You never realize the moments that change your outlook on life when they occur. Looking back in my life, there have been many of these moments, but one in particular has really stood out. It occurred when I was a freshman, in a high school economics class, with Mr. Causey, and it really affected my investment strategy and created an intense interest on my part in the industry. Looking back, it was probably my favorite class at any level of education because I found it more useful than any other financial class that I ever took. There were countless lessons and exercises that taught material that I still use today. The class was so instrumental that it helped me find a direction in life. I can recall riding home one day after school and telling my Aunt Becky that I knew what I wanted to do when I finished school—I wanted to work in finance and in the market.
I remember one exercise in particular that allowed me to visualize and understand the basics of a public company. It was the first time that I truly began to understand what drove a public company. The exercise involved our class building its own public company, which included stocks, costs, profits, and real-life operations. In our class, 100 total shares were issued. Each share cost $1, and everyone had to buy at least one share.
As a whole, our class decided to build a company based on candy. We spent $100, which was raised from selling shares, to buy as much candy as possible, leaving some additional cash for unexpected expenses. Over a period of several weeks, the candy was sold at football games, outside events, pageants, and so on, and our goal was to turn our investment into a profit. I can’t recall the exact amount of money we earned, but I believe it was near $400. As a result, we divided the $400 into 100 based on the total number of issued shares, which brought our return on investment to $4 on the original $1 we spent for each share. Therefore, in the end, if you purchased 20 shares, your return was $80.
Now here’s the catch: When you think of a company or a stock, you need to view it like you would my ninth grade economics project. A stock is a reflection of a company’s sales and profits. If a company’s earnings increase, its stock should follow suit. There are a lot of factors at play that determine the worth of a company, but when you sort through all the jargon and the various opinions, you’ll find that a stock is a reflection of the company’s growth, and companies with explosive growth (such as our candy-selling business) might see a higher valuation for growth that exceeds the rate of growth for the industry—all of which will be discussed throughout this book.
We closed the doors of our “business” after only a few weeks and cashed in our stock to live the good life. However, what if we would have continued to operate and reinvested the money into the business? The valuation at the time we “cashed in” was $4 a share, but if we had kept going, how much would you have paid for such a stock? How large could the valuation have become? If we could turn $100 into $400, then how long do we keep this stock, and could we have turned $400 into $1,600? If so, the stock would have been worth $16 a share, and it would have made for a great investment. But would you as an investor maybe have paid a premium for the stock when it was $4 if we would have decided to continue operations? Perhaps an investor, or in this case a 14-year-old student, would have decided that it was worth it to purchase someone else’s shares for $6 based on future earnings growth.
These are the types of questions that are answered on a daily basis in the market. For every buyer, there is a seller. And sometimes investors will determine that a stock is worth buying at a premium and will place their bets on the future growth of a company in the hope that a high growth rate can continue. Therefore, if we would have continued our business, it might not have been uncommon for a new investor (or a classmate) to offer $5 to $7 for a share of stock, when it was worth only $4, because of its growth. For argument sake, though, let’s play out one more scenario: Would you buy the same shares, valued at $4 a share, if they were priced at $2? Most would say, of course!
You might be thinking, “How could you sell stock in a company at such a discounted price when the earnings growth and fundamentals tell you that it’s worth $4?” Fortunately, this occurs every day in the market. The reason it occurs is the same reason that stocks are often bought for premiums—for every buyer, there is a seller, and sometimes the market incorrectly values a company. Sometimes investors may be willing to sell their shares for less because they need quick cash, or maybe they value the company incorrectly. Either way, it can be a gold mine for you if you can correctly identify such a company. So how do you identify when a company is undervalued and is being sold for $2 a share when it’s worth $4 or potentially worth even more? How do you find the guts to pull the trigger and buy an underperforming stock but a strong performing company when investors are selling it cheap? And how do you know when to buy? In this book, all these questions, plus more, will be answered.
Part I looks at the inner workings of Wall Street and money managers alike. I will explain how the measures of success for you and the firm that handles your money are often few and far between. This includes the fact that firms, such as hedge funds, get paid no matter how your portfolio performs. Most hedge funds use a fee structure that involves earning 2 percent for them on all assets under management and then another 20 percent of annual gains, meaning that they get paid no matter what! Throughout the first part of this book, I will explain what this means and also explain how you can perform better by taking charge of your own financial future, which includes developing an economic outlook, separating myths from reality, and introducing value investing in an easy-to-understand manner.
Part II digs deeper into what makes a company a good investment. I will introduce and explain the fundamentals of a company and discuss how a company is valued in the market. This often can be the most confusing aspect of investing, but my goal is to simplify the information and give you a simple way to value a company. This will allow you to make better financial decisions and improve your returns significantly.
Part III looks at the part of investing that has allowed me to become successful: the psychology of the market. By understanding the behavior of the market, you will be better equipped to know when to buy and will understand why stocks may move in an incorrect direction. This will allow you to remain calm and emotionless and return larger gains. In this part I will use life stories and my personal successes and failures as lessons for what to do and what not to do.
Finally, Part IV puts all the information together. I combine the fundamentals with the psychological aspects of the market to find the best stocks. I also will discuss diversification, positioning your portfolio, and how to succeed in the new era of investing.
So let’s get started. Sit down next to a fire, have soft piano music playing in the background, grab a notebook, and prepare yourself to change your financial future.