Lesson #3: There's A Business Behind Every Stock

f were to ask you to bet your money on the future success of one of your classmates or colleagues, whom would you
choose?
Would you bet on your best friend amongst these people?
Or would you bet on the most capable person (assuming that you friend is not the most capable out there)?
f can trust your Q, betting on the most capable person would make greater sense for you than betting on your best
friend.
The same philosophy holds true while investing in stocks. You must not put your money on a stock whose name you like
the most or whose chairman is your best friend.
nstead, you must invest in the stock of a business you believe has the maximum potential.
But this is one reality that most investors forget that.
". a stock is not just a piece of paper that has a name, but a share of a business that
has reaI assets and profits."
While buying a stock, you should take the same approach as you would if you were buying an entire business. The only
difference is that instead of buying the whole of the business, or a partnership in the business, you are only buying a tiny
share.
Investing's nine most important words
"nvesting is most intelligent when it is most businesslike, said Ben Graham.
As per Graham's best student Warren Buffett, these are the nine most important words ever written about investing. And
rightly so!
The biggest differentiating trait of Buffett's own investing philosophy is the clear understanding that stocks are
representative of businesses, and not just pieces of paper.
The idea of buying a stock without understanding the company's operating functions its products and services,
management quality, employee relations, raw material sources and expenses, plant and equipment, capital
reinvestment requirements, and needs for working capital is unacceptable.
This mentality reflects the attitude of a business owner as opposed to a stock owner, and is the only mentality an
investor should have.
Owners of stocks who perceive that they merely own a piece of paper are far removed from the company's financial
statements.
They behave as if the stock market's ever-changing price is a more accurate reflection of their stock's value than the
business's balance sheet, income statement, and cash flows.
For Buffett and all other successful investors , the activities of a stock owner and a business owner are closely
connected. Both should look at ownership of a business in the same way.
As Buffett says:
"I am a better investor because I am a businessman and a better businessman because I
am an investor."
As explained in 'The Warren Buffett Way' by Robert Hagstrom, these are some of the key questions that you must
answer to understand the business of a company.
Questions you must answer to understand a company's business
Let's discuss them in some detail here.
Questions on the core business
1. Is the business simpIe and understandabIe?
Never invest in a business you do not understand, for you can't see the future opportunities and challenges before they
arise.
2. Does the business have a consistent operating history?
Past performance is no guarantee for future success, but it shows if a business can operate under varying business
conditions.
3. Does the business have favourabIe Iong term prospects?
'Sustainable business' is the key word here. Stay away from companies that operate on trends and fads that can go out-
dated in the future. Look for business that can sustain in the long term.
Questions on management quality
4. Is management rationaI?
Now this is a very important part of an investor's business analysis. The rationality of the management and its ability to
deploy cash in a profitable manner is what separates a good business from a bad one.
5. Is management candid (frank) with its sharehoIders?
You don't want to get into a future Satyam, right? Look for managers that admit mistakes and take complete
responsibility of their actions.
6. Does management resist the institutionaI imperative?
nstitutional imperative is the need for managers to act like their peers, no matter how irrational their actions may seem.
Avoid managers who have the tendency to give in to peer pressure.
Questions on financial position
7. What is the return on equity?
As we will understand later, return on equity is one of the most important metric for evaluating the profitability of
companies. Earnings can be manipulated, but return on equity will show how worthy a business is.
8. What are the profit margins?
A company that can convert its sales into profits is a successful business. The key is to keep costs at the minimum, and
go for higher profits instead of higher market share. Avoid companies with low margins.
We will discuss all these above-mentioned points in the subsequent lessons of 'Value nvesting for Smart People'. Till
then, just remember what Buffett said:
"If a business does weII, the stock eventuaIIy foIIows."
P.S.: Got here via a link from a friend, or a forwarded email? This is the 3rd lesson of the 20-lesson free email course
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