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Tuesday, August 9, 2011

My Philosophy in Investing

My Philosophy in Investing by Adam Khoo 

After learning and testing out all the various investing techniques available; top-down approach, bottom-up approach, stock screening, sector rotation, fundamental analysis, technical analysis, macro-economic analysis, momentum trading, swing trading, contrarian investing etc…
I finally found that what made me the largest and most consistent profits was ‘Value Investing’. This is a medium term (or long term), bottom up, selective contrarian approach to investing that was practiced by Benjamin Graham and Warren Buffett (the world’s greatest investor, and world’s Richest man- 2007).

My investing strategy has basically three steps.
Step 1: Identify stocks of very good businesses.

A very good business is one that I can predict with a high degree of confidence that over time, the profits will increase consistently and predictably. Hence, the value of the company and the stock will appreciate significantly over time.

In order to be able to grow its profits consistently, the business I look for must have no competitors (i.e. a monopoly) or very insignificant competitors (i.e. the company has huge economies of scale, a strong brand that allows it to dominate the market). 

When there is no credible threat from competitors stealing market share or cutting prices, the business will be able to keep generating higher sales and profits annually.

For example, in the context of Singapore, SMRT and Singapore Exchange (SGX) are monopolies with no competitors. IN the context of the US, companies like Google, Wal-Mart, Coke, Visa are consumer monopolies with insignificant competitors that threaten them.

The business I buy must also make a product (service) that does not go obsolete easily. It must make a product that people must use regularly. This way, future earnings are predictable. For example, US company Apollo Group provides academic education, a product that will never go obsolete. 

This is in contrast with Research in Motion (RIMM) that makes the Blackberry phone. Although it is doing very well now, its ability to succeed 5-10 years from today is unpredictable as technology can be made obsolete very fast.

Finally, the business I buy must have a very strong balance sheet, with lots of free cash flow and insignificant debt. This way, there is no threat of bankruptcy and in fact, the company will have the cash to buy out any competitors.

Step 2: Only Buy When the Stock Price is Selling Way Below the Intrinsic Value of a Business.

The biggest mistake investors make is to pay too high a price for a stock. This is when investing becomes very risky. Whether a stock’s price is high depends on what its intrinsic value (IV) is. IV means what the stock is actually worth based on its profits and cash flow.

For example, a great company that I wanted to buy in Singapore was Raffles Education. It was selling at $0.80. After falling from a high of $1.60, many amateur investors thought that it looked really cheap (50% below the highest price).

However, after calculating its intrinsic value, I found that it was worth $0.44. So at $0.60, it was actually overpriced. Sure enough, those that bought at $0.60 (and way above) got screwed! The stock fell to $0.35 and below!

On the other hand, I only found it a good buy at $0.35, when it went BELOW the intrinsic value of the stock. When you buy at a price below intrinsic value, you can be certain that there is very little downside. 

Buffett’s calls this the MARGIN OF SAFTEY. One thing I learnt from studying this great man is ‘it’s not risky when you buy stocks at a fraction of what they are worth’.

I have found that whenever I bought stocks way below their intrinsic value, I very rarely lost money. While the downside was low, the upside was really very high. When US-company American Express (AXP) fell to $16, during the financial crisis, I bought like crazy! 

The stock’s intrinsic value is worth $35. At a 50%+ discount to its true value, it was a sure-win deal. Sure enough, when confidence returned to the stock market, AXP shot back up to $40, making me a nice profit.

(Intrinsic value is calculated manually, It is the present value of the future cash flows of the company. In my Wealth Academy programmes, I spend hours teaching how this is done using an intrinsic value calculator)

Step 3: Wait for the Market to Recover and the Stock Price to Rise Above Intrinsic Value

Usually, the stock of a very good company sells at a price way below intrinsic value when there is a stock market crisis and lots of people are selling out of fear (this happens every couple of months and very severely every few years).

After a buy a stock at a great price, I can never predict when the stock market confidence will come back and push stocks back to its high prices. It could be a few days, weeks or even months…nobody can predict with certainty. So, I wait patiently for it to happen and collect my huge profits when it does. So, has this three-step method worked for me? You bet!
Adam Khoo
Wealth and Investment Tips

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