Here’s How to Understand Investing in the Simplest Way Possible

A few weeks back, I had set a challenge for myself to distill stock market investing in a way that even my nephews and nieces (who are only in Primary school) can understand.

This is an important endeavor because investing often scares and mystifies many due to its apparent complexity. But the thing is, investing can be a simple affair, and need not be complicated.

The challenge though, is how to bring that simplicity across. As I thought long and hard about it, I remembered a great story from Joel Greenblatt’s gem of an investing book, The Little Book That Beats the Market.

Greenblatt’s a great investor, and his book has a knack of deconstructing complex investing-thoughts into bite-sized pieces. There was one particular story he narrated involving his son’s friend Jason, and for me, it manages to demystify what investing is all about.

Here’s a retelling of the story in my own words:

Jason is around 12 years old, but yet runs a thriving business selling chewing gum in school. He buys a pack of gum (which contains five sticks) for 25 cents each, and sells each stick for 25 cents.

As you can see, each pack of gum Jason sells would net him a profit of $1 (125 cents in revenue minus cost of 25 cents).

Jason sells around three packs a day, for five school-days a week, for 36 schooling-weeks a year – that would amount to a profit of more than $500 annually ($540 to be exact; but let’s use round numbers for the sake of simplicity).

With Jason having six more years in school, he would stand to make more than $3,000 by the time he graduates.

Now, Greenblatt turns around and asks his son, “Would you buy half of Jason’s gum business if he’s willing it to sell it to you for $1,500?”

Greenblatt’s son (let’s call him Greenblatt Jr.) cleverly quips that he would not be buying it for $1,500.

After all, why would he? Jason might end up selling less than three packs a day as time passes, and Greenblatt Jr. has to stump out $1,500 now in order to get back just $1,500 six years later.

Greenblatt Jr. then suggests that he would buy half the gum business for $450 because in that way, he would be able to make a profit after six years, and he would also be able to cater for any unforeseen negative circumstances.

With that, Greenblatt proudly announces that Greenblatt Jr. finally understands what investing is all about: It is simply the act of “figuring out what businesses are worth” and paying a price lower than that.

The story ends here, and the book goes on to further discuss Greenblatt’s investing philosophy. That’s not important here though. What’s important is the takeaway on what investing really is: Which is to buy businesses that are selling today at prices lower than what they are really worth.

It might now make sense to ask: Where can we find such bargains? The answer’s simple: The stock market.

Believe it or not, but bargains do appear from time to time for all kinds of reasons. The last time stocks were being cleared off the shelves at fire-sale prices was during the Great Financial Crisis of 2008-09.

At the start of 2009, the Straits Times Index (SGX: ^STI), a benchmark made up of an agglomeration of the stock prices of 30 of Singapore’s largest listed companies, was changing hands at around $6 per dollar of profit.

Over a 20-year period ending 2012, the Straits Times Index had, on average, sold for around $17 per dollar of profit; this can give you some perspective on how cheap the index – and by extension stocks in Singapore – had been.

Today, the index has more than doubled since bottoming out on March 2009. That sharp rebound also means we’re nowhere near the previous bargain status with the SPDR STI ETF (SGX: ES3) selling for around $13.50 per dollar of profit; the SPDR STI ETF is an exchange-traded fund which mimics the fundamentals of the Straits Times Index.

But this doesn’t mean the stock market is now expensive such that bargains can’t be found. At the very least, the index’s valuation (the amount of dollars being paid per dollar of profit) is still some way below its long-term average.

Also, with more than 750 companies listed in Singapore and the Straits Times Index being a representation of the fates of just 30 companies, it’s likely that investors may still find companies which are selling for less than they’re worth if enough rocks are turned over.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.