Larry Sarbit, CEO and CIO at Winnipeg, Canada-based Sarbit Advisory Services, has written an insightful article about the rational way to invest in stocks.

Like Cars or Groceries

Too often investors turn irrational when it comes to buying and selling pieces of paper — or, more likely, electronic entries in a brokerage account — called stocks. They forget that the latter are nothing more (and nothing less) than part-interests in real-life businesses. Other things equal, it would behoove investors to buy those stakes at as low a price as possible, just as they would try to do with cars or groceries. Advises Sarbit,

When you invest, behave like a rational consumer. Behave like you do when you buy a car or groceries. That’s our approach: research and decide on the few businesses that are worthy of purchasing. A shopping list if you will. Then only buy stocks when they are on sale. When these conditions don’t prevail, sit on the sidelines until they do.

Sarbit, whose firm serves as a sub-advisor on three funds for IA Clarington, reminds us that investing is simple but not easy. When it comes to cars and groceries, consumers tends to act quite rationally. However, when it comes to equities they, for whatever reason, depart from the tried-and-true logic of buying something for less than it’s worth.

Here is the instructive parallel Sarbit draws to shopping for a car:

Picture yourself buying a vehicle. What are the steps you take and what is the final outcome? First off, what type of car do you desire? Sports car, convertible, SUV, truck, or hybrid? Okay, so you have decided on a fuel efficient hybrid. Next you will research what is the best hybrid for your budget and preferences. You may search Google for reviews of various vehicles, talk to your local mechanic, or go for coffee with your friend the “car guy.” Next is to decide on the options you must have. Power windows, heated seats – maybe a heated steering wheel for those of us in cooler climates.

Making the final decision will take a fair bit of time no matter how you cut it. Now you have the hardest part–to actually find a vehicle to buy in the real world. There will no doubt be haggling over the price. A rational consumer would not pay black-book value for a vehicle that has a big scratch on the driver’s side door. In the end you may not even buy one because there is nothing for sale worthy of your hard earned money.

Consider your decision to sell a vehicle as well. Would you drive a brand new vehicle off the lot, panic because it just depreciated $5,000 in 5 minutes, turn around and sell it back to the dealer before it dropped any further? As a consumer, a rational sell decision is based on logical thought, not panic over the rapid change in price.

Sounds simple and easy. Unfortunately, in the stock market, even among professional investors, few have the capacity to remain rational when markets turn euphoric or fearful. This allows fund managers like Sarbit to find the kinds of bargains that are the foundation for long-term outperformance.

Larry Sarbit’s Four Pillars of Rational Investing

We have had the pleasure of interviewing Larry on a few occasions as well as seeing him share his wisdom and insights with our members at Latticework 2016.

In one of our conversations, Larry discussed the keys to long-term investment outperformance. What are the pillars on which Larry Sarbit’s long-term success is based on? As Larry says, the basics of investing are really very common sense. Yet, over time, few investors grasp these basic, easy-to-understand ideas. Or perhaps they are just not disciplined in how they apply them in practice.

In the following excerpts from the conversation, Larry discusses the four key concepts and practices employed by successful business owners and investors that drive their long term success. Of course, these concepts will not be new to Warren Buffett followers. However, it is only by constantly reinforcing and refining these concepts that we can improve our odds at staying disciplined in their application.

(Listen to the full conversation in The Manual of Ideas Members Area.)

The following are excerpts from the transcript of our conversation:

It’s just saying forget about numbers and just think about buying a business. If you were going to buy a business, if you wanted to go into a private business somewhere, how would you perceive it? How would you think about it to be successful? I derived a lot of this from Warren Buffett, of course…he thinks business. He is very much a rational business investor. He’s not a stock market guy, he’s a business owner – that’s how he perceives himself. And when I look at how successful businesspeople have achieved their wealth, all I’m trying to do is copy what they have done. Just duplicate as much as possible how a very successful business owner and manager has behaved in the past.

What they have, the first pillar we would say, is buy a wonderful business. A terrific business is a business that has terrific characteristics: It has a sustainable competitive advantage… first and foremost you have a business that has terrific characteristics that mean that its odds of success are going way up. Again, that’s just rational. That’s what businesspeople do all the time. They care about price or what they pay for it, but first and foremost it has to be a terrific business. They don’t mind paying a bit more for something that is truly, truly great.

The other thing that successful businesspeople have done is they have almost always done it in one business. They have not done it in a well-diversified portfolio of stocks – that is not how wealth is created. It is created almost every time in one business. Occasionally, two businesses but you don’t see a hundred businesses in a successful businessperson’s portfolio. That just is not how it’s done. You can’t manage hundreds of businesses. You can’t understand hundreds of businesses. And you end up as Warren Buffett says – you end up “diworsifying” your efforts. And that is the exact opposite way to which successful businesspeople have behaved.

And of course, it takes time to build a business. You don’t get instant returns. Building a business, if you own and run a business, it’s a multi-year, multi-decade, perhaps generational process of growth. People in the stock market seem to think that they should be given returns on a regular and short term basis. If you think in that fashion, if you approach it as a rational business owner and keep this top of mind, and start with those principles, you have a far greater probability of creating wealth.

Pillar 1: Buy a Wonderful Business

Successful business people have been winners because they usually own companies that possess a few simple, but critical characteristics.

These include, an enormous sustainable competitive advantage against others in the same industry. They generate large growing streams of free cash flow (excess cash not needed by the company for ongoing operations). They are simple and understandable businesses. They have a high degree of predictability with repeatable consistent revenue streams, selling products or services that people will require now and in the future. They have a high return on invested capital – that is, they don’t require much capital or future capital expenditures in order to succeed.

A wonderful business is allowed to make mistakes – sometimes large ones – but the company survives such events because of the strength of the franchise. Such companies obviously differ significantly from an average business where competition and future revenue and cash flow streams are usually much less predictable.

Pillar 2: Pay a Bargain Price

This simple concept means that the business buyer will purchase a company in whole or part (shares) only when the price of the business is below a conservative evaluation of the estimated range of the true underlying value of the enterprise.

This allows the investor to achieve two goals: first and most importantly, to protect capital. Paying such a price means the investor is naturally less likely to suffer a lose of capital. Successful business owners are usually very conscious of never overpaying for any input to their business or in buying other companies. Secondly, paying a bargain price for a wonderful business enhances the return generated by that business, in exactly the same way that buying a bond below issue price will increase the coupon to the debt holder. The end result: high returns and lower risk – the ideal objective of intelligent investing.

Pillar 3: Concentrate

Again, we are imitating successful business owners. In practically every case, they have prospered by being in and understanding one business. Owning hundreds of companies as characterized by most mutual funds and investment portfolios is a guaranteed road to mediocrity, not the path take by the few winners in the field of business and investing.

Pillar 4: Have Patience

Real successful business investors own businesses for years, decades and generations. Bargains don’t emerge because of positive events. Patience is required in undervalued situations in most instances because often, a negative event has occurred. We don’t know when the event will pass, but we have a high degree of certainty that it will happen at some point in the future. Investors in our funds may have to wait for these events to unfold. But the returns received from having patience far outweigh the time that is needed to be patient.