An Alternative Way of Looking at Investing in Stocks

Posted By Robert On Monday, January 20th, 2014 With 0 Comments

Any investment involves laying down a sum of money today, in order to receive a residual series of payments in the future, with the idea of receiving more over time than you pay today.

We might invest £100k for a 10% stake in a business with mutual benefits to both parties – the business receives the money to expand its operations and improve its ability to earn money over time. The investor benefits saying “I don’t need the 100k as much today, I’d prefer to receive 5-10k a year for a period longer than 10 years, and hopefully grow my capital as the business retains the rest of its earnings”

In the heat of the stock market, 24-hour financial news and the perception of risk that hangs over volatile stock prices, it’s no surprise that we lose sight of the basic ideas of investment.

So what if we strip away our stock market preconceptions and imagine a market where people – rather than companies – offered a share of their future earnings in exchange for capital today. Let’s imagine a Student Market – where hopeful 18 year olds cut a deal with investors, to finance their studies in exchange for a % cut of their future earnings.

The concept is the same as investment in a business. The investor believes that by paying the student’s £100k cost of education (that’s to cover Uni fees, living expenses, the lot), he’ll get a cut of the student’s earnings for the rest of their lives which will hopefully turn out to be greater than the 100k investment.

And so in our Student Market, the investor has his pick of the best and brightest in the land – some will be future Doctors, some will be Engineers, some will be Bankers, some will flourish and open their own business generating lots of money, some will spend their 100k digging for oil on faraway continents. Others, will spend the 100k foolishly, or less effectively than others.

Naturally, the 18 year olds who have their eyes on Cambridge and Oxford, will not offer us much of a cut for our money. Afterall, they expect to make hundreds of thousands a year in their prime – so for our 100k investment might only offer us a 1% per year cut of their salary. Equally, the 18 year old looking to make their way in the competitive world of telesales, might offer 50% of their salary every year for the 100k – if there was little confidence in their salary improving much with time.

There are good 18 year olds and bad 18 year olds to invest in – some will make the very most of their money, and will use it to improve their income each year. Out of the money they don’t give you, they might spend the rest of their salary on more qualifications, or on rental properties, to improve the amount they earn as time goes by. Others will make inefficient use of money, perhaps no fault of their own if every qualification only earns them an extra few hundred pounds a year.

Some will become specialists in their field, and might command a very high salary as one of the only people in the country capable of a certain type of surgery. Others might only offer a “commodity” service, and might find themselves squeezed in competition to a relatively low salary, because they can’t demand more money for a job someone else can fill.

By the same token, there are expensive and inexpensive 18 year olds – the Cambridge student who offers you a tiny fraction of their salary, might surprise you by earning relatively little for your 100k. The 18 year old in telesales might become the CEO of the company through wit and determination, even though you didn’t pay much to own 50% of his earnings.

The good investor weighs the likelihood of the student doing well, compared with the price being paid to get a cut of those future earnings. Earnings will fluctuate – in a bad economy the best of people can suffer reduced earnings, while in a good economy salaries will be inflated on a whole. You could lose your whole 100k, if the student blows the money and sits at home. But you make an educated, informed decision on the right price to pay for the right student.

Can we make educated guesses on how much bang for our buck we get for our 100k? Trying to be precise, and placing a decimal-point value on each student, is simply not worthwhile. But by being sensible and conservative, if we find a case where we’d happily receive a 2-3% cut, but are offered a 10% cut of future earnings, there’s a sufficient margin of safety to ensure we’re getting a good deal.

The principles are very much the same as investing in common stocks, often with the exact same factors to consider. What return are we getting for our money? When earnings are retained instead of distributed, how does that improve next year’s earnings? Is there a burden of debt that’s eating into our % cut?

When we think in these terms, often the same qualities of a “good student” apply to a “good company”, and a good investment too.

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