Some investors in the stock market have had such a strong track record that you cannot dismiss their success as chance.

Here are five key pieces of advice handed down from the investment gurus, which have been analysed and illustrated with some practical market examples.


Understanding the investment

‘Never invest in any idea you can’t illustrate with a crayon and a sheet of paper’

Peter Lynch, noted fund manager


Peter Lynch managed the Fidelity Magellan fund with distinction between 1977 and 1990, with assets under management increasing from $18m to $14bn over that period.

He believed in keeping things simple and argued that if you don’t understand what you’re buying at the outset then your investment is doomed to failure.

On this basis, it makes sense to start with companies whose products you can recognise, understand and easily research, particularly if you’re new to investing.

This could, for example, include a supermarket like Tesco (TSCO), or a consumer goods business like Unilever (ULVR).

It doesn’t mean investments in sectors such as technology or resources are entirely off limits, but they should be approached with more care and it is worth familiarising yourself with key industry issues and jargon before getting involved.


Seeking value

‘Whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down’

Warren Buffett, the ‘Sage of Omaha’, widely considered the most successful investor of the 20th century


Buffett is not prepared to pay just any price for a stock: he looks for value. Value investing involves buying assets which trade at a discount to their intrinsic worth.

The most widely used measure of worth is the price/earnings (PE) ratio, which is derived by dividing the share price by a company’s forecast or historic earnings per share.

This essentially tells you how many years it will take a firm to make profits equivalent to its market valuation. Other yardsticks include net asset value, which encompasses the value of a company’s assets minus the value of its liabilities.


Patience

‘The stock market serves as a relocation centre at which money is moved from the active to the patient’

Warren Buffett


Choosing exactly the right time to buy and sell shares is a skill which is extremely difficult to master. It involves keeping a close watch on an overwhelming number of different factors and having the cool judgment to act decisively when necessary.

Arguably, it makes more sense to adopt a patient approach and ensure you are constantly invested in the stock market. After all, if you miss just a few of the market’s best performing days your returns can be significantly lower than the market index.


Cash is king

‘In the short-term, the stock market is a voting machine but in the long run it is a weighing machine’

Benjamin Graham, legendary financial analyst and mentor to Buffett


What Graham means is that fashionable investments may hold sway for a period but eventually earnings and cash flow must be delivered to sustain the valuation attributed to a stock.

Cash is the life blood of any business and without it a company’s days are numbered, as the collapse of support services group Connaught in September 2010 clearly illustrated.

Example: Connaught cash crunch

The building services specialist posted a 15% rise in profit after tax to £17.5m between 2008 and 2009 but a closer look at the accounts revealed all was not well.

Working capital, the amount of money that it had tied up in funding its day-to-day operations, had increased from £13.9m to £39.7m.

This demonstrated that cash flow was not mirroring profit growth and eventually the company ran out of funds to pay its contractors and suppliers.


Don’t believe the hype

‘The four most dangerous words in investing are: This time it’s different’

John Templeton, mutual fund pioneer, once described as ‘arguably the greatest global stock picker of the 20th century’


Economies are cyclical: levels of economic activity fluctuate over time and this is reflected in the performance of shares.

Generally, the market goes up when the economy is growing and goes down when it is contracting.

What Templeton was warning against was rejecting fundamental principles around the cyclical nature of markets on the basis that the world has changed somehow, and stocks can continue to rise indefinitely.

Example: The dotcom bubble

The argument in the late 1990s was that the internet had rendered traditional investment criteria redundant - effectively that it was ‘different this time’.

Objections were dismissed as grumbling by Luddite naysayers who were unprepared to move with the times and this was used to justify heady valuations for many internet start-ups which had never come close to achieving a meaningful profit.

On 10 March 2000, the technology-heavy NASDAQ Composite index in New York reached an all-time high of 5,048.6 - more than double its value just a year before.

Within a matter of days, a savage sell-off was in motion as investors realised a number of these internet start-ups were rapidly running out of cash as they continued to post losses.

Just 10 days after its peak the NASDAQ had surrendered 10% of its value and by 2002 it had fallen 77% to 1,139.9.

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Issue Date: 22 Nov 2017