There are three main ways to make money in the stock market:
Value
Last week we spoke about the disparity between private companies (that sell for 3 to 5 times their earnings) and public companies (that can easily sell for 15+ times their earnings):
‘Value investors’ like Warren Buffett look at what a business is really worth, and buy it when it’s at that price LESS a margin of safety (they usually try and buy when the current stock price values the company at 50% – 80% of the ’sticker price’ i.e. what their discounted future cashflow analysis tells them the company is really worth).
This is the long-but-true road to financial success in the stock market (after all, do you know ANYBODY who has made more from the stock market than Warren Buffett?).
Explosion
This is what Brandon was referring to when he said:
That’s why the holy grail for private equity firms is the IPO. Buy a company at 5-10x earnings and take it public for a valuation of 15-30x.
You ‘explode’ a company into lots of tiny pieces and, magically, the parts add up to many times the original value … nice.
Flow
If the ‘big money’ is made by the great ‘Value Investors’ and the venture capitalists and private equity firms that ‘explode’ companies via IPO’s and capital raisings, where is the SMALL money made and the BIG money lost?
Well, the SMALL money is made by trading the ‘flow’: once the company has been carved up and it’s stock is worth, say, between 15 and 3o times its earnings as Brandon suggests, there is no concensus as to what a stock is really worth … so money is made by trading the ‘flow’ of a stock’s price between the upper and lower estimates of what the ‘market’ thinks the stock is worth.
Now, don’t give me the ‘market is perfect’ spiel because the whole point is that money is made (and lost) by trading stocks between those who BELIEVE the market is perfect and those who don’t!
In fact, come up with ANY theory of how to value a stock and as soon as you buy or sell it, you are betting against the person on the other side of the transaction … you are both betting on FLOW.
Except for one of you it is an ‘ebb’ (they lose) and for the other it is a ‘flow’ (you win) …
… of course, the flow does have a preferred overall direction … fortunately for us, that is UP.
Over the long run, company earnings (profits) increase due to inflation … and, where the profits go, so does the share price (sooner or later … but, fortunes have been made and lost on the exceptions); but, it is a SLOW increase.
So, how is the BIG money LOST in the stock market?
Simple, look where the BIG money is MADE …
… it’s lost as soon as the FLOW investor buys their stock from either the Value investor or the guy who triggered the initial Explosion, and that loss is passed on – plus or minus the ensuing ebbs and flows – from ‘flow investor’ to ‘flow investor’ until the value dribbles back out of the stock [enter the Value Investor, again].
Interesting, what about LBO’s of companies with low valuations and strong cash flow…? Maybe not for the small investors but the big boys know how to play this game!
-Mike
@ Mike – Sure … it’s how Warren Buffett got started (well, he made the cashflows of his little textile company – Berkshire Hathaway – larger by not issuing dividends) 🙂
But the ebb and flow is also a source of opportunity. For those who for whatever reason do not want to invest in unlisted companies (regardless of whether the reasons are valid or not), listed companies are often the next best thing. As an example, as I am not in a position to keep a close eye on a business, I would rather hold shares in several listed companies than have a lot of money tied up in one or two small unlisted company with no assured exit arrangement.
As an aside, I have had two venture capitalists (each working for major players in the industry) tell me that the expected returns on small cap listed stocks is about the same as for investments in unlisted companies – you pay more on an earnings basis for shares in the listed company but the failure rate among the small cap listed companies is significantly less than for unlisted companies.
@ Trainee – I can’t argue with your friends (I don’t know them) … but, you are correct: as you move down the ‘market cap’ range the P/E’s go down (otherwise nobody would buy the stocks!) and the returns (generally) goes up as does the volatility (usually) … in other words, in the long term as Warren Buffett (and/or Benjaim Graham) said “the market is a weighing machine”.
Thanks for another reason why people pay (in my mind a ridiculous) premium for a listed company: if you are not “in a position to keep a close eye on a business” …
… of course, if you aren’t keeping a close eye on the business, then you are really gambling ‘ebb and flow’ and/or that the P/E (and inflation) will hold true for the long-term (so your stocks go up). Not that this applies to you; just talking generally, here.
Interesting. Never quite thought of it that way. But makes perfect sense 🙂