Fundamental Investing – 10 commandments

Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.

I’ve been investing in the stock market for a decade now and in most years I have been beaten the FTSE100 by some margin. You can take a look at my more recent performance in the ‘My Trades’ section of my site.

I get a few emails asking for my approach. There is no universally accepted way to invest, otherwise we would all be millionaires. Here though are the 10 rules I stick to religiously, which have served me well:

  1. Fundamentals above everything else – Cash is all that matters in the long term.
    Remember that a stock’s true value is the discounted present value of future cashflows. When you value a stock you should always think about the actual or potential cash generated and not get distracted by anything else. Earnings, e.g. ‘EBITDA’, or even worse the dreaded ‘ADJUSTED EBITDA’ are often nothing more than PR. The first thing you should look at when a company releases results therefore is the cashflow statement.
  2. Never, ever invest without doing research.
    This doesn’t mean reading a couple of house broker notes, instead this should be balanced research which includes preparing your own valuation of the stock. As with rule #1, this valuation should be based on the potential for future cash development and your view on the risk/reward profile. I typically spend 10 hours on a stock before going anywhere near the buy button, you should do the same. It is so tempting when you see a share rocket to try and jump in, I have been guilty of it myself, but more times than not I have lost money, particularly on ‘penny stocks’ when at times you need a stock’s mid price to rise 10%+ to even get out of the market maker’s spread. So unless you want to spend all day staring at level 2 praying that the book turns in your favour then avoid this. Remember, there will always be another trade or investment opportunity. Final point – only when you can place a BUY order with confidence and you don’t feel the need to keep a constant watch on the share price, is when you have done enough research.
  3. Employ Targets rather than overtrading
    Set yourself a BUY and SELL target on each stock you research and stick to it religiously and only adjust this based on newsflow. It is very tempting to sell out at 10% profit or 20% profit but some of the biggest mistakes I have made is not letting my winners run. If you still believe there is upside why sell? By the time you add back stamp duty, transaction fees and the market maker spread you may need the stock to fall by 3-6% or more before a re-entry is economic.If you are getting anxious once you reach your SELL target, then consider to place a stop loss in to lock in some gains at a few % below the current share price, you might be able to let your winner run longer this if you repeat this approach. Remember sentiment drives the market as much as fundamentals. The later always beats the former in the longer term though.
  4. Be a cynic, look for the worse in everything.
    Question everything. The city is a very seedy place and you should be skeptical of everything, especially rumours but also information released by the company. With rumours, even when they come from credible news outlets they often turn out to be spoofs, which sadly can be attempts to drive the share price higher. This ‘whisper’ can often be driven by someone with a major position can exit. This is particularly true at the junior end of the market. When it company released news (RNS), don’t forget that companies employ PR firms to put positive spin on stories. You need to look beneath the PR.
  5. Momentum Trading – it has it’s place
    Don’t be tempted to jump into a stock based solely on momentum, you can make money on this approach but it is not investing, it is really no different from playing the casino. Instead be patient and do your research – rule #1.Don’t hate traders and chartists that play on momentum though either, love them. They are the guys who can often drive a price in a certain direction, this creates opportunities for us fundamental based investors. There are though always points where a stock becomes very cheap and very expensive, if you know the stock well you as a private investor can nimbly jump in (and out) at the right moment – this gives you an advantage over institutional investors.
  6. Beware Leveraged Companies
    A business model can be great and the company can be generating cash at an operational level, but watch out for companies that are highly leveraged. I’ve seen too many companies which are viable but the equity is practically worthless.Always remember that the debtholders have legal right over shareholders in the event of a liquidation. If debt covenants are breached the threat of these powers can be used for the bondholders to acquire assets often well below market value. Very rarely do shareholders escape with anymore than a few % of the company in these situations. Don’t be tempted to jump into distressed companies without doing a lot of research.
  7. Be prepared to cut your losses
    If new information is released which materially alters your valuation of the company downwards then be prepared to sell. One of the most common mistakes that new private investors make is to constantly average down on their loss making holdings. Accept that you will make bad investment decisions on occasion and learn from the mistake. What separates the long term winners from the losers is those who are not afraid to cut their losses.
  8. Risk Management
    Create a balanced portfolio and review your portfolio regularly. Through this ensure you are not too focused on one industry, or even worse one company. You should also compare your performance to a benchmark such as the FTSE100 total return index. If you regularly come in lower against the index you might be doing something wrong.
  9. Don’t over diversify
    Conversely to rule #8, avoid also having too many holdings, the maximum number of shares and funds in my opinion you should have at one time is 20-30. It is far too difficult to keep track of more than 30 holdings but also the more holdings you have the more likely you are to achieve the benchmark returns, so why not just buy a index tracker instead? I have around 20 stocks and 10 trusts across all my investments, ISA, SIPP and trading accounts. I know these 30 investments inside out and I can sleep easy at night knowing I have researched them well. Think Macro as well as Micro, particularly on trusts to ensure you are positioning yourself to where you think things will move towards. For example, is it time to start loading up on gold if you think uncertain times ahead?
  10. Learn From Your Mistakes and be Disciplined
    Embrace your mistakes. For every investment that goes wrong and you lose money on, spend some time reflecting on why. I always write down the key reasons why it went wrong for me and try and take away a few points to learn from. Don’t beat yourself up, particularly for black swans! I also keep a record of all my closed trades and assess whether I sold at the right time, if the stock went on to add another 10%, why? Some final advice – Develop your own investment handbook to capture your own learning and develop your own rules which work for you and that you promise you will stick to. The best investors I know are the most disciplined people I know. Good luck!

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s