I wanted to do a post about this because I think a lot of casual investors (and probably some professional ones) get it wrong. First my completely unofficial definition investment:
investment - The purchase of an asset that is reasonably expected to return more cash value than the initial purchase price.
The first part of the statement is easy. You are buying something. The last part is where people go wrong. They buy things that they believe will return them more money then they bought it for. BUT I purposely said 'reasonably expected' to return more cash value. How does one go about determining what can be reasonably expected to return more cash value? That's the tricky part. Here are some tips:
1. Keep your emotions out of it.
Why did so many people buy Facebook? Because of great valuations? Because of a reasoned analysis given financial statements, growth potential? No. More than likely, most of those people bought it because they use Facebook and know that millions if not billions of others use it as well. Does that mean it's a good investment?
Where emotions come into investing is in terms of morality. I would never invest in a tobacco company. I don't believe in buying a company, regardless of the financial analysis, that sells a product that kills people. Not my thing. There are other business that you would have to search your heart to see if it is comfortable to invest in. Weapons manufacturers, pay-day loan companies, etc.
However, that's where the emotions should end. You should only buy a stock or other investment (house, car, baseball card) if you can reasonably expect to make more money then you put into it.
Please keep in mind I'm talking only about investing. If you WANT to buy a car, buy it but do not think you are 'investing' in that car unless for some reason you think you can make more money then you put into it.
2. Dig
It drives me nuts when people say things like this: 'XYZ company is selling at $25 a share. That's cheap!'. The reason it drives me nuts is 99 out of 100 times, they are not basing that on anything but the price itself.
Let me put it this way. If I offered you a car for the price of $20,000 and gave you no other information , would you give me $20,000 and hope that the car was a new Ferrari rather than a 10 year old Honda Civic? No, you'd ask about the car. You'd want to see that it was in good shape and worth $20,000.
So if I told you I could sell you a stock at $25 a share or another stock at $50 a share, which would you buy given no other information? The $50 stock is a better deal if it is Berkshire Hathaway (which normally sells in the 10s of thousands of dollars range) and the $25 share is Nortel which is de-listed and selling on the over the counter market for around $0.20.
What I am saying is you have to know what you are buying to know what it is worth. An knowing what you are buying means more than the name or the history of the company. It's looking at what do they earn, how steady or risky are those earnings. Then taking that knowledge and deciding if the price is good or bad or whether or not you'd buy the company at any price!
That's largely the point of the analysis I have been doing for the last 6 years and what I have been putting into the blog posts.
One more point here. Just because two companies are in the same industry and have similar histories does not make them equal as investments. A great example is CN Rail and CP Rail. Both are long time railway companies in Canada. Both together have essentially a monopoly on rail transport in Canada. Which would you invest in?
CN has a 5 year average Return on Equity of 19%, CP's is 13 %. CN has had earnings growth over the last 5 years of 6% and have fully recovered to earning above pre-recession values (2007 earnings $4.25/share 2011 $5.41/share). CP has a 5 year earnings growth of -8% and has not recovered from the recession at all.
These two companies look just like Canadian railway companies. They even sell for roughly the same price (CP $83.18, CN $88.40) and if you don't look any deeper than that you might think it doesn't matter which you buy. You might even choose CP since it is more that $5 cheaper.
But look even a little deeper you will see that 83.18 buys you unpredictable and shrinking earnings and a lower return on equity. CN buys you predictable resilient earnings and a great ROE!
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