Over the last few years I have read a number of different books on the world of finance and investment. For each book that I have read I have taken detailed notes for myself to reference at a later date. In this post it will be my goal to consolidate their teachings with the hopes of converting the information into a relevant investment approach to today's markets.
Here is the list of books whose notes will be covered in this post:
- The Intelligent Investor
- Security Analysis
- Margin of Safety
- Common Stocks and Uncommon Profits
- The Little Book that Still Beats the Market
Looking for Investments
- Survey industries and companies that are currently unfavorable in the eyes of the financial community
- Be aware of sales and mergers and complete or partial acquisitions for investment opportunities
- Use the 'scuttlebutt' technique to find additional investment opportunities
- Look for companies that are invested in R&D to create new products that will lead to earnings growth
What is 'scuttlebutt'?
Scuttlebutt is a term used by Philip Fisher that refers to rumors and/or gossip that are used to find out additional information about a given company (or investment opportunity) in question that the general public may be unaware of. This consists of talking to all of the companies in a given industry about the strengths and weaknesses of its competitors. This also refers to talking to customers, suppliers, research scientists at universities, the government, and former employees as they relate to the target company. Fisher also states that any questions left unanswered after having completed the scuttlebutt technique should be directed towards the company executives.
Qualitative Factors of a Favorable Investment
Value
- Good management should place just as much importance on the day-to-day operations of the business as it does on the long-term goals
- Does the company have an above average sales organization?
- What is the company doing to maintain or improve profit margins?
- Does the company have outstanding labor and personnel relations? (companies that still have no union likely have great labor relations but unionization does not necessarily imply poor labor relations)
- Does the company have outstanding executive relations? (executives and board demonstrate confidence in leader)
- Are there other aspects of the business that pertain specifically to its industry which will give the investor important clues as to how outstanding the company may be in relation to its competitors? (ie. if retailer, does it have good control over lease contracts?)
- In the foreseeable future, will the growth of the company require equity financing that will dilute the existing shareholders' benefit? (usually occurs when there isn't adequate stability for debt financing)
- Does the management talk freely to investors about its affairs when things are going well but 'clam up' when troubles occur?
- Does the company have a management of unquestionable integrity? (sense of moral responsibility to its shareholders)
Growth
- Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years into the future?
- Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
- How effective are the company's R&D efforts in relation to its size? (R&D as % of sales; $R&D/share; compare to industry)
- Does the company have depth to its management?
- Does the company have a short- or long-term outlook in regards to profits? (want companies that focus on a long-term, consistent profits)
Look for possibilities of an enhancement of earnings power that can stem from:
- General industry improvements
- Changes in the company's operating policies (with or without management changes)
- More efficient operating methods (cost cutting, etc.)
- New product offerings
- Abandonment of unprofitable product lines or services
- Effective R&D that has led to earnings growth in the past
Quantitative Factors of a Favorable Investment
Value
- Does the company have a worthwhile profit margin? (want this to be as high as possible but compare with industry; not necessarily bad if profit margin is decreasing if being spent on R&D)
- How good are the company's cost analysis and accounting controls?
- Paying no dividend isn't bad unless the company in question is stockpiling an excess amount of cash in order to maintain a feeling of security
- When doing a valuation, come up with a range of values as opposed to a single figure and then buy stocks that are trading at a discount to this range and the same thing when deciding when to sell (compare to the maximum value of the range)
- Company with the lower P/E (higher earnings yield) but higher return on capital is almost always better
- A high ROC is key because it allows businesses to make a greater profit with the same assets that can then be reinvested into the same assets that are already known to produce a high ROC
Figures to check:
- Profit margin
- Book value per share
- Price to book ratio (ideally < 1:1)
- Earnings per share*
- Price to earnings ratio (ideally < 30)
- Liquidation value per share (as a % of current assets)
- Does the stock pay dividends?
- How many years has the stock paid dividends for?
- Current ratio
- Quick ratio
- Interest coverage
- Debt to equity ratio
- Growth estimates**
- Return on capital (ROC)***
*Note on earnings per share:
In order to be as conservative as possible when calculating EPS, use a 5 year weighted average of the diluted EPS. The weights should be calculated using the sum of the years' digits method. For example, if diluted EPS over the last five years was 1.33, 2.02, 1.62, 1, 3.5 we would take the sum of the years digits over 5 years to find out the respective weightings for each year and then apply this to each EPS figure. To illustrate:
EPS over 5 years so: (5 + 4 + 3 + 2 + 1) = 15
Year 1 (most recent year): 5/15 = 33%
Year 2: 4/15 = 27%
Year 3: 3/15 = 20%
Year 4: 2/15 = 13%
Year 5: 1/15 = 7%
(3.5 * 33%) + (1 * 27%) + (1.62 * 20%) + (2.02 * 13%) + (1.33 * 7%) = 2.1 EPS
**Note on growth estimates:
Growth estimates should be based on taking the growth in EPS (based on the above calculation) over the same 5 year period and then taking the average to find the EPS growth per year. Subject this to some percentage margin of safety (50% to 90%) depending on your confidence in your estimates and use this as the projected growth in EPS. I would recommend capping growth at around 20%.
***Note on return on capital:
Oftentimes the common return on assets (ROA) figure is too broad to carry any real value to it. What we are really interested in finding out is if the tangible capital is producing a good return. For this reason, ROC should be calculated as follows:
ROC = EBIT/(Net Working Capital + Net Fixed Assets)
where,
Net working capital = Current Assets - Current Liabilities
Net fixed assets = Total Fixed Assets - Total Depreciation
When to Buy
Fisher's most ideal time to buy is right around when the company in question is starting the first commercial production of the new product that is expected to lead to earnings growth. This is because unique costs in getting the new plant/process up and running and selling leftovers of the old product will show a decrease in earnings, thus lowering the stock price. Market participants will thing the new product is a flop just before sales start to show an increase which is why it's a good time to buy in.
When to Sell
- Sell whenever a mistake has been made in regards to the original investment thesis and the factual background that originally made the company appealing no longer exists
- Sell when changes resulting from the passage of time no longer qualifies the investment with regards to the above points about what makes a good investment
- Sell when funds are not available and better investment alternative arise over the current holdings
"If the job has been correctly done when a common stock is purchased, the time to sell is -- almost never." - Philip Fisher
Warren Buffett's Criteria for a Wonderful Business
- They have a good return on capital without too much debt
- They are understandable
- They see their profits translating into cash flow
- They have strong franchises and have freedom to price
- They don't take a genius to run
- Their earnings are predictable
- The management is owner-oriented
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