Investing in stocks is a lot like lending your friend money

Written by Chong Ser Jing of The Good Investors and edited by He Ruiming

Investing in stocks is sometimes made unnecessarily complex.

But really, if you boil it down, it’s basically making an educated guess on whether you’ll see your money return to your hands (hopefully more than the initial amount). 

So, we decided to come up with an analogy that you might find all-too-relatable –  lending your friend money. 

Okay, but before the nitpickers start, we have a few caveats to make.

There are key differences between investing in companies and lending money that we will disclaim upfront. Namely:

  • Lending and getting your money back (hopefully) involves a short time frame, but investments are often for the long term
  • Lending can be an emotional decision; investing emotionally is often a bad idea
  • You’d expect to get 100% of your money back when you lend people money, but you’d expect more from your investments 

Now that we’ve gotten that out of the way, let’s get straight to it.

These are the things that both investors and prospective lenders might wanna look out for when parting with their money.

Factor 1: The industry they are in 

First things first. The industry they’re in matters, because that affects how much income they will be getting.

Are they exposed to a growth industry, or one that’s stagnated and going through rapid decline?

For example, you’d prefer to lend money to someone who’s working to develop productivity software as opposed to someone who works at a print newspaper. One has the potential for a lucrative career path. 

The other’s best days are over. It’s obvious who is more likely to return your money.

Similarly, when investing in stocks, the industry that the company is exposed to is important.

Being in a large and/or growing industry means that it’s easier for a company to grow.  But companies that are in a sunset industry have little room for expansion, and may meet their demise sooner than later. 

Factor 2: The stability of their income

The next thing you think about is the stability of income.

Are they working at an established technology company as a software developer, or are they a freelance developer who relies on gigs?

Don’t get us wrong. freelancing can be highly lucrative, but it may not be as stable as working at an established company – and having a stable income increases the chances that they can repay you.

When applied to the stock market, having stable income (in other words, having recurring revenues) is better than having income that comes from unpredictable sources (such as depending on big sporadic projects for revenue). Having recurring revenues means that a company’s management team is able to better budget for growth investments for the future, without worrying that the business may fall into a rut.

Remember – investors love predictability.

Factor 3: Their financial strength

Is your friend laden with a heavy mortgage, car loan, and/or credit card debt?

If so, it’s going to be really difficult for them to repay you, as compared to somebody who has minimal financial liabilities at the moment. 

After all, if they already owe so many people/organisations money, what is the likelihood you’ll get your money back?

In a similar way, companies can also be either heavily in debt, or be flushed with cash and assets.

I prefer a company with a strong balance sheet – (aka more cash than debt). This simple trait makes a company antifragile, in my opinion. 

Antifragility is a term introduced by Nassim Taleb, a former options trader and author of numerous books including Black Swan and Antifragile. Taleb classifies things into three groups:

  • The fragile, which breaks when exposed to stress (like a piece of glass, which shatters when dropped)
  • The robust, which remain unchanged when stressed (like a football, which does not get affected much when kicked or dropped)
  • The antifragile, which strengthens when exposed to stress (like our human body, which becomes stronger when we exercise)

Companies too, can be fragile, robust, or even antifragile. 

The easiest way for a company to be fragile is to load up on debt.

If a company is heavily indebted, it can crumble when facing even a small level of economic stress. On the other hand, a company can be robust or even antifragile if it has a strong balance sheet that has minimal or reasonable levels of debt. 

During tough times (for whatever reason), having a strong balance sheet gives a company a high chance of surviving. 

It can even allow the company to play offense, such as by hiring talent and winning customers away from weaker competitors, or having a headstart in developing new products and services. In such a scenario, companies with strong balance sheets have a higher chance of emerging from a crisis – a period of stress – stronger than before.

Factor 4: Their cash flow

Also linked to financial strength is cash flow – which refers to the cash they have left from their income after all expenses are deducted. 

Example: Let’s say your friend has a promising career, a high income and little debt. However, they’re still living paycheck to paycheck because of an extravagant lifestyle.

This makes lending money to them riskier. In the event they lose their job, they might have to sell some of their stuff to get by. It also won’t be easy for them to change their lifestyle to make sure they have sufficient savings to repay you.

Similarly, when investing in stocks, I’m focused on the free cash flow that a company can generate.

All things equal, a company with higher free cash flow is more valuable than one with lower free cash flow.

Factor 5: Their income growth

Some people keep continuously upskill throughout life, and improve their earning power – whether it’s through new skills, networking or starting a business. 

Others get stuck in jobs they dislike for years and take no action because of learned helplessness.  They suffer from little job progression. 

(To be clear, there’s nothing wrong with a person not wanting to improve their income over time. For instance, there could be cases where a higher income would mean a trade-off of lesser family time.)

But simply for our context, we’d prefer if the person we are lending money to has a history of growing their income.

In stock market investing, I too want to look for companies with a proven track record of growth. 

This is because I believe that businesses that are winning tend to have a certain momentum that allows them to carry on winning. Think about it. If you’re a talented employee working in a company that’s struggling, would you prefer to stay put, or join a competitor who’s flourishing?

What happens is that businesses that are winning stand a higher chance of attracting talented employees, which allows them to carry on winning, which allows them to continue to attract talent, and so on and so forth.

Factor 6: Integrity and history of personal growth

Is your friend a trustworthy and dependable person? Or one of those people who are infamous for owing people money, dodging calls and going on radio silence? 

Make no mistake: Character and track record are incredibly important, and cannot be ignored.

Yet another important aspect about their character is attitude towards personal growth.

We touched on this earlier, but it’s important to bring it up again.

If your friend is someone who’s willing to constantly reinvent themselves, they’ll likely be able to enjoy a growing income stream in the years ahead. This makes it even more probable that they are willing and can afford to repay you. 

It’s the same with companies.

I am attracted to a company with a management team that has demonstrated integrity, capability, and innovativeness.  Each of these factors is important: 

  • A management team without integrity can fatten themselves at the expense of shareholders.
  • A management team without capability is bad for self-explanatory reasons.
  • Without innovation, a company will struggle to grow and can easily be overtaken by competitors.

The logic behind this investment framework

What we need to understand is that the fundamental nature of the stock market is a place to buy and sell pieces of a business.

What drives stock prices over the long run is the stock’s underlying business performance. If the business does well, the stock should do well, eventually.

Conversely, if the business does poorly, the stock will fare poorly too, eventually. 

The word eventually is important, because a stock’s price can swing all over the place, in an unpredictable fashion, in the short run. 

But over the long run, the underlying business performance of a stock acts like gravity for the stock’s price, with the direction of pull (upwards, downwards, or sideways) determined by the state of the business.

TWS: Read more about the author’s investing methodology here and here.

A final word

This last paragraph has nothing to do with investing in stocks, but it has something to do with lending money. We wrote this article with the intention to help make investing more easily understandable. 

That said, all of us need to realise that unlike stock market investing, lending money is often an emotional decision.

And if emotions now come into the picture, then all that logical decision-making-framework needs to be thrown out the window. The important question to answer becomes: “Am I willing to never see this money again if I lend it to my family/friend in need?”

If the answer’s yes, then you need to hope that you’re not enabling destructive financial behaviour in your family/friend by lending them money.

If the answer’s no, then you may be denying them of a second (or third, fourth, fifth) chance they might desperately need for a breakthrough in life. 

For that reason, the decision to lend money is incredibly difficult to make – it’s much harder than investing in stocks, and we hope you’ll always make the best decision for yourself and the person-in-need who’s knocking on your door. 

TWS: But just to be on the safe side: when in doubt, don’t lend.

Stay Woke, Salaryman

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