The past few days have been unsettling for many investors. Every day, it seemed, a new announcement on tariffs ‘changed the game’. But the game never changed. Not really.

The principles of sound investing remain the same as they were two weeks ago, a year ago, and even a decade ago.

Principle 1: Keep your end point in mind

Your trading history should not be a random collection of buys and sells. Each should align with the high level investing strategy that you have in place.

That high level strategy should be guided by your goal: what you want from life, how much you need in dollars to fund that, and your time horizon.

The biggest single goal I am investing towards is a comfortable retirement. This is still 30-plus years away, which means my approach to investments and my buy/sell decisions should reflect this timeframe and the returns I need to hit my target.

I certainly shouldn’t be thinking in days, quarters, months, or even years at this stage. Food for thought if you are ever tempted to ‘sell everything’ in an attempt to avoid a rocky few months for markets.

Principle 2: Buy high quality assets

What makes for a successful investment? Again, I am going back to basics. We want to own assets that become more valuable over time. If that asset is a bunch of shares in a business, the most reliable way for this to happen is for each share to eventually have more earnings or asset value attached to it.

Warren Buffett put it best when he said the following: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.”

How might you find companies of this nature? The truth is that there aren’t many situations where you can be “virtually certain”. But your best bet might be looking for companies that 1) operate in niches with growth opportunities and 2) have strong competitive positions in those niches.

Companies with sustainable competitive advantages and growth opportunities have the best potential to compound in value over time. Not only will they have opportunities to reinvest in their business to increase profits. The returns they get on those investments are likely to be higher because of the moat.

You can read more about finding companies with sustainable competitive advantages, or moats, in this article by my colleague Mark LaMonica.

Principle 3: Be picky on valuation

Over the long term, the return you get from an investment will mostly reflect changes in the company’s earnings power and competitive position. But the price you buy in at also matters.

Imagine a 20-year investment in a company that generated $5 in free cash flow per share at the time of your purchase. Now imagine this company achieves the admirable feat of increasing its free cash flow on a per-share basis by an average of 8% per year.

After 20 years, the company now generates over four-and-a-half times the free cash flow per share that it did when you bought it. But that doesn’t mean you will get a 4.5x return on your investment.

Let’s say the company ‘usually’ trades at around 15 times free cash flow. At that valuation, our imaginary company’s share price after twenty years would be $349.50.

Focusing purely on the share price as opposed to potential dividends, here is how your purchase price affects the annual return:

  • If you initially paid the same 15 times multiple for your shares, your return would mirror the 4.5x or 8% per annum return.
  • If you bought at a time when markets were unusually down on the shares and snagged them for 12 times free-cash-flow, your annual return would be 9.21%, assuming they eventually traded back to the “normal” level of 15 times free cash flow.
  • If you bought when markets were unusually hot on the company’s prospects and paid 25 times free cash flow for your shares, however, your annual return after a return to the ‘normal’ 15 times multiple would be just 5.28%.

This from exactly the same results in the underlying business.

Effect of purchase price on return

Figure 1: Price return of imaginary 8% free cashflow grower at 15x exit multiple and different purchase prices. Source: Author

Thanks to the power of compounding, the difference between a 5.28% annual return and a 9.21% annual return over 20 years is over $3000 for each $1000 invested. That is the power of underpaying rather than overpaying for shares.

Your aim, then, should be to buy shares in high quality companies when they trade at unusually low valuations.

Principle 4: Try to ignore short-term noise

Why might shares in a high quality company suddenly become available for cheaper than usual?

It doesn’t generally happen that often. And when it does, it is unlikely to be because everything is going perfectly. In fact, it is quite likely that investors are alarmed about something.

Maybe the near-term outlook weakens or, even worse, becomes highly uncertain. Maybe there are concerns that a new competitor or technology could hurt the business. Or maybe something like a serious product defect leaves investors scared about a permanent loss of value.

At times like this, your job as a potential investor is to work out whether the problem or source of poor sentiment appears to be permanent or temporary. If you can find a high quality company facing a temporary problem, taking advantage of a slump in its share price could be rewarding in the long-term.

An important aspect of this is being able to exercise patience while the problem rights itself or your thesis plays out. As I said in this recent article, just because you think you bought cheap doesn’t mean the shares can’t get cheaper afterwards. But a short-term loss on paper doesn’t mean you are wrong.

Principle 5: Think about what not to do

Charlie Munger popularised ‘inversion’: the practice of flipping problems or goals on their head to figure out the best way forward.

Instead of asking how to get the best investing results, for example, you could ask how to avoid getting poor investment results and focus mainly on that.

One behaviour that everybody knows is unprofitable, and yet many fall prone to, is emotional trading and feeling a need to buy the asset du jour regardless of price. Especially at times when things get volatile and financial media outlets are replete with sensationalist headlines.

At times of panic like that, selling assets that everybody wants to sell will probably leave you with a raw deal. So too will buying ‘safe’ assets that everybody suddenly wants to buy. So what can you do to increase your chances of not panicking when everybody else does?

I would say that, like most things, prevention is easier than the cure. You want to own assets and businesses that you are truly happy and comfortable owning for the long-term. Even during times of stress. And even, as Buffett put it, if you did not have a daily market quote to reassure you of their value.

Dare I say there aren’t that many companies and assets of that ‘sleep at night’ quality. But it is definitely worth thinking about what qualities and attributes might provide you with that kind of comfort. Those qualities, in turn, can become part of the investing criteria you set as part of your strategy.

For a five-step process you can follow to define this strategy, read this guide by my colleague Mark LaMonica.

Closing thoughts

The five principles I’ve touched on today are: keep the end goal in mind; buy high quality assets; be picky on valuation; ignore short-term noise; and thinking about what not to do.

The glue holding these together, really, is a dedication to quality over quantity of action. I know it can be hard, but the potential rewards are huge.

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