The Intelligent Investor – 16 – Convertible Issues and Warrants

As per Mr. Graham, convertibles are smaller into the risk compared with the common stock of the same company. We also know that preferred stockholders get first preference compared to the common stock for dividend/interest and also at liquidation.  Convertibles are more related to common stocks rather than debt instruments.

But always a question that when to sell convertibles? Should we opt for the conversion to common stock? Or keep on holding a bond and getting interested in it?

When the company is doing well, growing more than a cost of capital, generating higher return ratios, then it is advisable to hold convertible and let them getting convert to common stock.

If the company has an average performance, average return ratio, no clue for potential decent growth then it is advisable to hold convertible and keep getting interested in it.

Generally, warrant or stock option are not recorded under the common stock capitalization and also, EPS is shown without an impact of it. So that we need to add those warrant or the stock option to the outstanding equity shares and consider EPS. Company issues warrant when they require a capital, prepayment of bond / preferred stock, etc. But this is not a suitable way to raise capital. If a company wants to issue a common stock then they need to directly issue to shareholders on the prevailing market price rather issue a warrant on the below market price. This will result in more dilution of equity compared to the issue at a higher price.

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 – 15 – Stock Selection for the Enterprising Investor

Enterprising investors or aggressive investors are those who put more effort into stock selection and investment decisions. Graham-Newman Corporation was involved in the few investment classifications such as –

Arbitrage – opportunities where companies involve the reorganization, merger, demerger, etc.

Few businesses have a good quality but due to operating with the other gruesome businesses, good business does not get value. So that demerger of good business from the gruesome business will create value for the shareholders.

Details on postSIMPLE IS BETTER – ISSUE -14 – DEMERGER

Liquidation – opportunity to earn profits where the company is gone through liquidation phase, sold out of assets and make cash payments to the stockholders. Many a time, company liquidate non-core assets for improving productivity and to reward shareholders.

One of the pharma companies has sold out their business to the MNC company and rewarded shareholders with a special dividend.

Related hedges – buying a convertible bonds/preference shares and selling of stocks into which they are going to convert. Such opportunities are rare and difficult for the Indian market due to the unavailability of wide derivatives stocks.

Net current assets or bargain issues – purchasing an issue which is available below net current assets value, not giving any value for the plants, land, machinery, etc. Here, wide diversification requires.

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We should buy cyclical companies when the business cycle is depressed and due to depressed earnings valuation seems to be higher. I have explained on cyclical companies in detail in Warren Buffett’s letters series.

We can find out some of the undiscovered companies by using different types of criteria. Such a criterion helps us to filter out a few companies from the huge list. And then we need to put further due diligence, efforts for selecting or rejecting companies for an investment purpose from the available filtered list.

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Enterprise investors can make an investment into the bargain issues and to the workout or special situations (I.e. demerger, merger, buyback, divestment, etc.) where they can reap an additional profit. Special situations have a lower probability of large loss so that we can earn lower losses with a satisfactory return.

We as an investor also need to do a practice for making an investment decision. We can make paper trade and decisions which help us to improve our decision making. As we know that cricketers, musicians, athletes, etc also getting engage in the practice before the actual performance. When we are learning to drive then we do not directly drive a car on the highway but we learn at peaceful roads so that we can avoid a big accident. Similarly, we need to perform with the investment field, rather make an initial huge investment, we need to put efforts to learn investment skills. This will help us to improve our decision making, philosophy, minimization of errors, etc.

We need to focus on the ROIC rather than focus on the EPS.

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It shows us how efficiently a company is utilizing the fund to generate optimum returns. And provide us with good returns over a longer period.

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We also need to check about the management who runs the business, whether they focus on the stock price or business, do financial statements are easy to understand or full of ambiguity? what company has promised and how-much they have delivered? does top management turnover higher or they stay for the long-term with the company?

We will find out many of the answers to the above questions from the annual report.

We also can learn and improve our approach by reading the approach of other investors such as Warren Buffett, Phil Fisher, Ben Graham, Charlie Munger, Howard Marks, Prof. Sanjay Bakshi, Neeraj Marathe Sir, etc.

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 – 14 – Stock Selection for the Defensive Investor

For stock selection and for investing for defensive investors, Mr. Graham has mentioned a few criteria –

  • Adequate size of the enterprise

Mr. Graham has quoted that investment candidate companies should not be too small into the size. As per him, we should not invest in the company which does not have sales and assets less than $100 Mn (Rs.700 crore) and $50 Mn (Rs.350 crore) respectively.

  • A Sufficiently Strong Financial Condition

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We should check the long-term debt to working capital also. Such strength provides a margin of safety to defensive investors.

  • Earning stability

Earning of the company does not get highly fluctuated during the past ten years. This indicates that a company has a stable business model. The stability of the business model provides safety to defensive investors.

  • Dividend record

Uninterrupted dividend for at least the last 20 years. Further, we can check that whether company paying dividend through cash earning or through debt, which I have already explained in – The Intelligent Investor 11

  • Earnings growth

Earning should be grown for the last ten year. We should decide the % of earnings growth, we seek from the business.

  • Moderate price/earnings ratio

As per Mr. Graham P/E ratio should not be higher than 15x for the past three years of average earnings. Reverse P/E ratio is near to the AAA bond rate, which means 1/15 = 6.67%.

  • The moderate ratio of price to assets

The price to book value should not be higher than 1.5x. and also, P/E * P/BV will not be higher than 22.5x (15x * 1.5x). it can be possible that P/E can be 20x and P/BV can be 1.12x or vice-versa.

We should not invest in the companies where earnings getting worst though those companies are available at the cheaper valuation. And if everyone thinks similar for an investment opportunity then advantage for a similar investment opportunity will be gone. Similar happens during the FY17 to FY18 to equities where everyone wants to invest in the equities and equities valuation reach at the higher level.

Mr. Graham has also mentioned that we should not put all our eggs into the one basket, diversification protect us, minimize the risk. But diversification should help when we have a stock of quality companies, also over-diversification does not help. If we own the worst quality companies and make diversification then also our winning odds will never be favorable.

These all parameters are important for initial screening, after that we need to make our due diligence before investing in a particular stock. We need to read at least five years of annual reports, if the institution holds more than 60% to particular stock means that it is highly discovered (>15% is much more for Indian companies), and need to put efforts before investing.

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 – 13 – A Comparison of Four Listed Companies

When we have decided to make an investment then we need to perform an analysis work so that we do not be stuck with the wrong investment avenues or at the wrong time. For making an analysis, we must need to focus on a few points.

Profitability – how the company performs? Return on invested capital, margins, growth in sales-profits, earning per book value, etc. If the profitability of the company gets hampered then we need to check whether it is permanent or temporary.

Stability – earning of the company decline in any of the years from the past ten years? Do the earnings of the company get fluctuations? Does a company involve in a seasonal or cyclical business?

Growth – companies with higher growth command for the high multiples and lower growth with low multiples. The growth of the company can help us to grow our wealth also. The growth provides an opportunity for the company to use capital appropriately.

Financial position – liquidity ratio, the position of a balance sheet, debt, preference share, etc. Tree does not grow in the sky. If financials are not strong then the business will not be surviving for a longer period. So that we need to put emphasis on the financial. How does a company utilizing assets? Company is capital intensive or asset-light? Working capital intensive or negative cash conversion cycle?

Also, we need to check what the company is doing with the capital generated. What is the capital allocation decisions of the management? Long dividend track record, increment into the dividend, buyback, buyback at higher than intrinsic value or lower than intrinsic value and if a company requires fund for growth then reinvest profits for growth rather pay dividend or 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

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