3 Things Every Investor Needs To Know
Flying an airplane is one of my passions. The view from 4,500 feet on a clear day is just unbelievably refreshing.
Despite my passion for flying, there are inherent risks in taking an aircraft 10,000 feet above the earth. Everything from weather to mechanical issues can provide a brutal end to an otherwise beautiful day.
#-ad_banner-#So safety is paramount when planning a trip. Whether the trip is to practice landings or a cross-country trip, emergency planning is the rule. Now, think about what equipment you’d want when flying — beyond the most basic stuff like fuel and a properly functioning aircraft.
The most obvious piece of equipment is a GPS. A good GPS provides the pilot with information about the position of the aircraft in relation to the earth, but most models today provide weather data as well as charts identifying backup airports in the event of an emergency.
Another piece of equipment essential to the safe operation of an aircraft is a radio. The ability to communicate with air traffic control — especially when the weather unexpectedly turns — is critical. And that alone has saved thousands of lives.
So what does flying have to do with investing?
It turns out, a lot…
You see, many investors manage their investments similar to a pilot flying without a radio or GPS. They fly along without seeing any landmarks. And since they have no charts with them, they can’t find a safe harbor in an emergency. More often than not, the results are often catastrophic.
But a little “preflight” planning can help investors avoid financial crashes. Below are three things every investor must know to be successful…
Buy Great Businesses
The first, and most important, thing for investors to know is what kinds of businesses make great investments and, more importantly, how to value them.
Take Snap (Nasdaq: SNAP), for example. Snap’s primary product, Snapchat, is an image-sharing app that allows users to send and receive edited photos and videos to and from other users. It has plenty of active users, but its competitors, namely Facebook and its own image-sharing app Instagram, are quickly copying Snapchat’s features with greater success. Even worse, it’s losing hundreds of millions of dollars every year as it attempts to grow further.
If you can look at SNAP’s financial metrics and conclude that the company is a viable investment — your GPS is malfunctioning. The same is true of fast-casual Mexican food chain Chipotle (NYSE: CMG). In both cases, these stocks are not solid investments by any stretch of the imagination.
Now, if you don’t know whether Chipotle is expensive or cheap just by looking at the company’s metrics on Yahoo, don’t worry. You’re not alone. In fact, less than 20% of investors really understand the fundamental financial concepts relevant to valuing a company. But without this understanding, an investor is flying by the seat of his pants. And that rarely ends well.
And in case you’re wondering, CMG is currently trading at an absurd trailing price-to-earnings ratio of 608. Worse, to me, is its EV/EBITDA ratio of 63.09 (I prefer EV/EBITDA ratios under 14). You may like their food, but their stock is a no-go.
See The Big Picture
But there’s more to investment success than just finding good stocks at reasonable prices. Every time a pilot gets behind the yoke of an airplane, they have to be prepared to make hard decisions based on changes in weather or airplane mechanics.
The same is true in investing. Quite often, it turns out the market fundamentals have materially changed from when we took a position. Prudent investors trim their long positions by selling low-performing stocks, while hedging their exposure to the overall market by selling other stocks short.
But the key here is they don’t sell everything they own. Nor do they immediately go to a 100% short portfolio. Taking such action is tantamount to trying to dodge other air traffic while never communicating with a control tower. It’s a terrifying ride that might just cost you everything.
Don’t Chase Hot Stocks
Lastly, investors must learn never to chase what’s “hot.” It takes great discipline to stick with buying stocks of great businesses at reasonable prices. And it takes that same discipline to follow your position-size limits.
But when the next “great” thing comes along, many investors throw discipline out the window. They buy stocks based purely on hype. Take Facebook’s (Nasdaq: FB) IPO in May 2012. The company opened at $38. Everyone was clamoring for shares.
By August, shares were trading at about $19 — a 50% decline from its IPO. And no matter how disciplined an investor you may be, it’s hard to sit through a 50% drawdown. Worse, the shares didn’t hit breakeven until August 2013 — a full 15 months later.
It was even worse for shareholders of eBay (Nasdaq: EBAY). Investors that purchased shares of eBay when it was “hot” in 2004 would have experienced an 81% decline before the stock leveled off.
In both cases, investors would have been much better off to buy “hot” stocks after they’ve cooled off and are trading at reasonable prices.
Fair Weather Flying
Whenever I climb in my plane, everything possible is done to ensure a safe experience. Every trip is treated as if it were a cross-country adventure. And that same preparation is applied to my investing. And it’s kept me safe through many Wall Street storms.
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