As I write, there are many ways that people use to profit from the stock market.
Some prefer investing while many others choose to trade and speculate. Surely, there were profits made and losses incurred irrespective of one’s preferred way to venture in the stock market. These choices tend to be influenced greatly by a belief, a perception, and past experiences of what the stock market is.
Personally, I chose investing as I find that Warren Buffett is the best in this field. Also, his method of investing is one that is logical and can be easily understood, thus, it resonated well with me. I don’t speculate stocks as I believe it is as good as gambling. Whereas for trading, I find chart reading mind boggling. So, I guess that my chances of success are the best if I stick to investing.
Basically, investing is about understanding businesses and valuing them. Hence, if a stock (business) is priced below its valuation, it is undervalued and thus, it is worth investing. If a stock is priced above its valuation, it is overvalued. As such, it is not worth investing.
This field of study is known as ‘value investing’. Today, there are three key types of value investing and they are as follows:
#1: Deep Discount Investing
We have a stock namely, A Ltd. Its balance sheet is as follows:
A Ltd’s equity (book value) is $1.4 billion and let’s say, A Ltd issues a total of 100 million shares. Thus, its book value is $14 a share.
Today, the stock price of A Ltd is $7 a share, a 50% discount from its book value, or commonly presented as P/B Ratio of 0.5.
For deep discount investors, A Ltd can be an attractive investment. They think if A Ltd’s businesses are to be discontinued and liquidated today, A Ltd could raise let’s say, $900 million in fast disposal of its property, plant and equipment, $400 million in fire sale of its inventories and $200 million from its customers. With A Ltd’s existing cash balance of $200 million, it would have $1.7 billion in cash.
Out of which, it could settle $600 million in total liabilities and hence, leaving as much as $1.1 billion in cash to be distributed to all shareholders. This works out to be $11 a share and thus, profiting $4 a share to investors who purchased this stock at $7 a share.
The workings of this type of investing is as follows:
So, do I practice this type of value investing?
The answer is no. This is because I’m investing for income productivity. I believe that the value of a business is beyond its financial assets in the balance sheet. It is now valued based on its long-term income-generating ability, attributed to its ability to create, innovate, and improve. Intellectual properties, talents, and the characteristics of a business can be far more valuable than its tangible assets. In this instance, I’m not a practitioner of deep discount investing.
#2: Dividend Investing
This style of investing aims to earn recurring and growing dividends from stocks in the long run.
How it works is really simple. First, it is about finding fundamentally solid stocks that have resilient business models. This is important as you want to invest only in the consistent ones. Second, you value them to avoid overpaying for them.
In a nutshell, dividend investing is summarized as follows:
Personally, I practice dividend investing. I find it suitable as I’m investing in both Malaysia and Singapore, where their tax structures are friendly and the markets for both these countries are relatively smaller as compared to the United States and China. Also over time, I had built a portfolio that acts like a cash-generating machine as it pays me dividends in 8-9 months every single year. It is exciting to sit back and always collect dividends from a portfolio on an autopilot basis.
#3: Growth Investing
Growth investing is similar to dividend investing in respect of the focus to find a fundamentally solid stock. Both styles of investors would only invest in stocks, if their business models and financials are solid.
But, their difference lies in how a stock should use its earnings:
Dividend investors prefer more portion of a stock’s earnings to be paid to them.
Growth investors want these earnings to be reinvested for business growth.
This style of investing makes more sense if the stock (business) has a good track record of attaining more earnings from its reinvestment activities. In addition, it is suitable for investors who are investing in the US market where dividends are subjected to a 30% withholding tax upon receipt. So, let me explain:
Let’s say, I founded a US-listed company known as B Inc. This company can earn US$ 1 billion in gross profits a year from 5+ million customers in the West Coast of the United States. There are two options that I can use these gross profits:
Option 1, I can keep my operations lean and report high profits before tax (PBT) of $500 million, which are subject to 21% corporate tax. Then, from the balance US$ 395 million in net profits, B Inc pays out 80% of its earnings as dividends. In this case, these dividends shall be netted after a 30% withholding tax.
Option 2, I can expand my business operations by investing in talents, sales and marketing, research and development (R&D), and intellectual properties. These efforts could grow B Inc’s market presence to the East Coast and customer base to 10+ million for the next 3-5 years. But, B Inc will report lower PBT at US$ 200 million. After tax payments, I retain all of its earnings within the company.
To ensure that we’re making the most out of our R&D investments, it’s crucial to have a well-documented R&D claim report, not just for compliance, but also to assess how our R&D efforts are contributing to B Inc’s long-term goals.
Which of the two options make more business-sense?
Of course, it would be Option 2.
This style of investing would be suitable for you if you know how to read a story of a business from its financial reports. This is high-level accounting and it could be an ideal playing ground for seasoned and experienced investors. If presently, you have no knowledge or skill on interpreting financial reports, I believe you’re not ready for growth investing.
Out of the three, I believe that both dividend and growth investing will be more suitable to build long-term wealth for investors. This is because both types have a disciplined focus on investing only in fundamentally solid businesses, at prices which are undervalued.
However, dividends are more ideal for new investors who are based in Malaysia and Singapore. These markets are good for confidence and experience building. Whereas for the US market, dividends are less ideal due to 30% withholding tax and I believe that earnings could be best utilized via reinvestments over regular dividend payments. But, to be successful in the US market, it is more suitable to those who are more seasoned and experienced.
If you wish to learn more about value investing:
Dividend Investing: How to Build a Stock Portfolio that Pays Increasing Dividends?
Growth Investing: How to Make Massive Profits from Stocks Safely?