Buffett simplifies the problem for us. He says there are only three kinds of businesses – the great, the good, and the gruesome.
In his 2007 letter to shareholders, Warren Buffett wrote …
Charlie and I look for companies that have
- a business we understand;
- favorable long-term economics;
- able and trustworthy management, and
- a sensible price tag.
We like to buy the whole business or if management is our partner, at least 80%.
When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stock market purchases.
It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone
Buffett terms a great business as an “economic franchise”, and believes that it arises in a business that sells a product or service that:
- Is needed or desired (continuous and rising demand)
- Is thought by its customers to have no close substitute (customer goodwill is much better than accounting goodwill, and allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price)
- Is not subject to price regulation (price maker)
Thus, the idea must be to look for companies that can survive and thrive at least over the next 20 years – businesses that have…
- Great brands;
- Operate in simple and growing industries;
- Clean balance sheets; and
- Managements with history of making rational capital allocation decisions (as seen from their high and/or industry leading ROE and ROCE)
Now, while “growth” rules the roost when investors are searching for businesses to invest in, stability – in industry, business economics, earnings, and growth – is more important than just growth.
Moat is such an important idea that it needs to be understood and appreciated by every value investor.
Buffet says:
The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
For most companies having long term sustainable moats, one or more of the following characteristics exist –
- Strong brand power
- High switching costs
- Network effect
- Low cost of operations
Three Financial Statements
- Balance Sheet
- Cash Flow Statement
- Income Statement
In simple terms, the balance sheet discloses what a business owns and what it owes at a specific point in time. It is thus also referred to as the statement of financial position.
The financial position of a business is described in terms of its assets, liabilities, and equity:
- Assets (A) are resources controlled by the company as a result of past events and from which future economic benefits are expected to flow to the company (like land, machines, plants, offices, brands, future receivables from customers, cash, investments etc.)
- Liabilities (L) represent obligations of a company arising from past events, the settlement of which is expected to result in an outflow of economic benefits from the company (like bank borrowings and future payment to suppliers of raw materials etc.)
- Equity (E) Commonly known as shareholders’ equity or owners’ equity, is determined by subtracting the liabilities from the assets of a company, giving rise to the accounting equation: A = L + E or A – L = E. Equity can be viewed as a residual or balancing amount, taking assets and liabilities into account.
- Current Liabilities: Liabilities for which payment is due normally in less than a year. This item includes things like Trade Payables (amounts a business owes its vendors), Other Current Liabilities (security deposits and advances from dealers, unclaimed liabilities etc.), Short Term Provisions (short term employee benefits, warranties on products, proposed dividend etc.), and Short Term borrowings (short term loans to mean working capital requirements).
- Non-Current Liabilities: Non-Current Liabilities include Long-Term Liabilities (due more than one year into the future like a redemption of debentures), Deferred Tax Liabilities (arising due to difference in depreciation rates by Companies Act and Income Tax act), Long Term Provisions (employee benefits, etc.) and Long-term Borrowings (long term bank loans).
- Non-Current Assets are assets that are not easily convertible to cash or not expected to become cash within the next year. This item includes the following things –
- Fixed assets – Tangible items like land, building, equipment, etc. Intangible items like goodwill, patents, copyrights, trademarks, etc. The third key item under Fixed Assets is Capital Work-in-Progress which are the assets that are in progress of being built.
- Long-Term Investments – Such investments can range from anything from buying a minority stake at another company to investing in equity shares and debt securities (for a period of more than one year).
- Long-Term Loans & Advances – Any loans and advance payments that the company has granted to employees, suppliers, and government, and which are to be received by the company in a period beyond one year.
- Current Assets expected to be realized or intended for sale or consumption in the business’s normal operating cycle, or within one year. This includes current investments (that a company makes for a short period of time), inventories and trade receivables, “cash and cash equivalents” (cash in a company’s bank accounts, plus highly liquid short-term investments), and short term loans and advances.
Suppose a company was to issue 500 new shares in an IPO. The shares have a face value of Rs 5 and an IPO issue price of Rs 100. After the company issues these shares, here is how the addition is made into its Equity
- Share Capital: Rs 5 of Face Value x 500 shares = Rs 2,500 will be added to its Share Capital
- Reserves and surplus: Rs 95 of Share Premium (i.e., Rs 100 minus Rs 5) x 500 shares = Rs 47,500 will be added to its Reserves and Surplus**.** Plus Company profit after dividend paid
The Income Statement presents information on the financial results of a company’s business activities over a period of time. It communicates how much revenue the company generated during a period (quarter or year) and what costs it incurred in connection with generating that revenue.
This is the revenue or income a company earns from the operations of its core business. It includes Revenue from Sale of Products and Other Operating Revenue.
This includes interest income on bank deposits and other investments, and dividend income. When a company sells an investment during the year, any gain or loss from the sale of such an investment is also recorded in Other Income.
As the term suggests, it includes the money a company spends to operate its business. It includes the cost of the raw materials consumed, employee expenses, interest paid on the company’s borrowings, sales, and marketing expenses, and depreciation.
his is the profit the company generates every year (or quarter) before paying income tax to the government.
Net profit is the result of PBT minus Tax, and EPS can be calculated by dividing Net Profit by No. of shares outstanding.
Most true form of accounting statement
- Inventory Turnover
- Receivable Turnover
- Payables Turnover
- Working Capital Turnover
- Current Ratio
- Quick Ration
- Debt-to-Equity Ratio
- Debt burden ration or Debt-to-FCF ratio: Debt / Free Cash flow. It should be less than 2 or 3.
- Interest Coverage
- Gross Profit Margin
- Operating Profit Margin
- Net Profit Margin
- Return on Capital Employed
- Return on Equity
- Price to Sales (P/S) Ratio
- Price to Book Value (P/BV) Ratio and
- Price to Earnings (P/E) Ratio
In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.
There are three key variables you need to calculate the DCF value of a company:
- Estimates of growth in future free cash flows (FCF): Growth in FCF over say the next 10 years, using last 3 years average FCF as the starting point. (Click here to see the calculation of FCF from a company’s cash flow statement)
- Terminal growth rate: Rate of growth in FCF after the 10th year and till infinity.
- Discount rate: Rate at which the future cash flows must be discounted to bring them to present value.
The core idea of relative valuations is to convert the values of companies sharing similar attributes to comparable multiples and then seeing how those stocks stand in relation to their peers.
The reason these are called “relative” valuation techniques is because the value of an asset here is derived from the pricing of comparable or relative assets, standardized using a common variable such as earnings (P/E), cash flows (P/CF), book value (P/BV) or sales (P/S).
These are collectively called “relative valuation” techniques, and consist of –
- Price/ Earnings (P/E)
- Price/Earnings to Growth (P/EG)
- Price/ Book Value (P/BV)
- Price/Sales Ratio (P/S)
- Price/Cash Flow (P/CF)
Seth Klarman writes…
A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.The bad news for some people in all of this is that investing is hard. But the good news is also that investing is hard and if you have the right temperament and are willing to do the necessary work the process can be fun.
This margin of safety principle, so strongly emphasized by Ben Graham, is and would always remain the cornerstone of investment success.
Seth Klarman in his classic book Margin of Safety writes…
Because investing is as much an art as a science, investors need a margin of safety. A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable, and rapidly changing world.According to Graham, ‘The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price.’
Warren Buffett describes margin of safety concept using this example –
“When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000- pound trucks across it. And that same principle works in investing.”
In his 1989 letter to shareholders Warren Buffett wrote …
Stick to proven management with a lot of integrity, talent and passion. After some other mistakes, I learned to go into business only with people whom I like, trust, and admire.
One of the ways to do that is to start learning about a company’s management by gathering historical, current articles and annual reports(statements from the management) written about the top managers. These articles serve as a trail of evidence as to the past accomplishments of the management team, the type of people they are, and how they have dealt with different types of situations.
Look for evidence in four basic areas – honesty, passion, transparency, and competence.
Checklist to assess management aspects:
- How has the company performed – sales and profit growth – under the management over a 10-year period?
- How has the balance sheet been over these years?
- How has been the management’s record in making capital allocation decisions?
- For how long have the current managers been managing the business?
- How are senior managers compensated?
- Is management behaving in ethical way?
- Are managers clear and consistent in their communications and actions with stakeholders?
- Is the CEO self-promoting?
It is difficult to find CEOs who are both good at operating the business and at allocating capital. The main reason for this is that operating a business and allocating capital are two completely different skill sets; being proficient at one of these functions has no correlation to being competent with the other.
Now, there are five actions managers can take with excess FCF:
- Reinvest the capital back in the business – capex and working capital;
- Hold cash on the balance sheet;
- Pay dividends;
- Make acquisitions; and
- Buy back stock.
Clearly, as a value investor, we must ensure that any company in which you acquire shares has management that puts shareholder value above any superficial or selfish motives.
Legendary value investor Phillip Fisher, who had a lot of influence on Warren Buffett’s investment philosophy, had 3 simple rules for selling stocks –
- Wrong Facts: There are times after a stock is purchased that you realize the facts do not support the supposed rosy reasons of the original purchase. If the purchase thesis was initially built on a shaky foundation, then the shares should be sold. More money is lost by people who’ve held on to bad, losing businesses hoping to get their money back someday.
- Changing Facts: The facts of the original purchase may have been deemed correct, but facts can change negatively over the passage of time. Management deterioration and/or the exhaustion of growth opportunities are a few reasons why a stock should be sold according to Fisher. You must avoid the commitment bias here.
- Scarcity of Cash: If there is a shortage of cash available, and if a unique opportunity presents itself, then Fisher advises the sale of other stocks to fund the purchase.
Prof. bakshi says:
People need a way to de-bias themselves and one good way to do that is to mentally liquidate the portfolio and turn it into cash and then, for each security, ask yourself, “Knowing what I know now, would I buy this stock?” Often the honest answer would be a most certain “no”. Then the next question you have to face is – “Then why do I own it now?”
- Do I understand this industry?
- Is it industry within my circle of competence?
- Do I understand this business?
- How does the business make money?
- How has the business evolved over time?
- Does the industry have a high degree of change and obsolescence?
- Can the market for the company grow at above 10%+ per annum in volumes over the next 10 years?
- Can the company grow its sales and profits at 15%+ and maintain ROE in excess of 20% for next 10 years?
- Does the business have a sustainable competitive advantage and what is its source?
- Does the business have high/low entry/exit barriers?
- Does the business possess the ability to raise prices without losing customers?
- What is the competitive landscape, and how intense is the competition?
- Does the business enjoy power against its suppliers?
- Has the recent good performance largely been due to a cyclical upturn in the industry or is it sustainable?
- Has the company been growing its sales and profits consistently over the past 8-10 years? (Note – A new, small company can be growing very fast over the past 3-5 years, but may not be able to sustain that growth)
- Has the company earned more than 15% ROE (consistently) over the past 8-10 years, and what has been the driver of the same (Du Pont analysis would tell you this)
- Does the company have > 0.7 times debt/equity (Unless it is a bank / finance institution)?
- Does the company have a large FCCB borrowing (foreign currency convertible bonds)?
- Does the industry have high capital intensity (Sales / FA+NWC < 1.5 )?
- Does the company earn rising and positive FCF? If not, does it have thepotential to do so in the future?
- Does the management have integrity – any anti-shareholder resolutions in the past?
- Does the management discuss both negative and positives of the company performance candidly?
- Has the management invested incremental cash at 15%+ ROE levels?
- Is the management hoarding cash without raising dividend or reinvesting it?
- Has the management done acquisitions in the past at high valuations and did they work out successfully? (Check goodwill write-offs)
- Has the management used aggressive accounting in the past to manage results?
- Does the management make more than 3% of net profit as salary?
- Has the management been reprimanded by SEBI or other bodies. Does the management have a bad governance history with other firms? (check watchoutinvestors.com)
- Does the company have opaque transactions with subsidiaries (check related party) and are transaction sizes big?
- How many members of the promoter or family part of the Board of Directors? Does the family perform any useful role in management?
- Has the management pledged more than 20% of shares? If yes, why?
- Have the managers been buying or selling the stock?
- Does the company sell at PE > 20x?
- Does the current valuation assume growth in excess of the past or the same as past above average growth?
- Does the company sell at huge discount to market or to other companies in the industry? Why?
- Is the stock selling at 20-30% discount to your intrinsic value estimates as per the DCF model?
- Is the market expecting a fast growth in earning going forward as per Stephen Penman’s Residual Earnings Model?
- Social proof: Is this stock held by someone I like or admire and overoptimistic about it (not objective)?
- Sunk cost fallacy: Have I held the stock for a long time and hence not ready to change opinion?
- Is there performance envy involved? Others have done well with this idea and I have missed out on the gain?
- Authority bias: Is this stock held by other investors I like and admire and is that influencing me?
- Availability bias: Have I considered non annual report data, industry data and overall trends or only focussing on easily available information?
- Recency bias: Am I giving more weight to recent data (check if the projections based on recent data or averages / look at 10-12 yrs data)
- Confirmation bias: Have I checked for a similar company with identical economics which has not done well (in same and different industry). If yes, why did it not do well?
- Am I too overconfident on the situation – assuming over-familiarity , associating positive unrelated feeling, too high weight to optimistic scenario ( familiarity due to work / association with the industry )
- Have I done probability analysis for all negative factors
- Am I having too much loss aversion – over-weighing negative factors?
- Consistency bias: Am I slow in changing opinion – not responding to negative news?
- Have I looked at the base case for the industry – Have majority of the companies in the industry created wealth?
- Status quo bias: Am I unwilling to sell existing holding?