in putting all your eggs in one basket and watching the basket.

You simply cannot afford to be careless or wrong. 

Hence, you act with much more deliberation.

Of course, no thinking person will buy more of something than the market will take if he wants to sell, and here again, the practical test will force one into the listed leaders where one belongs. 

The less active a stock and the further distant the market, the more potential profit I need to see in it to make it worth buying.

It is purely a personal matter whether an investor feels that efforts at safety are more important than trying to get the maximum out of investing.



Stocks in the same business cycle

Diversification between the position of varying companies in their business cycle or as between their shares in their market price cycle is a very important consideration. 

Dividing one's funds between three or four different stocks which happen all to be in the same sector of their cycle can often be discouraging or dangerous.

After all, the final determinant of investment success or failure is market price.

• For example, industries which are in the final stages of a boom with rapidly increasing earnings, dividends and possibly split-ups, often offer shares high in price but apparently rapidly going higher.  There is a sound justification for an investor who knows what he is doing to buy into such a situation, especially for short-term gains, but it would be quite dangerous for him to put all of his funds in three or four such stocks.

• On the other hand, we naturally all seek deflated and cheap bargains, but very often shares like this will lie on the bottom much longer than we anticipate and if every share we own is in this same category, we may do very badly in a relatively good market.

Conclusions:

The greatest safety for the capable, lies in putting all one's eggs in one basket and watching the basket.  

The beginner and those who simply find their investment efforts unsuccessful must resort to orthodox diversification.

Greatest Care must be taken in Buying Convertible Bonds

Some common popular bonds in the market in recent years are the

• convertible issues and 
• bonds with warrants to buy stock attached.

Convertibles are popular because they seem under certain conditions to combine 

• a degree of bond dollar safety 
• with a chance of profit.

Profits can be made by careful selection, pricing and timing of these bonds.

Market price of convertible bonds

The market price of a convertible bond is a 

• combination of estimated true current investment value
• plus a premium for the current value of conversion privilege, if any.  

This premium varies with 

• the estimated opportunity to make a profit, 
• the length of time the privilege runs and 
• other factors.

The greatest care must be taken in buying convertibles.

The most common mistake is to look too closely into 

• the size of the premium or 
• the closeness of the conversion price on the bond to the current market for the stock into which it can be converted.

You should look first into the stock for which it can be exchanged.

• If you care to make a profit, this must go up.  
• You must start by being fundamentally bullish on the equity.  
• Only then can you look into the mathematical factors governing the price of the convertible bond.

An Ever-Liquid Account (Concept)

An Ever-Liquid Account

In its operation, an ever-liquid account is normally kept fully un-invested; i.e., in cash or equivalent only. "Equivalent" means any kind of really liquid short-term security or commercial paper.

Book values and market values are always kept identical.

Income is real income; i.e., interest, dividends, capital gains realized and realizable, less capital losses taken or unrealized in the account, which is always marked to market.




Cash and Equivalent (Beginning of period)

add Income:  
interest
dividends
capital gains realized
capital gains realizable

less losses:
capital losses taken
capital losses unrealized in the account


Cash and Equivalent (End of period)




How to keep the account truly ever-liquid?

Income and appreciation are obtained in the ever-liquid account by entering the stock market as a buyer when a situation and trend seem clearly enough established so that a paper profit is present immediately after making the purchase.

In order to keep the account truly ever-liquid, one must use a mental or an actual stop on all commitments amounting to some predetermined percentage of the amount invested (e.g. 3% stop loss or 10% stop loss).

One does not make a purchase unless one feels rather sure that the trend is sufficiently well established to minimize the possibility of being stopped out.  Yet it will happen occasionally anyway.

The decision of what and when to buy is made on a personal basis using various yardsticks best understood by individual investors.




Concentrated purchases of single issues

This investment philosophy leads into concentrated purchases of single issues rather than diversification, because one of the primary elements in the situation is that one must know and be convinced of the rightness of what one is doing.  

Diversification as to issue and type of investment is only hedging - a method of averaging errors or covering up lack of judgement.




Profiting from trends and pyramiding

This ever-liquid method also rarely calls for attempts to buy at the bottom, as bottoms and tops are actually impossible to judge ordinarily, while trends after they are established and under way can be profitably recognized. 

It is a method that leans towards pyramiding; i.e., towards following up gains and retreating before losses.  Such an account, properly handled, bends but never breaks. 

"Averaging down" is, of course, completely against this theory.

With mistakes, there is no cheaper insurance than accepting a loss quickly

Nevertheless, in investing, mistakes will be made.

And when they are, there is no cheaper insurance than accepting a loss quickly.  

That is the tactic of retreat than capitulation.



Serial losers

It would be very difficult for an investor losing, say, 5% to 10% each time on a succession of ventures, to continue to lose time and time again without checking his errors or stopping altogether.



Long term hold irregardless

A buyer who holds regardless of unfavourable news or action can become involuntarily locked in his "investment" for years and often, no amount of future waiting can extract him from his predicament.

It is important to regard the situation with an open mind, unbiased by a bad stale position, and it is important to be able to act each time convictions are very strong.

Unless losses are cut, such an attitude and such action are impossible.

Psychology and Investing: Herding

Stock Ideas

There are thousands and thousands of stocks out there.  Investors cannot know them all.

In fact, it is a major endeavor to really know even a few of them.

But people are bombarded with stock ideas from brokers, television, magazines, Web sites, and other places.





Herding Behaviour

Inevitably, some decide that the latest idea they have heard is better idea than a stock they own (preferably one that is up, at lead), and they make a trade.

In many cases the stock has come to the public's attention

• because of its strong previous performance, 
• not because of an improvement in the underlying business.

Following a stock tip, under the assumption that others have more information, is a form of herding behaviour.





Temporary Comfort from investing with the Crowd or a Market Guru

This is not to say that investors should necessarily hold whatever investments they currently own.

Some stocks should be sold, whether because

• the underlying businesses have declined or 
• their stock prices simply exceed their intrinsic value.

But it is clear that many individual (and institutional) investors hurt themselves by making too many buy and sell decisions for too many fallacious reasons.  

We can all be much better investors when we learn to select stocks carefully and for the right reasons, and then actively block out the noise.

Any temporary comfort derived from investing with the crowd or following a market guru can lead to fading performance or inappropriate investments for your particular goals.

Psychology and Investing: Mental Accounting and Framing Effect

Most of us separate our money into buckets - this money is for the kids' college education, this money is for our retirement, this money is for the house.   Heaven forbid that we spend the house money on a vacation.

Investors derive some benefits from this behaviour.

• Earmarking money for retirement may prevent us from spending it frivolously.

Mental accounting becomes a problem, though, when we categorize our funds without looking at the big picture.

• While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as "found money" to be spent more frivolously.  
• Since tax refunds are in fact our earned income, they should not be considered this way.
• For gamblers, this effect can be referred to as "house money."

We are much more likely to take risks with house money than with our own.

• There is a perception that the money isn't really ours and wasn't earned, so it is okay to take more risks with it.  
• This is risk we would be unlikely to take if we would spent time working for that money ourselves.

In investing, just remember that money is money, no matter whether the funds in a brokerage account are derived from hard-earned savings, an inheritance or realized capital gains.




Framing Effect

This is one other form of mental accounting.

The framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect decision.





Overcoming Mental Accounting.

The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments.

Take care not to think of your "budget buckets" so discretely that you fail to see how some seemingly small decisions can make a big impact.

Psychology and Investing: Confirmation Bias and Hindsight Bias

Confirmation Bias

How do we look at information?

Too often we extrapolate our own beliefs without realizing it and engage in confirmation bias, or treating information that supports what we already believe, or want to believe, more favourably.

If we have purchased a certain stock in a certain sector, we may overemphasize positive information about the sector and discount whatever negative news we hear about how these stocks are expected to perform.


Hindsight Bias

This is the tendency to re-evaluate our past behavior surrounding an event or decision knowing the actual outcome.

Our judgment of a previous decision becomes biased to accommodate the new information. 

For example, knowing the outcome of a stock's performance, we may adjust our reasoning for purchasing it in the first place. 

This type of "knowledge updating" can keep us from viewing past decisions as objectively as we should.

Psychology and Investing: Anchoring

When estimating the unknown, we cleave to what we know.

Investors often fall prey to anchoring.

They get anchored on their own estimates of a company's earnings, or on last year's earnings.

For investors, anchoring behaviour manifests itself in placing undue emphasis on recent performance since this may be what instigated the investment decision in the first place.

When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to "break even" or get back to what we paid for it.

We may cling to sub-par companies for years, rather than dumping them and getting on with our investment life.

It is costly to hold on to losers, though, and we may miss out on putting those invested funds to better use.



Overcoming Anchoring

It may be helpful to ask yourself the following questions about your stocks:

Would I buy this investment again?

And if not, why do I continue to own it?

Truthfully answering these questions can help you severe the anchors that may be a drag on your rational decision making.

Psychology and Investing: Sunk Costs

Sunk cost fallacy is another factor driving loss aversion.

This theory states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.

Our inability to ignore the sunk costs of poor investments causes us to fail to evaluate the situation on its own merits.

Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses.    

[?Had the dropping stock been a gift, perhaps we wouldn't hang on quite so long.]

Psychology and Investing: Loss Aversion

Loss Aversion

Many investors will focus obsessively on one investment that is losing money, even if the rest of their portfolio is in the black.  This behaviour is called loss aversion.

Investors have been shown to be more likely to sell winning stocks in an effort to "take some profits," while at the same time not wanting to accept defeat in the case of the losers.

"More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other since reason." (Philip Fisher, Common Stocks and Uncommon Profits).

Regret also comes into play with loss aversion.

This may lead us to be unable to distinguish between a bad decision and a bad outcome.

"We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons.  In this case, regret can lead us to make a bad sell decision, such as selling a solid company at a bottom instead of buying more."

We tend to feel the pain of a loss more strongly than we do the pleasure of a gain. 

It is this unwillingness to accept the pain EARLY that might cause us to "ride losers too long" in the vain hope that they'll turn around and won't make us face the consequences of our decisions.

Psychology and Investing: Self-handicapping

Self-handicapping bias occurs when we try t o explain any possible future poor performance with a reason that may or may not be true.

This behaviour could be considered the opposite of overconfidence.

As investors, we may also succumb to self handicapping, perhaps by admitting that we didn't spend as much time researching a stock as we normally had done in the past, just in case the investment doesn't turn out quite as well as expected.

Both overconfidence and self-handicapping behaviours are common among investors, but they aren't the only negative tendencies that can impact our overall investing success.

Psychology and Investing: Selective Memory, Cognitive dissonance and Representativeness

Selective Memory

Few of us want to remember a painful event or experience in the past, particularly one that was of our own doing.

In terms of investments we certainly don't want to remember those stock calls that we missed (had I only bought eBay in 1998), much less those that proved to be mistakes which ended in losses.

Such memories threaten our self-image.



Cognitive dissonance

How can we be such good investors if we made those mistakes in the past?

Instead of remembering the past accurately, in fact, we will remember it selectively so that it suits our needs and preserves our self-image.

Incorporating information in this way is a form of correcting for cognitive dissonance, as well-known theory in psychology.

Cognitive dissonance posits that we are uncomfortable holding two seemingly disparate ideas, opinions, beliefs, attitudes, or in this case, behaviours, at once, and our psyche will somehow need to correct for this.

"Perhaps it really wasn't such a bad decision selling that stock?"

"Perhaps, we didn't lose as much money as we thought?"

Over time, our memory of the event will likely not be accurate but will be well integrated into a whole picture of how we need to see ourselves.



Representativeness

Another type of selective memory is representativeness, which is a mental shortcut that causes us to give too much weight to recent evidence - such as short-term performance numbers - and too little weight to the evidence from the more distant past.  As a result, we will give too little weight to the real odds of an event happening.

Psychology and Investing: Overconfidence

Overconfidence refers to our boundless ability as human beings to think that we are smarter or more capable than we really are.

Such optimism isn't always bad.  Certainly we would have a difficult time dealing with life's many setbacks if we were die-hard pessimists.

However, overconfidence hurts us as investors when we believe that we are better able to spot the next Microsoft than another investor is.  Odds are, we are not.

Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade.  Trading rapidly costs plenty and rarely rewards the effort.  Trading costs in the form of commissions, taxes, and losses on the bid-ask spread have been shown to be a serious damper on annualized returns.  These frictional costs will always drag returns down.

One of the things that drive rapid trading, in addition to overconfidence in our abilities, is the illusion of control.  Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental, as studies of rapid trading have demonstrated.

What Matters and What Doesn't

It is very easy for new stock investors to get started on the wrong track by focusing only on

• the mechanics of trading or 
• the overall direction of the market.

To get yourself in the proper mind-set, tune out the noise and focus on studying individual businesses and their ability to create future profits.

Begin to build the skills you will need to become a successful buyer of businesses.



1.  Investing does not equal trading

Investing is like a chess game, where thought, patience, and the ability to peer into the future are rewarded.

Making the right moves is much more important than moving quickly.



2.  Investing means owning businesses

If you are buying businesses, it makes sense to think like a business owner. 

This means

• learning how to read financial statements, 
• considering how companies actually make money, 
• spotting trends, and 
• figuring out which businesses have the best competitive positions.  

It also means coming up with appropriate prices to pay for the businesses you want to buy. 

Notice that none of this requires lightning-fast reflexes.

You should also buy stocks like you would any other large purchase:  with lots of research, care and the intention to hold as long as it makes sense.

Investing is an intellectual exercise, but one that can have a large payoff.



3.   You buy stocks, not the market

One thing to remember when listening to market premonitions is that stock investing is about buying individual stocks, not the market as a whole.

If you pick the right stocks, you can make money no matter what the broader market does.

Another reason to heavily discount what the prognosticators say is that correctly predicting market movements is nearly impossible.

• No one has done it consistently and accurately.  
• There are just too ma y moving parts, and too many unknowns.

By limiting the field to individual businesses of interest, you can focus on what you can actually own while dramatically cutting down on the unknowns.  

You can save a lot of energy by simply tuning out market predictions.

With so many predictions about the stock market floating around, simple statistics says there are bound to be a handful of them that come true.  When thinking about this, it is helpful to remember the saying: "A broken clock is correct twice a day."

Stocks are volatile.  Why is that?  Does the value of any given business really change up to 50% year-to-year?   "Mr. Market" tends to be a bit of an extremist in the short term, overreacting to both good and bad news.



4.  Competitive Positioning is most important

Future profits drive stock prices over the long term, so it makes sense to focus on how a business is going to generate those future earnings.

Competitive positioning or the ability of a business to keep competitors at bay, is the most important determinant factor of future profits.

Competitive positioning is

• more important than the economic outlook,
• more important than the near-term flows of news that jostles stock prices and 
• even more important than management quality at a company.

Time is a precious resource in investing.

Business economics trump management skill.

A company with the best competitive positioning is going to create the most value for its shareholders.




Summary:


Active traders have three things working against them:  the bid/ask spread, commissions and taxes.

Stocks are not just pieces of paper to be traded; they are pieces of businesses.

The stock market as a whole is nearly impossible to predict, but predicting the outcome of individual businesses is a more manageable exercise.

Mr. Market is highly temperamental, over-reacting to both good and bad news.

Future profits drive stock prices over the long term, and the competitive positioning of a business is the most important factor in its ability to generate future earnings.

My Golden Rule of Investing

My Golden Rule of Investing: 
Companies that grow revenues and earnings will see share prices grow over time.

• Over the long term, when companies perform well, their shares will do so too.  
• When a company's business suffers, the stock will also suffer.

For examples:

Starbucks has had phenomenal success at turning coffee - a simple product that used to be practically given away - into a premium product that people are willing to pay up for.  Starbucks has enjoyed handsome growth in number of stores, profits and share price.  Starbucks also has a respectable return on capital of near 11% today.

Meanwhile, Sears has languished.  It has had a difficult time competing with discount stores and strip malls, and it has not enjoyed any meaningful profit growth in years.  Plus, its return on capital rarely tops 5%.  As a result, it stock has bounced around without really going anywhere in decades.




Over the long term

Over the long term, when a company does well, your interest in that company will also do well.

Stocks are ownership interests in companies.  Being a stockholder is being a partial owner of a company.

Over the long term, a company's business performance and its share price will converge.

The market rewards companies that earn high returns on capital over a long period.

Companies that earn low returns may get an occasional bounce in the short term, but their long-term performance will be just as miserable as their returns on capital.

The wealth a company creates - as measured by returns on capital - will find its way to shareholders over the long term in the form of dividends or stock appreciation.

The market frequently forgets the important relationship between Return on Capital and Return on Stock

Return on Capital

Return on capital is a measure of a company's profitability.

                Return on Capital = Profit / Invested Capital


Return on Stock

Return on stock represents a combination of dividends and increases in the stock price (capital gains).

                Stockholder Total Return = Capital Gains + Dividends




The important relationship between Return on Capital and Return on Stock

The market frequently forgets the important relationship between return on capital and return on stock.

A company can earn a high return on capital, but the shareholders could still suffer if the market price of the stock decreases over the same period.

Similarly, a terrible company with a low return on capital may see its stock price increase

• if the firm performed less terribly than the market had expected, or,  
• maybe the company is currently losing lots of money, but investors have bid up its stock in anticipation of future profits.

Short run

In the short term, there can be a disconnect between

• how a company performs and 
• how its stock performs.

This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create.

Sometimes this perception is spot on; sometimes it is way off the mark.



Long run

But over a longer period of time, the market tends to get it right, and the performance of a company's stock will mirror the performance of the underlying business.




The Voting and Weighing Machines

The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine - tallying which firms are popular and unpopular.  But in the long run, the market is like a weighing machine - assessing the substance of a company.




Message

What matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion about its prospects in the short run.

Why Stocks Perform the Best

Why, exactly, have stocks been the best-performing asset class?

Why should we expect those types of returns to continue?

Why should we expect history to repeat?



Answers

Quite simply, stocks allow investors to own companies that have the ability to create enormous economic value.

Stock investors have full exposure to this upside.

Because of the risk, stock investors also require the largest return compared with other types of investors before they will give their money to companies to grow their businesses.

More often than not, companies are able to generate enough value to cover this return demanded by their owners.

Bond investors do  not reap the benefit of economic expansion to nearly as large a degree. 

When you buy a bond, the interest rate on the original investment will never increase. 




Microsoft in 1985:  Buy its bonds or its stocks?

For instance, in 1985,

• would you have rather lent Microsoft money at a 6% interest rate, or 
• would you have rather been an owner, seeing the value of your investment grow several-hundred fold?

Your theoretical loan to Microsoft yielding 6% would have never yielded more than 6%, no matter how well the company did.

Being an owner certainly exposes you to greater risk and volatility, but the sky is also the limit on the potential return.

It is important to have a long-term investment horizon when getting started in stocks.

Time is on Your Side

Just as compound interest can dramatically grow your wealth over time, the longer you invest in stocks, the better off you will be.

With time,

• your chances of making money increases, and 
• the volatility of your returns decreases.

The Longer you invest, the Lower the Volatility of your Returns

The average annual return for the S&P 500 stock index for a single year has ranged from -39% to +61%, while averaging 13.2%.

After holding stocks for 5 years, average annualised returns have ranged from -4% to +30%, while averaging 11.9%.

If your holding period is 20 years, you never lost money, with 20-year returns ranging from +6.4% to +15%, with the average being 9.5%.


These returns easily surpass those you can get from any of the other major types of investments.




The Importance of having a Long-term Investment Horizon in Stocks

Again, as your holding period increases,

• the expected return variation decreases, and 
• the likelihood for a positive return increases.  

This is why it is important to have a long-term investment horizon when getting started in stocks.





Summary


While stocks make an attractive investment in the long run, stock returns are not guaranteed and tend to be volatile in the short term.


We do not recommend that you invest in stocks to achieve your short-term goals.


To be effective, you should invest in stocks only to meet long-term objectives that are at least 5 years away.


The longer you invest, the greater your chances of achieving the types of returns that make investing in stocks worthwhile.




Additional notes:

Though stocks typically perform best over the long term, there can be extended periods of poor performance.  

For example, the DJIA peaked in 1966 and didn't surpass its old high again until 16 years later in 1982.  But the following 20 years were great for stocks, with the Dow increasing more than tenfold (10x) by 2002.

Volatility of the Stock Market

One way of reducing the risk of investing in individual stocks is by holding a larger number of stocks in a portfolio.

However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly.

• You may experience large losses over short periods.
• Market dips, sometimes significant, are simply part of investing in stocks.

Yearly Market Fluctuations

The yearly returns in the stock market also fluctuate dramatically.  

The highest one-year rate of return of +67% occurred in 1933, while the lowest one-year rate of return of -53% occurred in 1931. 

It should be obvious by now that stocks are volatile, and there is significant risk if you CANNOT RIDE OUT MARKET LOSSES IN THE SHORT TERM.




The Bright Side of this Story

But don't worry; there is a bright side to this story.

Despite all the short-term risks and volatility, stocks as a group have had the highest long-term returns of any investment type.  

This is an incredibly important fact!

• When the stock market has crashed, the market has always rebounded and gone on to new highs. 
• Stocks have outperformed bonds on a total real return (after inflation) basis, on average.  

This holds true even after market peaks.

If you had deplorable timing and invested $100 into the stock market during any of the seven major market peaks in the 20th century, that investment, over the next 10 years, would have been worth $125 after inflation, but it would have been worth only $107 had you invested in bonds, and $99 if you had purchased government Treasury bills.

In other words, stocks have been the best-performing asset class over the long term, while government bonds, in these cases, merely kept up with inflation.

This is the whole reason to go through the effort of investing in stocks.

• Even if you had invested in stocks at the highest peak in the market, your total after-inflation returns after 10 years would have been higher for stocks than either bonds or cash.
• Had you invested a little at a time, not just when stocks were expensive but also when they were cheap, your returns would have been much greater.

Volatility of Single Stocks

Volatility of Single Stocks

Individual stocks tend to have highly volatile prices.

The returns you might receive on any single stock may vary wildly.



Best Performing Stocks

If you invest in the right stock, you could make bundles of money.

• For instance, Eaton Vance, an investment-management company, has had the best-performing stock for almost 25 years.  If you had invested $10,000 in 1979 in Eaton Vance, assuming you had reinvested all dividends, your investment would have been worth $10.6 million by December 2004.

Worst Performing Stocks

On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment.

• There are hundreds of dot-com investments that went bankrupt or are trading for a fraction of their former highs in early 2000.

• Even established, well-known companies such as Enron, WorldCom and Kmart filed for bankruptcy and investors in these companies lost everything.

All Stocks in Between these two Extremes

Between these two extremes is the daily, weekly, monthly and yearly fluctuation of any given company's stock price.

• Most stocks won't double in the coming year, nor will many go to zero.

• But the average difference between the yearly high and low stock prices of the typical stock on the NYSE is nearly 40%.

Stocks that don't perform over Long Time

In addition to being volatile, there is the risk that a single company's stock price may not increase significantly over time. 

• In 1965, you could have purchased General Motors' stock for $50 per share (split adjusted).  By May 2005 (4 decades later), your shares of General Motors would be worth only about $30 each.  Though dividends would have provided some ease to the pain, General Motors' return has been terrible.  
• You would have been better off if you had invested your money in a bank savings account instead of General Motors' stock.

All your Eggs in a Single Basket

Clearly, if you put all of your eggs in a single basket, sometimes that basket may fail, breaking all the eggs.

Other times, that basket will hold the equivalent of a winning lottery ticket.

With compound interest, the last few years of compounding make the most difference.

The 3 components that determine how much money you will have in the future are:

1.  the amount of money invested,
2.  the length of time invested, and
3.  the rate of return.

The earlier you invest, the more you invest, and the higher the rate of return, the more money you will have in the future.

The primary attraction to investing in stocks is that the long-run rate of return is higher than the interest earned in bank accounts or bonds.

With compound interest, the last few years of compounding make the most difference.




Additional notes:

The rule of 72 is an easy rule of thumb that tells you how often your money doubles.  Divide 72 by the percentage rate of return to determine the number of years required for your money to double at that rate of return.

Why Invest in Stocks?

Why stocks?

Stocks are but one of many possible ways to invest your hard-earned money.

Why choose stocks instead of other options, such as bonds, real estates, bank savings accounts, rare coins, or antique sports cars?

The reason that savvy investors invest in stocks is that they provide the highest potential returns.

Over the long term, no other type of investment tends to perform better.



Downside

On the downside, stocks tend to be the most volatile investments.

This means that the value of stocks can drop in the short term.

Sometimes stock prices may fall for a protracted period.

Bad luck or bad timing can easily sink your returns, but you can minimise this by taking a long-term investing approach.



Returns

There is also no guarantee you will actually realize any sort of positive return.

If you have the misfortune of consistently picking stocks that decline in value, you can lose money, even over the long term!



Education

By educating yourself, you can make the risk acceptable relative to your expected reward.

With knowledge, you can pick the right businesses to own and to spot the ones to avoid.

This effort is well worth it, because over the long haul, your money can work harder for you in equities than in just about any other investments.








Additional notes:

A slightly higher return in your investments can lead to dramatically larger dollar sums for whatever your financial goals in life may be,

Investing in stocks is an intellectual exercise and requires effort, but it is an effort that can bear many fruits.

Among the potential investments one can make, stocks provide the largest long-term returns, but they also have the largest volatility.

Stocks are ownership interests in companies.  They are not simply pieces of paper to be traded.

Understanding Your Circle of Competence

If Buffett cannot understand a company's business, then it lies beyond his circle of competence and he won't attempt to value it.

He famously avoided technology stocks in the late 1990s in part because he had no expertise in technology.

On the other hand, Buffett continued to buy and hold what he knew.

Although it might seem obvious that investors should stick to what they know, the temptation to step outside one's circle of competence can be strong.

Buffett has written that he isn't bothered when he misses out on big returns in areas he doesn't understand, because investors can do very well (as he has) buy simply avoiding big mistakes.

He believes that what counts most for investors is not so much what they know but how realistically they can define what they don't know.

Concentrating on Your Best Ideas

Buffett has difficulty finding understandable businesses with sustainable competitive advantages and excellent managers that also sell at discount to their estimated fair values.

Therefore, his investment portfolio has often been concentrated in relatively few companies.

Buffett rejects the idea that diversification is helpful for the INFORMED investors.

On the contrary, he thinks the addition of an investor's 20th favourite holding is likely to lower returns and increase risk compared with simply adding the same amount of money to the investor's top choices.

Successful investing requires the rare ability to identify and overcome one's own psychological weaknesses.

Successful investing is hard, but it doesn't require genius.

Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

Successful investing requires the rare ability to identify and overcome one's own psychological weaknesses.

Behavioural finance attempts to explain why people make financial decisions that are contrary to their own interests.

Behavioural finance has a lot to offer in terms of understanding psychology and the behaviour of investors, particularly the mistakes that they make.  

Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behaviour might move the market.

We can also focus on how the insights from the field of behavioural finance can benefit individual investors.  Primarily, we are interested in how we can learn to spot and correct investing mistakes in order to yield greater profits.


Some insights one can focus on in behaviour finance are:

• Overconfidence
• Selective Memory
• Self-Handicapping
• Loss Aversion
• Sunk Costs
• Anchoring
• Confirmation Bias
• Mental Accounting
• Framing Effect
• Herding

Non-Market Risk and a Concentrated Portfolio

Holding a concentrated portfolio is not as risky as one may think.

Just holding 2 stocks instead of 1, eliminates 46% of your unsystemic risk.

Holding only 8 stocks will eliminate about 81% of your diversifiable risk.


What about the range of returns?

Average return of the stock market during one period examined was about 10%.

Statistically, the one-year range of returns for a market portfolio (holding scores of stocks) in this period was between -8% and +28% about two-thirds of the time.  One-third of the time, the returns fell outside this 36-point range.

If your portfolio is limited to only 5 stocks, the expected return remains 10%, but your one-year range expands to between -11% and +31% about two-thirds of the time.

If there are 8 stocks, the range is between -10% and +30%.


Conclusion

It takes fewer stocks to diversify a portfolio than one might intuitively think.

Circle of Competence and Sector Concentration.

If you are investing within your cicle of competence, your stock selections will gravitate toward certain sectors and investment styles.

Following the fat-pitch strategy, you will naturally be overweight in some areas you know well and have found an abundance of good businesses.

Likewise, you may avoid other areas where you don't know much or find it difficult to locate good businesses.

However, if all your stocks are in one sector, you may want to think about the effects that could have on your portfolio.

Portfolio Weighting

It is important to know:

1.  how many stocks to own in your portfolio, and also,
2.  the percentage of your portfolio occupied by each stock.

A good investor has a knack for having a greater percentage of their money in stocks that do well and a lesser amount in their bad picks.


How does he do it?

Essentially, a portfolio should be weighted in direct proportion to how much confidence you have in each pick.

If you have a lot of confidence in the long term outlook and the valuation of a stock, it should be weighted more heavily than a stock than a stock you may be taking a flier on.


Weight your portfolio wisely.

Don't be too afraid to have some big weightings, but be certain that the highest-weighted stocks are the ones you feel the most confident about.

Of course, do not go off the deep end by having, for example, 50% of your portfolio in a single stock.



Additional notes:

If a stock has a 10% weighting in your portfolio, then a 20% change in price will move your overall portfolio 2%.

If a stock has only a 3% weighting, a 20% price change has only a 0.6% effect on your portfolio.

The Appropriate Attitude towards Market Prices

Once Mr. Buffett has decided that he is competent to evaluate a company, that the company has sustainable advantages and that it is run by commendable managers, then he still has to decide whether or not to buy it.



To buy or not to buy:  This step is the most crucial part of the process.

The decision process seems simple enough:  If the market price is below the discounted cash flow calculation of fair value, then the security is a candidate for purchase.

The available securities that offer the greatest discounts to fair value estimates are the ones to buy.

However, what seems simple in theory is difficult in practice.

• A company's stock price typically drops when investors shun it because of bad news.  So a buyer of cheap securities is constantly swimming against the tide of popular sentiment.
• Even investments that generate excellent long-term returns can perform poorly for years.  [In fact, Buffett wrote an article in 1979 explaining that stocks were undervalued, yet the undervaluation only worsened for another three years.]
• Most investors find it difficult to buy when it seems that everyone is selling and difficult to remain steadfast when returns are poor for several consecutive years.

The appropriate attitude toward market price

Buffett credits his late friend and mentor, Benjamin Graham, with teaching him the appropriate attitude toward market prices.

Graham's parable:  "Imagine the daily quotations as coming from Mr. Market, your very temperamental partner in a private business.  Each day he offers you a price for which he will buy your share of the business or for which you can buy his share of the business.  On some days he is euphoric and offers you a very high price for your share.  On other days he is despondent and offers a very low price.  Mr. Market doesn't mind if you abuse or ignore him - he will be back with another price tomorrow."




The most important thing to remember about Mr. Market.

He offers you the potential to make a profit, but he does not offer useful guidance.

If an investor cannot evaluate his business better than Mr. Market, then the investor doesn't belong in that business.

Thus, Buffett invests only in predictable businesses that he understands, and he ignores the judgement of Mr. market (the daily market price) except to take advantage of Mr. Market.

Wide Moat Companies: Fat Pitch Approach and Low Turnover of Portfolio.

Fat Pitch method.

Great companies (wide-moat) selling at a discount are rare. So when you find one, you should pounce.

Over the years, a wide-moat company will generate returns on capital higher than its cost of capital, creating value for shareholders.

 This shareholder value translates into a higher stock price over time.




Move In and Out of Wide-Moat Stocks

IF YOU SELL AFTER MAKING A SMALL PROFIT, you might not get another chance to buy the stock, or a similar high-quality stock, for a long time.

For this reason, it is irrational to quickly move in and out of wide-moat stocks and incur transactions costs ( and also capital gain taxes in some countries).

 Your results after trading expenses (and taxes), likely won't be any better and may be worse.




Low Turnover

That is why many of the great long-term investors display low turnover in their portfolios.

 They have learned to LET THEIR WINNERS RUN AND TO THINK LIKE OWNERS, NOT TRADERS.

Stocks are ownership interests in companies.

Being a stockholder is being a partial owner of a company.

Over the long term, a company's business performance and its stock price will converge.

The market rewards companies that earn high returns on capital over a long period.

Companies that earn low returns may get an occasional bounce in the short term, but their long-term performance will be just as miserable as their returns on capital.

The wealth a company creates - as measured by returns on capital - will find its way to shareholders over the long term in the form of dividends or stock appreciation.



My favourite financial ratios: ROA, ROE and ROIC.

Using Earnings Power Value (EPV) to weigh up the value of a share

Earnings Power Value (EPV) is another way to weigh up the value of a share.

EPV gives you an estimated value of a share if its current cash profits stay the same forever.



Calculating EPV

This is how you calculate it.

1.  Take a company's normalised or underlying trading profits or EBIT.

2.  Add back depreciation and amortization.

3.  Take away stay in business capex.

4.  Tax this cash profit number by the company's tax rate.

5.  Divide by a required interest rate# to get an estimate of total company or enterprise value.

6.  Take away debt, pension fund deficit, preferred equity and minority intersts to get a value of equity.  Add any surplus cash.

7.  Divide by the number of shares in issue to get an estimate of EPV per share.



#What interest rate should you use when valuing a business?

All you need to know is that the higher the interest rate you use, the more conservative your estimate of value will be.

Here are some rough and ready guidelines of the interest rates you might want to use when valuing different companies:

• Large and less risky companies:  7% to 9%
• Smaller and more risky (lots of debt or volatile profits):  10% to 12%
• Very small and very risky:  15% or more.

Compare your estimate of EPV per share with the current share price.  

1.   Current Share Price > EPV

For example:
                      EPV per share                    151.4
                      Current Share Price            320 

We can see that the estimate of EPV accounts for less than half of the existing share price.

• A large chunk of the current 320 price is based on the expectation of future profit growth.  

2.   Current Share Price < EPV

EPV can be a great way of spotting very cheap shares. 

Sometimes it is possible to find shares which are selling at a significant discount to their EPV.

• When you come across a share like this, you need to spend time considering whether its current profits can stay the same, or whether they are likely to fall.  
• If profits are likely to fall, it might be best to move on and start looking at other shares.

To minimise the risk of overpaying for a company's shares, you should try to buy when its current profits - its EPV - can explain as much of the current share price as possible.

• As a rough rule of thumb, even if profits and cash flows have been growing rapidly, do not buy a share where more than half its share price is reliant on future profits growth.  

An example of how to calculate EPV

Company ABC  Earnings Power Value ($m)

Underlying EBIT                                      73.6
Dep & Amort                                              6.6
Stay in business CAPEX                           -8.9
Cash trading profit                                    71.3
Tax @ 20%                                              -14.3
After tax cash profits (A)                       57.0
Interest rate (B)                                        8%
EPV = A/B                                                713

ADJUSTMENTS
Net debt/net cash                                      40.4
Preference Equity                                          0
Minority interests                                          0
Pension fund deficit                                       0
Equity value                                          753.4
Shares in issue (m)                                497.55
EPV per share (cents)                           151.4

Current share price (cents)                         320
EPV as % of current share price                47.3%
Future growth as % of current share price 52.7%