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Four Must-Reads That Will Radically Change Your View of Stocks

By Dan Ferris, editor, Extreme Value
Friday, August 6, 2010

Most people view the stock market like a lottery game. They make short-term bets on businesses they know little or nothing about... and generally lose money.
But there's another way to practically guarantee you'll make money in stocks. It requires you to stop obsessing about the market's day-to-day fluctuations and learn something about the businesses you're buying and selling.
You can learn about this method in a number of ways. But I think a great introduction is to read three short books, and one important chapter of another book. By the time you've read all four, a lightbulb ought to switch on in your head. You should be convinced there's a better way to buy stocks than making random guesses about short-term share price movements.
Last fall, at my publisher's annual lifetime subscriber meeting, I was asked for a single book recommendation. I enthusiastically recommended Joe Ponzio's F Wall Street, which I had just finished a few hours earlier.
F Wall Street teaches you to think about the value of a business first and forget about the price of it until you understand the value well enough. That's what all the best investors say. Look past the noise. Look past the short term. Forget about market risk... F– Wall Street! Focus on value. Be a business analyst, not a market follower.
I probably shouldn't tell you any of this. If you gained expertise in valuing businesses, you'd almost never buy stocks. Most public companies are simply too hard to value. Those that aren't too hard to value spend most of their lives overvalued by Mr. Market. When I tell my readers I'm having trouble finding "cheap stocks," it goes without saying I mean "cheap stocks I understand well enough to value."
Ponzio also provides a reasonable shortcut method "for 'armchair' investors who see the value in stocks, want to stick with large, stable companies, and don't want to invest hundreds of hours of research each year."
Ponzio's final chapter is on patience, another hugely important concept. As I showed my Extreme Value readers in my August issue (out yesterday), mastering time is the most important factor in any investment plan. If you can't learn to be patient, you simply cannot make money in stocks. If you can be patient enough, success is virtually guaranteed.
Overall, F Wall Street is well-written and highly readable. It's also worth rereading. I keep it within arm's reach at all times when I'm at home. Most financial books stink. This one is great. Read it and learn from it.
Another valuable investing book is Joel Greenblatt's classic, The Little Book That Beats the Market. Using a simple story that's a joy to read, Greenblatt teaches the reader the ideas behind his Magic Formula investing concept. Magic Formula investing is a simple idea that says you should buy the best businesses when they're trading at suitably cheap prices. Greenblatt offers simple metrics and guidelines so you can learn to identify a good business and know when it's cheap enough. Greenblatt's book, too, is worth rereading. It's next to Ponzio's book on my shelf.
Another book I often recommend is Frank Singer's little 27-page masterpiece, How to Value a Business. Singer's booklet provides a simple formula for valuing a business, which requires that you estimate the probability of a company's earnings occurring.
Think about that. Most people take the earnings for granted. They don't bother wondering about the likelihood of earnings occurring. There are many highly cyclical businesses out there. Once you get real about the likelihood of a given level of earnings happening again, you start realizing a lot of stocks are just too risky to fool with.
Singer's book also prompts you to think about three different types of value: liquidation value, stock value (which is really IPO value), and ongoing business value. Liquidation value is not the subject of the book. And Singer admits there seems to be no sense or logic to IPO valuations.
What Singer does is provide you with basic tools to understand the value of an ongoing business. He also shows you how ongoing business value can be much higher for a strategic acquirer than for an investor like you or me. A strategic acquirer is another company in the same business. Businesses are worth more to strategic acquirers because the key inputs, the earnings, and the probability of the earnings occurring are higher for the strategic buyer. He buys the business because he thinks he can wring more profit out of it. And he thinks higher profits are highly certain. So he pays more. Like Ponzio and Greenblatt, Singer's book contains good examples and anecdotes.
The other must-read I recommend most consistently is Chapter 20 of Benjamin Graham's The Intelligent Investor. The chapter is called "Margin of Safety as the Central Concept of investment." I recommend you reread it once a month. It's that important.
Once you learn about value, you have to keep in mind business values are inherently imprecise. You can't pinpoint them. You can only estimate them within a given range. Margin of safety is simply the margin for error investors need because it's impossible to pinpoint business value.
For example, if you think a company's stock is worth $100 a share and you buy it for $95 a share, you don't have a real margin of safety. If that $100 company is a World Dominator and you buy it for $75 a share, you're getting a margin of safety. Say the company is a riskier business, not a World Dominator. In that case, you'll want a bigger margin of safety. You might want to wait until it sells for $60, or even $50, a share.
If most investors learned to value a business, they might exit the stock market altogether. My guess is most stock investors who learn to value a business become very picky about the stocks they'll own.
They buy less often, sell less often, and hold longer.
And they make more money.
Good investing,
Dan Ferris

Further Reading:

For another great read, try Alex Green's Secret of Shelter Island. Each chapter in Alex's book contains one simple idea, a secret "to living a prosperous and fulfilling life," making the book a collection of fables for the 21st century. As Tom Dyson wrote recently, "If you're in the market for great stories, I highly recommend it." Find Tom's full review here: The Best Book I've Read This Year.
You might also want to check out Felix Dennis' How to Get Rich. In his review for DailyWealth, Chris Mayer writes, "The book is quite blunt about the lessons Dennis learned in becoming a rich man. It is also personal, in that he tells you in some detail about his own failings in life and business. It is the best book of its kind that I have ever read." Read more here: A Book Investors Should Read Immediately.

Market Notes


Today's message from the market: It loves our "contrarian's commodity" idea...
Early this year, we began recommending oil's clean cousin, natural gas. Natural gas is used to produce fertilizers, plastics, and various chemicals. It's also a major source of fuel for firing electrical power plants and heating homes.
We call natural gas the "contrarian's commodity" because huge new domestic gas supplies have come online recently... which has sliced the price of "natty" by more than 60% since 2008.
Our thesis is not that a big rally in natural gas is in the cards... simply that the fuel is done falling and the situation for natural gas prices is getting "less bad." This allows our preferred vehicles for gas investment – U.S. royalty trusts – to pay out fat distributions.
As you can see from today's chart of royalty payer San Juan Basin, the market likes this idea. Since our recommendation, San Juan has enjoyed a steady uptrend... and has kicked off large monthly yields... all the while producing a commodity at blown-out levels. We love it when a plan comes together...

The uptrend in natural gas royalties

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