This article was written by Jonathan Soh
Jonathan is currently a digital marketer at VIC. He joined VIC about a year ago and started to learn how to invest in March. He recently bought his first stock a few months ago.
The MODS investment principles, in short, can be considered a guideline or a framework that you should bear in mind when investing. Simply put, the MODs principles is an acronym for the following: Mr. Market, Ownership of Business, Diversification vs. Diworsification and Margin of Safety.
Without further ado, let’s take a look and have a deeper understanding of each of the following:
The “M” in MODS stands for Mr. Market, a fictitious character first described by Benjamin Graham in his book The Intelligent Investor.
Imagine being in business with this guy called Mr. Market, whom would without fail come up to you with a proposal to buy over your shares everyday. And each day he will offer a different price according to his mood. If he is feeling optimistic, he will offer you a high price for your shares. If he is feeling pessimistic, he will offer you a low price. Also, he will not be offended should you reject him repeatedly.
Benjamin Graham created Mr. Market as it mirrors the stock market. Bearing in mind that there is a difference between price and value, what Mr. Market offers is the market price, and this price is dependent on whether he is feeling optimistic or pessimistic about the business. Meanwhile, the value of a company is determined by the business’ fundamentals. If you can differentiate these two terms, you are already well ahead of quite a number of people who treat price and value to be one and the same.
So, Mr. Market is here to serve you: not the other way around. If you tend to follow the mood swings of the market, you are then allowing the market to lead you, as opposed to letting the market serve you. In relation to this point, it is worthwhile remembering this quote from Benjamin Graham: “In the short term, the market is a voting machine; in the long term, the market is a weighing machine”.
To a lot of people, the idea of buying stocks is that they buy and then sell it later at a higher price. They treat it as if it were just a game of numbers. These numbers actually represent market prices. It is crucial for investors to bear in mind that when they buy a stock, there is a business behind the stock that goes beyond these figures. And when an investor purchase the stocks of a company, he/she is also the owner, or rather part-owner of the business.
When you invest in a company, you should consider the prospects and dynamics of the business and industry Does the company have a track record for me to base my evaluation on? Is the management capable? Do they operate with integrity? What is the price that the business is selling at?
These questions then form the foundation of what we look out for when investing in a company. In the case of listed companies, fluctuations in share prices of stocks are attributed to changing market sentiments, rather than changes in fundamental value of the business. This is contrary to the price of a private business, should it be on sale, where prices are less likely to fluctuate. So when the market crashes, or at times when investors behave irrationally typically when the onset of dooms day-like scenarios, and share prices come to a low, it would hen e the first time for one to invest.
As an investor, or part-owner of a listed business, you enjoy ownership of a company without having to attend to its daily operations, since the management takes care of that.
If you consider yourself a business owner, you will find yourself looking at things in a new light. For example, if you had invested in Singapore Press Holdings (SPH), a media, property and investment business, you may find yourself looking at The Straits Times from a different perspective. Instead of just focusing on the news, you may find yourself looking at the advertisements and the number of pages in the newspapers. Why? This is because newspapers generate most of their revenue through advertisers. So if there are plenty of advertisers, the newspaper will be thicker. Just look at The Straits Times on a Saturday and you will realise it’s typically thicker.
Even though we do not run the business as mere investors, we must keep ourselves well informed about the company’s results and operations. We need to keep an eagle eye on the business’ performance, the industry, as well as the actions of the management. When you know more about a business, you will find yourself being able to keep calm in times of market crisis. You may even have the courage to buy more into the business, if it has proven itself to remain fundamentally sound.
If you were to invest specifically in a retail business, one of the things you would do as a part-owner is to take note of the crowd patronizing its stores. You may want to pay attention to the window display of the retail shop and how they are attracting consumers to buy. Instead of being a mere consumer, you will now find yourself observing things like a business owner.
Another way to know more about the business is to understand and know its management. One way to meet the management is to attend the annual general meetings (AGMs) public-listed companies hold yearly. During the AGMs, you have the opportunity to meet the board of directors in person, as well as understand their values, competency and drive.
Unfortunately, many people appear to attend these AGMs for the freebies, in particular the food and door gifts. Sure, those are the little perks that you will be able to enjoy, but the main purpose of attending any AGM must be to understand the business and management you have invested in. During these meetings, you should network to get to know more about the board of directors. Question them about their future plans. Ask them how they intend to make the company grow? More often than not, you need not be the one asking questions. Usually, a few savvy investors would be asking some very good questions and all you need to do is to listen to the response from the management. That should give you substantial insights on the company.
As an investor, we get to enjoy a greater degree of flexibility, as compared to a businessman who starts his own business. Owing to a variety of reasons, a businessman is tied up to the business, and will not be able to exit the business as easily as an investor. But as investors, you can choose exit the business fairly easily, unless you have a very major stake in the company or if the stock is not liquid. With this flexibility to exit, you do not have to hold on to the stakes of unprofitable companies. Since returns come in the form of dividends and price appreciation to the average investor, holding on to a profitable company is just a bonus as we ride on the growth of the business.
In this way, an investor certainly has its advantages. In fact, do you know that Warren Buffett is the largest individual shareholder of Coca-Cola, with some 200 million shares, but yet he own less than 10% of the company?
We are always reminded to diversify our investments in order to minimize our risks. But Warren Buffett once said, “Wide diversification is only required when investors do not understand what they are doing”.
So why is there mixed opinion on this? Now, if you think about it, if you want to achieve excellence in any area of your life, chances are, you will need to channel most of your resources towards that specific area. Naturally, this applies to the performance of your investment portfolio too. Just as you will achieve outstanding results by channeling your efforts correctly into certain areas you wish to excel in, you can also achieve outstanding portfolio returns by directing your funds and resources correctly towards the top winners.
Peter Lynch, an outstanding fund manager who used to manage the hugely successful Fidelity Magellan Fund, came up with the term “diworsification” in his book One Up On Wall Street. In his book, he referred to the example of a business owner who delved into areas outside his area of expertise. To cite an example, it will probably not make sense for a business owner running a profitable manufacturing business to expand into a shipping business all of a sudden. If there is no proper strategy for the company, this move will prove to be detrimental to shareholders. In this example, the businesses are unrelated and cannot be streamlined for optimal operations.
So should you diversify? Well, it really depends on your investment objectives. If your objective is to maximize returns, then you must focus on certain investments. If yours is to preserve capital, then you are probably better off diversifying your investments across several stocks, or even asset classes. Between the two, the former will require you to display greater courage and a willingness to bet big when the opportunity arises.
If you plan to diversify, do ensure that you have the time to research and monitor your stocks. Usually, an individual retail investor and employee, can monitor up to a maximum of 20 stocks each time. By placing your eggs in different baskets, your returns are probably lower, and your losses are potentially lower too.
It should also be pointed out that some investors diversify for the sake of diversification, just to feel safe. But in my opinion, security does not come from placing your money in different stocks, but in investing in businesses that you understand. If you only have time to research and unearth three companies, then simply invest in these three when the prices are right.
For normal investors, the circle of competence is quite small. But this is in fact normal! With years of investing, one will slowly grow that circle of competence.
Margin of safety is a concept first formally introduced by Benjamin Graham in his book The Intelligent Investor. This concept can perhaps best be explained by using the analogy of a bridge.
Imagine having a choice of two bridges to cross a river. One is a primitive bridge made of a thin piece of log, and the other being a modern bridge made of steel structures. Between the two, it is obvious that the modern bridge built of streel is safer to cross. In this context, you can say that the steel bridge provides a greater margin of safety as compared to the log bridge.
Using the same example, an engineer will no design and build a bridge meant to hold exactly 100 tons, even if that is the capacity required of it. Instead, the engineer would build the bridge with a buffer of say 200 tons or even more, so that the bridge can withstand any extra load.
In investing, the same theory can be applied. When a company’s share which you have valued at $10 is available for $10, would you want to buy it? No, because the price offered is the same as your valuation of the share; there is no margin of safety. However, if a company’s share is worth $10, and is selling at $6, you now have a 40% margin of safety. As a result, you should take a greater interest in acquiring it.
So why is having a margin of safety important? The reason is that our assessments and valuations are not always right and accurate. Should our assessments or evaluations prove to be incorrect, the margin of safety will serve as a buffer to reduce our potential losses
Here, the challenge of applying the correct margin of safety is two-fold. The first is the valuation of the company you are looking at. More specifically, the valuation of a company is not definite, and is at best an estimate of the value of a company. Because many assumptions are used in valuing a company, the valuation would understandably be off the mark when the assumptions do not hold. Such assumptions are more difficult to validate, when the business does not achieve very consistent sales and earnings. In fact, businesses with very predictable sales and earnings are more likely to command a premium, since investors like earnings visibility. So for quality businesses, it is acceptable if the margin of safety is lower.
While these principles may seem fundamental and easily ignored, we need to iterate and highlight the importance of having a deep understanding of the foundations so as to help you make sound investment decisions and make positive returns.
If you’d like to know more of such key highlights to help you achieve results and make improved decisions, why not join us for legendary value investing masterclass that has impacted thousands of lives? Not to mention that is is completely free too! To help you get a headstart, you read our landmark article on how to start investing in Singapore, or even how to start investing for dividend stocks!
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