The Intelligent Investor – 20 – “Margin of Safety” as the Central Concept of Investment

Posted on December 29, 2019 by Jimit Zaveri under Bibliophile: The Intelligent Investor

This is one of the most important concepts which we need to understand thoroughly for becoming a successful investor.

The margin of Safety concept is for getting saved in the future while unfavorable situations occur. If we have projected sales, PATM (%) for the next 2 years but also conservatively, we have made few haircuts on the projected sales, PATM (%) for making an investment decision for getting saved if any unfavorable situation occurs into the future. Or we can provide a valuation multiple in a conservative manner that protects us from future unfavorable events. This protection against the future unfavorable situation is known as the “Margin of Safety”. The major risk is not uncertainty but losing capital. We can make a good return while there is uncertainty. If we keep on playing the game without proper care for protection against future uncertainty then we always need to be depended on the luck.

Mr. Graham has mentioned that he looks for a greater margin of earning power compared with the bond rate. That means if the AAA bond rate is around 6% then we should buy a company with higher earning power then 6%. Now, the question comes that above 6% but what should be that rate- 7, 8, 9 ….? Such earning power rate should be depended on the quality of business, quality of financial, the stability of earning, growth of future earning, quality of management, future visibility of the business, cyclical nature among the business earnings, future return expectation by investing into the particular business, etc. If the business does not have a stable earning, quality of financial is average, cyclical nature of the business, etc. then we should make an investment at least around the twice of AAA bond rate, I.e. earning power at 12%. We should measure earning power on the PBT, CFO and FCF levels for better judgment.

We should focus on better chances of profit rather than chances for loss. If prices are low for the good assets then that provides us with an opportunity to make an investment with a margin of safety. If prices are too much higher than there will be no availability of any margin of safety.

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Few principles are given by Mr. Graham-

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We should not rely on the others’ opinions or optimism on the particular business rather we should focus on the data and arithmetic. Though the crowd does not agree with our view, our data and arithmetic support our view then we should stick with it. If we get over-optimistic towards our investment then we ourselves become a risk for us.

For not being ourselves as a risk for ourselves, there are few points which we need to focus –

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The above questions work as a checklist for removing our emotions from the decision making and make a better decision. We do not know the future and sometimes our best analysis will be turnout as a worst so that we need to keep the margin of safety with it.

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

The Intelligent Investor – 19 – Shareholders and Managements: Dividend Policy

Posted on December 22, 2019 by Jimit Zaveri under Bibliophile: The Intelligent Investor

When a question about the questionable management getting asked the shareholders then –

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It is always a debatable situation for paying a high dividend or reinvesting profits into the business.

One of the finance company which paying out lower dividend but reinvesting to the business

Bajaj Finance

One of the capital goods company which pays out a decent dividend

Greaves Cotton

If the company does not require to make a reinvestment of profit and no further huge growth opportunity then the company should pay out a higher dividend. But if a company does not pay out a dividend or pay with a lower payout then market price can be seeming to be lower to the fair value.

Another point is when the financial position of the company is not favorable then the company should work on paying out debt and other obligations first rather pay a dividend.

One of the steel company of India

TATA Steel

In theory, we have learned that equity shareholders are the owners of the company but in practice, such things do not go to happens. As a minority shareholder, we need to follow the recommendations given by the management. We cannot go against them.

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There can be two types of problems, we found among the management. First, they are not able to run the business efficiently and second, they do not work in the favor of minority shareholders, they make decisions that help them & create their personal wealth. We need to thoroughly read annual reports, footnotes, corporate announcements, etc. for understanding the efficiency and shareholder-friendly behavior of the management.

For checking the efficiency of the company, we need to compare the company with its peers in terms of profitability, size, growth, competitive advantage, etc. If the company is doing better than peers consistently for a longer period of time, then we can say that management can able to run the company more efficiently.

For checking the shareholder friendliness of the management, we need to check compensation, stock ownership, related party transactions, etc.

Though We are owning a 100000, 1000 or 1 share of the company, if we do not read an annual report of the company and company has gone for a toss then we need to only blame ourselves.

The stock repurchase is considered a good strategy, the dividend comes with tax obligation but buyback is tax-free and also improves financial of the company. But in reality, the company issues ESOP to the executives as a performance bonus and that will end up with the dilution of the equity. Many times, buyback is done for counteracting such dilution. Also, stock buyback is done at the overvaluation or at the undervaluation is matters a lot.

SIMPLE IS BETTER – ISSUE -13 – BUYBACK

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

The Intelligent Investor – 18 – A Comparison of Eight Pairs of Companies

Posted on December 15, 2019 by Jimit Zaveri under Bibliophile: The Intelligent Investor

We should take care when company deliver their promises but actually traded at more than their promises. Companies that have to deliver a higher sale, earnings growth then they will be available at higher multiple. But we should distinguish between higher and reasonable multiples. Stocks which does not have underlying soundness then those will become speculative and riskier.

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When sales growth keeps coming people ignore the underlying quality of business and financial. As the company grows, its growth becomes slower otherwise the company will eat up the entire world. As growth gets slower, multiple also gets lower. We need to understand that we cannot provide similar multiple to the same company at every phase of the company. Higher quality growth commands a higher multiple but as growth slows down, multiple for the same business gets lower down.

One of the air-cooler manufacturing company of India

Symphony

Symphony1

We can see that as growth slowdown in the FY2018 and 2019 then P/E multiple of the company has fallen down rapidly.

Comparison of Real Estate VS Pharma VS FMCG

RE PH FMCG

We can see that in the Jan-2008 Real estate companies (Just two companies) MCap was ~4x of 10 pharma companies and ~2x of 10 FMCG companies. Pharma and FMCG companies have posted growth and real estate companies are not able to grow at the same peace. In addition, real estate companies were traded at sky-high valuations which resulted in an average return of ~-91% whereas Pharma (*not taken from high mcap) and FMCG has posted average return of ~963% and 1109% respectively.

If we look at the fall in price too low of 2008 then also pharma and FMCG have outperformed real estate.

RE PH FMCG1

If we see the quality companies i.e. pharma and FMCG then those fall less than the entire market fall, Nifty fell by 50%+ in the year 2008.

In the Short term, any stocks win the popularity of the market but in the long-term earnings matters. If we see that fancy business has does not perform in the long term but boring business such as FMCG has outperformed in the long term.

If we look at the P/E multiple of DLF and Unitech then that was 36.69x and 82.22x in high of the year 2008 and that fall to 4.67x and 4.21x respectively. Whereas Lupin, Sun Pharma, HUL, ITC, and Nestle was traded at P/E of 13.54x, 17.91x, 26.23x, 29.34x, 26.90x and fall to 12.50x, 17.52x, 26.71x, 22.28x, 24.80x respectively.

Market panic provides us with an opportunity to enter into such business which helps us to get more returns. If we have bought the above-mentioned pharma and FMCG companies at a high of the year 2008 and then bought again at low of the year 2008 then-current average return of pharma and FMCG has been increased by ~347% and 137% respectively.

For the current scenario, if we see HUL MCap vs 10 Pharma companies then HUL has a 24% higher MCap from pharma 10 companies.

This analysis is given by many of the investors and fund managers but if we look at the return ratios then average RONW% & ROCE% of top 25 pharma companies is ~20% and average RONW% & ROCE% of top 10 pharma companies is ~16% whereas RONW% & ROCE% for the HUL is 80% and 90% respectively.

Pharma VS HUL

So, if we look at the growth and profitability of the top 10 pharma and HUL then does not has a wide difference but asset quality is far good for HUL compared to the top 10 pharma which must need to look. This comparison is not similar to real estate and pharma and FMCG whereas real estate has poor asset quality compared to the pharma and FMCG but here HUL has a better asset quality. If pharma has a huge earning growth compared to the HUL with 15-20% of return ratios then we can look into it. If we look at the ~73 listed FMCG then those companies do not have similar asset quality then they do not have a similar kind of valuation but those have, they command.

Closed watch also shows real-time sometimes in a day that does not mean, we consider that watch as a good watch.

If we compared sugar companies’ vs tea & coffee companies then it can be a good comparison where sugar companies are available more than double in MCap.

Sugar VS Tea & Coffee

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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

The Intelligent Investor – 17 – Four Extremely Instructive Case Histories

Posted on December 8, 2019 by Jimit Zaveri under Bibliophile: The Intelligent Investor

Mr. Graham has mentioned a few points which need to be check for any of the companies in which we are planning to make an investment. And if the company having such points then should avoid it is a better choice.

The company not paying income tax through earning profits. We must have doubts about the earning of the company if the company continuously not paying income tax. We need to check whether the company has any tax benefits or not. If the company has any tax benefits then we need to check where such benefits are going to expire and need to adjust tax benefits for our calculation of future estimation of profitability / per-share earnings.
Overpriced giant companies. Giant companies are those which have shown decent growth in the past and gaining market share. Thus, such companies have won the trust of the investors and available at a higher valuation. We need to understand that not always a great company can be a great investment. Also, we need to stay away if the company available at an extreme higher valuation. One of the current giant IT companies was traded on 200+ of P/Ex during the IT bubble and after that company has posted sales & profitability growth of 30%+ but the stock has given return ~7-8% CAGR during that period.
Interest coverage is less than 5x. If the company cannot able to generate pre interest profit 5x higher than the interest amount then any unforeseen circumstances can affect the profitability of the company.
The company involves frequent mergers and acquisitions. Frequent merger and acquisition turn a simple financial statement into a complex which becomes much difficult to understand. In addition, the company can hide many things through mergers and acquisitions which becomes difficult to identify.
Merger and acquisition are huge in size compare with the size of the company and also, funded through huge debt. Such M&A can create trouble for the company if not played well. The majority of such M&A has failed badly. One of the steel company which has done an acquisition of the company which is huge in size by taking a huge debt.
Here, we can see that the company has faced a hugely difficult to get survived. Also, the company has to take a huge debt + equity issuance.
Acquisition of the company at a higher valuation. When one company has acquired another company at higher valuation then it will consider as a capital misallocation and it will take time to cover the extra value which the company has paid. If the company has paid a huge premium + balance sheet also not stronger than it can be troublesome.
Frequent merger and acquisitions. This will create trouble for an investor to understand financial statements. In addition, the company can hide many things under such frequent M&A and can boost up revenue and profitability in a fraudulent way.
Deferred debt expense which is greater than entire shareholders fund
Amortization of deferred debt expense
The company has a debenture that is traded at a huge discount then also, the company buying warrant.
Increasing debt in more peace compared with the revenue
We need to deduct preferred stock payment, debenture payment from available cash & investment of the company to reach the conclusion regarding available cash & investment for the common stockholders.
Checking a liquidity position of the company
Expansion strategy, if expansion is huge enough that it has a higher probability to get fail, the profitability of the company can wipe out. And if such a huge expansion funded through external fund then can be the hero or zero kinds of situation arise.
One of the chemical company of India has announced a huge expansion plan which is a hero or zero kinds of plan
Here, we can see that the company can able to grow its revenue and profitability after the huge Capex which has helped the company to get survived very well.
The company owning huge preferred, warrants and convertibles then need to check such companies with more patience or should avoid it.
Changes into the method of arriving at the pension
Changes into the depreciation rates
Stock trading at Extreme cheapness. When things available at cheaper valuation then we need to be cautious and ask to question & try to find out the reason for cheap valuation.
Avoid hot stocks and hot fancy businesses
An initial public offering of shares in a basically worthless company. IPOs of the company which are not good in the balance sheet and just coming up with an IPO due to fancy in a sector or in the market.
Inspection from SEBI or other regulatory authorities. When we come across such news then we need to study carefully with that company.
Few more things to avoid – MY LEARNING FROM MY MISTAKES
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