Stop speculating, invest in the best companies

IT'S time to analyse why people buy what they do.

PARTICIPATION in the stockmarket is at a low ebb. Brokers are finding it hard to make ends meet and shedding staff, asset consultants are making larger allocations to cash and many fund managers are experiencing outflows even if they are on 26 platforms.

This should come as no surprise. Low returns and high volatility do nothing for confidence.

Yet we all know that the best time to buy is when very few believe the market is a wise place to be. It is true that bull markets are born amid pessimism and that you pay a high price for a cheery consensus.

Sadly, the values of most investors' portfolios will tend to rise only when the market does.

When the market comes crashing back to earth, so do their values. That's why there is so much interest in how the market performs each day.

If the market is up, it is likely the investor's portfolio is up. A rising tide lifts all boats.

The problem, however, is not the market but the investor.

After all the talk of strategies and techniques that lead to mediocrity, such as index investing, I am convinced that those who return to the market using the approach I will describe and apply here, and in future columns, will produce returns that cannot help but beat the market in the long run.

The market as measured by the major indices is nothing more than a report of the share price performance of a collection of big companies.

Big, however, is not good. Buying all the big companies, which is exactly what you are doing when you invest in a major index fund, is bound to lead to mediocrity unless bigger "fools" are simply willing to pay more for those shares than you.

And predicting that is almost impossible to do consistently.

I suggest we ignore the market and replace investing in the perceived safety of big with the known safety of good.

That means Oroton, not Pacific Brands. It means Seek, ARB and Embelton (cork specialist), not Brambles, BlueScope or Qantas.

The difference in returns in the long term is as stark as night and day. Your role is simply to buy a great business at a bargain price.

Preferably it will be a business that will earn lots more money in the future and is run by management and a board that treat you like an owner rather than lavishing gold upon themselves.

So you should turn off the television, the market reports on the radio and all of the daily updates and commentary about why stocks went up or down today.

Focus on businesses rather than stocks. Concern yourself with understanding businesses.

Then you can identify the truly wonderful ones, avoid the most risky and navigate the market and its manic-depressive condition with confidence.

Thinking like an investor means understanding the difference between price and value, and the difference between a business and a stock.

If you have not done as well in the stockmarket as you believe you should have, it is highly likely that you have been led astray by an industry preoccupied with the price of everything and the value of nothing.

Unwittingly, you may have been looking at stocks as chips at a casino and betting on whether their prices rise and fall, rather than considering them as pieces of businesses.

This is a very common trap. When buying an unlisted business such as a newsagent or the local butcher you know immediately what to look for.

In the acquisition of a small business, you would look at revenue and profit, margins and contracts, competitors and staff.

So what happens when most investors buy a stock?

All that goes out the window and the only question often asked is whether it will it go up.

They buy shares simply because they believe they will go up. And once you start doing that you are not an investor any more, you are a gambler.

This focus on price is not the same as a focus on value. Price and value are two entirely different things.

The focus on price, which prevails in stockmarkets the world over, dominates the business media and vies for your constant attention, leads to attempts to try to predict its course.

Some people are so focused on price that what the business does, what it sells, who is running it and what its economics are like are largely irrelevant.

Buying and selling shares on a prediction of the future course of their price is speculation, not investing. Focusing on value while ignoring price helps develop an investing mindset.

True value does not change, irrespective of what people may hope or expect it to do.

The only thing that changes the value of a business is its performance and its economics.

If you would like to stop worrying about the short-term gyrations of the market, or even see those as an opportunity, the key is to stick to the very highest quality businesses, turn off the market and its distracting noise, cease speculating and start investing.

In our next column I will show you how to identify an extraordinary business.

 Roger Montgomery is the founder of Montgomery Investment Management and the author of bestseller Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth, available at www.rogermontgomery.com.