The Intelligent Investor – 11 – Security Analysis for the Lay Investor: General Approach

A security analyst has to deal with the past, the present and the future of any security issues. The analyst works on the understanding of businesses, financial strength, strong & weak points, possible risk, future earning power under the various scenario, etc. after all works, he decides whether to invest in the given security or not. We do not always rely on past performance, but for selecting the growth stocks, we need to value a future earning power and growth rate. Additionally, we should not forget the past performance given by the businesses for making a mathematical calculation of valuations. When we forecast for the longer future horizon then it will become the involvement of more errors.

Bond analysis

We need to focus on the safety, quality of the bond issue. And our prime criterion should be several times interest charges have been covered by the earnings currently. Cover on the average earnings of previous years and cover on the poorest earning year. As preferred stock dividend is not tax-deductible so that we need to check cover on PBT to interest charges + 2x of preferred dividend.

With the above points, we need to check the size of the company, (debt + preference stock)/equity ratio and property value. Now, if bonds passed through the stringent test and survived into the past performance then it has a higher probability to survive into the future. If the bond does not meet such criterion then it must be avoided though it offers a 2-3x yield compared to the risk-free rate.

Common stock analysis

Valuation of common stock needs to perform for deciding whether a common stock is attractive to purchase or not.

This means estimating future earnings and then multiplying it with the multiples. Multiple decided as the 1/expected earning yield. For example – if I expected to get 6% earning yield then my multiple would be 1/6% so multiple will be 16.67x. Different people provide different multiples and estimate different earnings which tends to a different price target for them. Why one company available at 10x of earning and other at 20x of earning? Do we pay rightly or paying overdue to a rosy picture? These all questions getting answered by the following factors –

Long term prospects – we cannot able to know that what will be going to happens in the longer future but then also, we try to estimate for the far future. This estimation creates a different multiple for the same stock. Also, need to check that whether the company is a serial acquirer or they make an investment to own company? If serial acquirer then what is the track record of previous acquisitions? Whether the company able to generate enough cash from operating a business or has to rely on other people’s money? Whether diversified customer base or rely on one single customer?

Does the company spend money on research & development, developing new products though they have a successful product? (R&D as a % of sales) and also how much company is spending on selling and marketing? (Selling & marketing, distribution spending as a % of sales)

One of the Pharma company of India

A company having R&D and Selling spending combined account for ~16.73% of sales. Such spending improves the longevity of earnings. Sales and profit of the company have grown by CAGR of 17% and 26% respectively during FY12-19.

Management – we know that management plays an important role in the development of the business. And many a time, given weight to the management leads to overvaluation or undervaluation to the stock. If any business is continuously successful for a longer period then it will be considered as having good management. Does management has fulfilled promised made by them? How they behave while meet failure – they admit failure or pass responsibility to the economy, uncertainty, weak demand, etc.? Look at their behavior during the best period. Does senior management involve the frequent buying and selling of shares? Does management involve to direct the market speculation through announcement? Does the financial statement of the company is transparent?

All the above points provide a study of qualitative aspects of the management part. If we focus on the above points then we can avoid the management who is not shareholder-friendly.

Financial strength and capital structure – one company has an excess of cash on the balance sheet and another one has a bank loan + preference shares + bonds then we should consider the first one good compared to the second one though both have the same revenue, EPS, etc. Good business does not frequently require huge cash to run a business and they generate a good sum of money.

I am not quoting any example over here; I have already explained the same in Warren Buffett’s 2007 letter article. And many businesses pass and fail from the above parameters.

Dividend – consistent dividend payment is one of the criteria for judging the quality of the company. Defensive investors will focus on the consistency of the dividend payments. We also have to check that the company paying dividends out of free cash flow or from borrowings.

One of the steel manufacturing company

There are few companies which are into the expansion phase then also paying out dividend by taking a debt and equity dilution rather retain cash for expansion. In such cases, we should not focus on the dividend. Also, if the company can grow with generating a good return ratio then we should prefer to retain cash for expansion purposes rather than the distribution of dividends.

One of the retail company

The company has good growth and over some time, the company has started generating a decent return ratio. Here, the company does not require to distribute dividends and retain cash for expansion of the business which the company is doing with zero dividend payout.

If the company does not have a growth opportunity and does not require to bring external funding to run a business then it is preferable to distribute earning as a dividend.

Dividend policy – how much company is distributing profit as a dividend, higher the dividend distribution higher the valuation the company gets. Here, we need to see that whether dividend serves the purpose of shareholders or retaining profits for future expansion serves the purpose. The company should buy back the shares when it available cheap, not when it traded at high/overpriced.

The capitalization rate for growth stocks

Value = Current Earnings * (8.5 + 2 * Expected annual growth rate)

*Expected annual growth rate would be considered as growth for upcoming seven to ten years

Industry Analysis

For making an analysis of any security, we need to check the industry growth, position of the particular company within industry, how industry will grow and earn profits, what was the past of the industry, what is present state and what will be the future state of the industry, what will be the new product and process.

For calculating the value of the company, we need to check how the company has performed into the past and what are the factors which can change the future performance of the company. Calculate valuation on the past performance and list down the factors which make changes to the valuation based on past performance. Also, mention points that can change the future performance of the company.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

SIMPLE IS BETTER – ISSUE -14 – DEMERGER

We have seen many companies are separating their business division to the different entities and many times, those different entities are getting managed differently.  We also consider such step of the management as a shareholder-friendly and value creation for the shareholders of the company.

In this issue, I am going to explain what demerger is and how it can impact the financial of a company?

For Detail Issue, Click here —> SIMPLE IS BETTER – ISSUE -14 – DEMERGER

WARREN BUFFETT’S LETTER – 1996

Warren Buffett’s Letter – 1996

Acquisitions

Kansas Bankers Surety (KBS)

The company is an operating into the business of insurance which has a presence in 22 states, decent underwriting record with Don Towle as a manager. They made a deal to acquire a company at \$75 million.

FlightSafety International

The company is the world’s leader in the training of pilots. The company operates in 41 locations, outfitted with 175 simulators of planes ranging from the very small, such as Cessna 210s, to Boeing 747s. About half of the company’s revenues are derived from the training of corporate pilots, with most of the balance coming from airlines and the military. They made an acquisition at \$1.5 billion.

We need to prepare a list of the errors which can be dangerous for the health of our investment and work to avoid those errors. If we work on the avoiding mistakes then we can win 50% of the battle.

List of mistakes which I have experienced during my investment journey –

• Never ignore the true value of the company—Every business has some value and that we should not have to ignore. If we commit such a mistake then the market will defiantly punish us. Be careful with the true worth of the company and only buy it when it falls below its true worth. And if business not available below its true worth then ready to missed that opportunity. Loss of opportunity is better than the loss of capital.
• Don’t buy HOT —-If we buy the hot business such as recent trend, new IPOs, business on which everyone is bullish etc., then we must have to exit it at the proper time. So if we aren’t able to exit at the proper time then it’s better to let it go such opportunities. If we buy HOT then that HOT will BURN our portfolio.
• Buying a high leverage business — We need to avoid a business which has a huge borrowings, such borrowings can kill the business and also kill our investment journey.
• Using the wrong valuation method — Every business will not get valued with a similar valuation matrix. We need to identify the nature of the business and then value a particular business. Such as we should not use the valuation matrix of growing non-cyclical business for cyclical business, should not use the valuation matrix of assets light business for assets heavy business and vice-versa. If we made such a mistake then whether we might miss a decent investment opportunity or we might lose our capital.
• A mistake of buying a story, not a fundamental — I have never ever made such a mistake because I am a hard-core lover of numbers. But I have seen many of the people who always focus on the story and also which is very trending to the market. I believe that without the support of numbers, no story can survive for long. In the year 2014-15, Logistics stocks due to GST gets a trending story but due to lack of good numbers, the story gets failed. People generally avoid numbers due to lack of understanding of it. I firmly believe that “Stories are for kids, not for investors.”
• Investing without a process and philosophy — I can overcome this mistake at the initial period of my investment journey and that is only because of my guru – Neeraj Marathe Sir (who always believe on having a process and philosophy for making an investment). I have seen many people who spent lots of time into the market but they do not have any process or philosophy. They change their philosophy as they meet various people. If we do not have our own process and philosophy for making an investment then we will not able to create a successful investment journey. I also learn from my guru that we must have our philosophy in a written format so that we can refer it over a period of time and stop ourselves from occurring a mistake.
• Not using a checklist — We should have a checklist for a business, industry, financial, management etc. so that we can focus on the points to study and also not forget any point to study. I am using a checklist for the last 3 years and I can say that having a checklist helps me a lot. My checklist keeps on improving as my experience grows.
• Making an investment decision with disturb mind — We should avoid making an investment decision while our mind is disturbed. Disturbance in mind will end up with the faulty investment decision and which can be harmful to our wealth.
• Cloning a well-known investors/fund managers — Again I can overcome this mistake at the initial period of my investment journey and again credit goes to my guru. If we have our process and philosophy then we will not try to clone others. I have seen many people who have spent 10-15-20 years to the stock market then also not having any process and philosophy & they clone others. Many of the people have cloning as their investment philosophy because they love to use shortcuts. I always remember the quote of my guru –

When Company does not have an opportunity to reinvest earnings at a higher rate than the company should distribute those earnings to the shareholders so that they can use it somewhere for getting a higher return. If the company does not have a good opportunity to reinvest earnings and then also company does not distribute earnings as a dividend then we need to be careful with a company (Question on the capital allocation decision of a management or earnings can be manipulated or business always needs a huge capital to sustain only).

Examples – No/Low growth high dividend payout

Examples – No/Low growth low dividend payout

We need to check the above-mentioned factors in the company where we have made an investment and where we want to make an investment. Most important is to gain a market share. The company cannot able to gain market share, though the company has a competitive advantage then that competitive advantage not useful for us. We should not focus on the leadership position of the company rather need to focus on the companies which focus on the manufacturing, distribution, packaging and product innovation. Market leadership can be changed if the company does not focus on the mentioned points.

According to Mr.Buffett, paying a higher price does not risk for the good companies compared to paying higher prices for the bad companies.

Let me take an example of one the biggest wealth creator company of the Indian stock market—

If someone has bought this company during the March-2000, at the high price of around Rs.431 then after the 16 years of the period, he gets returned at 7% CAGR. And if enter to the similar company at the low price of around Rs.275 during the March-2000 then after the 16 years of the period, he gets a returned of 10% CAGR (*Considering all-time high price for calculating returns). Though revenue has grown at 30% CAGR, Operating profit grown at 27% CAGR and Net profit also grown at 27% CAGR during the same period with supported by a good management team. During March-2000, the company was traded at 64x P/E at the low price of Rs.275 and this multiple is common nowadays.

When management of a good business diverts their focus into the business which is not performing well then such decision of the management affect the performance of the business.

Example – We have seen examples such as liquor manufacturer enter into the airlines business, airport contraction business has diversified into the power business.

Mr.Buffett has also mentioned the Circle of Competence concept –

Control on our temptation, control on our emotion towards our investment is essential to survive and create wealth from our investment.

Warren Buffett’s Letters 1957 – 2012

BIBLIOPHILE: THE MOST IMPORTANT THING BY HOWARD MARKS “THE RELATIONSHIP BETWEEN PRICE AND VALUE”

As we have discussed regarding value in the previous article of a Bibliophile. Now, I am going to talk about the 4th Chapter of The Most Important Thing – The relationship between price and value.

There is not an availability of any asset class which having a birthright for providing a higher return. If we bought a particular asset class at an appropriate price, then that provides us a higher return to safety.

An example of one the biggest wealth creator company of the Indian stock market—

If someone has bought this company during the March-2000, At the high price of around Rs.431 then after the 16 years of the period, he gets returned at 7% CAGR. And if enter to the similar company at the low price of around Rs.275 during the March-2000 then after the 16 years of the period, he gets a returned of 10% CAGR (*Considering all time high price for calculating returns). Though revenue grew at 30% CAGR, Operating profit grown at 27% CAGR and Net profit also grown at 27% CAGR during the same period with supported by the good management team.

If we buy such a good thing at a too high price, then we have to wait for the very long time for getting fair returns rather getting superior returns. But if we have bought junk asset class or good asset class at an appropriate value, then we can able to create a superior return.

We should focus on correctly buying an asset at a cheaper price so that we need not keep focusing on the selling decisions. Because our buying decision provides us a huge safety. Whenever we buy any stock at a cheaper price and all our calculations of intrinsic value are correct, then over a period of time, the stock price should reach its intrinsic value.

So, that One of a good idea of making an investment is to buy whenever the pessimistic situations around us which provide us a good return with proper safety. But such scenario not always comes. This means we construct our portfolio at the time of crisis, but every time, we cannot stay only dependent on the crisis for making our buying decisions.

Thus, most important are to understand the relationship of price & value. By knowing the relationship between price and value, we can able to take an advantage of mispriced valued stock and consistently create a wealth for the longer period of time. We also need to understand the Psychology of investors along with the understanding the price – value relationship because the psychology of investors can drive stock prices in the short run. But at a longer period, the price should reach its intrinsic value. So, that it is an essential for us to buy an asset at a discount from its intrinsic value.

Investors Psychology is also one of the important factors along with the Fundamental value of the security which can drive stock prices to an extreme side and that provide us an opportunity for our entry/exit. We should avoid falling into the trap with short term price fluctuation due to the psychology of investors but should take an advantage from it.

People never focus on the price at clever people make an investment. But they start herding towards the news of such deals. So, that more and more people start buying the same stock and due to the flow of buying, the stock starts rising and again more investor start buying into it and stock start rising again. Thus, psychology drives a price much more rather than its fundamental in the shorter period of time. Everyone starts creating stories after the clever people make an investment, those stories drive the price of the asset class at extreme direction.

As per the Howard Marks, there are few ways by which we can earn a profit on the investment:

• Benefiting from rising in the asset’s intrinsic value.

In this method, an investor has to predict accurately to the improvement in the intrinsic value of the assets in the future. But this task is not as easy as it seems. We even don’t know our future and we are going to predict the future of the intrinsic value which is very uncertain in nature.

• Applying leverage

Leverage means investing using borrowed money. Leverage always works as a double edged sword. It can either make you or will break you. It magnifies both gains as well as losses. So, leverage might provide us a higher return, but it can also create a threat to our own capital. Selling for more than your asset’s worth

• Selling for more than your asset’s worth

Here, we need to hope for the buyer who is ready to buy an asset at a higher price. If we are holding an asset which is overpriced or fairly priced than we need a greater fool to buy an asset from us at a higher price.

• Buying something for less than its value

In this option, we are buying an asset at the discount, from its intrinsic value. It’s just required for the proper functioning of the market and that brings an asset to its intrinsic value. This can be one of the most useful ways to make a consistent return with a safety of our capital.

Click for Video — Sultan Mirza

As we have seen in the video that Ajay Devgan has bought Guava at a very high price compared to the real value of the Guava. We have many a time experienced such kind of the irrationality among the investors who focus on story prevailing at market space rather than focus on the real value of the particular stock. We will not always able to meet Sultan Mirza (Ajay Devgan) / Irrational investor who buy an asset from us at a very irrational price. So, that we always need to focus on the buying an asset at a discount from the real value for getting a consistent return to safety.

Read for more detail: The Most Important Thing Illuminated by Howard Marks