How is Investing and Owning a Small Business Related?

When I first created and named this blog, my wife asked me the question “How is investing and entrepreneurship related?”  She didn’t see the connection.  Perhaps my audience doesn’t either, and I’ll explain.  They are very much interrelated.

With index funds, you are investing a bucket of companies that match specific criteria.  For example, the S&P 500 is a very common index.  To the average observer, the S&P 500 looks like a mystical black box, and in a way it is.  The issue is it’s hard to relate to a specific company within the index.  There is nothing wrong with index investing, and I believe it’s an easy way to invest and beat 80% of the active mutual fund managers in the process. It’s a very passive process, and you are betting that the pool will do better over time.  What makes index investing great can also lead to just average performance. For the purpose of this article, I won’t talk about proper asset allocation, but that is one method to help improve passive investing.

The issue with index investing is you are betting that the overall economy (macroeconomics) will do better, and not a specific stock.   As history has shown, the economy generally grows over long periods of time (5-10 years), so it’s a smart bet to take.   This then means most company stocks will increase over time, and in turn will increase the value of the S&P 500.   Just like a life preserver that rises with the tide, stocks collectively rise with the economy.

Now take an index and compare it to a specific stock.  When you invest in a specific stock, you are dealing with the specifics of that company.  It’s not uncommon for a specific company to grow, while their competitors are contracting, or even the entire economy is in a recession.  Investing in specific stocks is where the experience of entrepreneurship is key.  You can apply your small business skills to investing in stocks. When you own shares of a specific stock, it’s like being a silent partner in that business.   When owning shares in a company you trust that the board of directors and the executives will properly manage the company, and you’ll get a return on your investment.  Your skill sets are even better used when investing in sectors you know (in my case technology).  You know the trends in the industry.  You know the good companies from the bad ones.

Now lets talk about the financial side.  At least with value investing, you analyze the financials of a company and determine their tangible book value.  That then in turn can be derived down to a price per share of their stock.  The question is, does the stock and the valuation you determined match?  Is your valuation higher or lower?  If the valuation is higher than the current stock price, that means the stock is not priced correctly and a possible stock to buy.  If you believe in efficient market hypothesis, this should never happen.  Does the market always price a stock correctly?  From my experience, the answer is definitely no.  For the long term yes, for the short term maybe no.  Fortunately, in the short term (weeks, months and in some cases even years) a stock can be priced lower than its real market value.  Benjamin Graham called this Mr. Market.  As we mark the 1-year anniversary low point in the Dow Jones, it is a perfect case in point.  During that time there were many stocks priced as they were going out of business, and the world was going to end. Warren Buffet has stated, “Be greedy when others are fearful” and this definitely applied last year.  Many stocks last year had red tag sales like “40% off!” and “buy two shares, get one free”.

To give a specific example from my investments, I’ll mention Apple (AAPL).  At their low point they were priced at around $80/share, yet at the time, they had over $30/share of cash on hand.  Meaning $50 of their price was for their future sales, their technology patents, other assets and employees.  Without going into the details of financial analysis, it was a real bargain for sure. People panic when stocks reach new lows, yet flock to stores when things are on sale?  To give a little insight, they are exactly the same! The real skill is being able to spot the real bargains stocks from the artificially marked up and then slightly marked down (net means it’s not a bargain, which is also a tactic stores do).

To help you determine what’s cheap and what’s expensive, you should have a good understanding of financial statements.  At least from my experience in owning a business, it’s the most important asset I have.  If you don’t, you might as well pack things up and go home.  With that said, what applies to your small business works with larger corporations. Check out the my recommended best finance books.

As a business owner, it’s not uncommon for me to deal with these issues on a daily basis:

• Cash Flow – Do we have enough money to pay bills and salaries?
• Assets and Liabilities -  How much debt we have and at what interest rate?  Do we have too much debt?
• Business Planning – Are my business plans solid and will they generate income?  How much income should we expect?  Where is the market heading in my industry?  What are the trends?
• Sales and Marketing – How can I attract new customers to our product/service?

All of these are also important factors when doing stock picking.

My suggestion.  Own a business.  Even a part-time business that ultimately results in a failure.  At minimum you’ll get a priceless education about investing and entrepreneurship.  Best case, you’ll have a profit, turn it into a full time career, and become a good investor in the process.

Disclosure: Long shares of AAPL