Tuesday, 8 August 2017

Summary Notes on 5 Rules for Successful Stock Investing

When looking at PE ratio, make sure that you look at the historical PE and make sure
that you don’t buy it at the high. If you do buy it at the high, you have to be confident
of the company’s outlook. More often than not, it is overestimating growth prospects.
DISCIPLINE + CONSERVATION in figuring out the prices.

When should you sell?
1) Did you make a mistake
2) Have the fundamentals deteriorated?
3) Have the stock risen too far above its intrinsic value?
4) Is there something you can do better with the money?
5) Do you have too much money in one stock? – Don’t make sense to have too
much egg in one basket

Chapter 2
7 mistakes:
1. Swinging for the fence
2. Believing that it’s different this time: not knowing market history is a major
3. Falling in love with products
4. Panicking when the market is down
5. Trying to time the market: Stock market returns are highly skewed- bulk of the
returns (positive or negative) from any given year comes from relatively few
days in that year. This means that the risk of not being in the market is high for
anyone looking to build wealth over a long period of time.
6. Ignoring valuation: the reason you should buy a stock is that you think the
business is worth more than it’s selling for- not because you think a greater
fool will pay more for it down the road. Buying the stock based on the
expectation of positive news flow or strong relative strength is asking for
7. Relying on earnings for the whole story: cash flow not earnings. This
statement of cash flows can yield a ton of insight into the true health of a
business, and you can spot a lot of blowups before they happen by simply
watching the trend of operating cash flow relative to earnings. Watch out
operating cash flows stagnate or shrink even as earnings grow, it’s likely that
something is rotten.

Chapter 3
The bigger the profit, the stronger the competition.
To evaluate moat:

1) evaluate the firm’s historical profitability. Has the firm been able to
generate a solid return on its assets and on shareholders’ equity? This is

the true litmus test of whether a firm has built an economic moat around
a) Does the firm generate FCF? How much? Divide FCF by sales
(revenues), which tell you what proportion of each dollar in revenue
the firm is able to convert into excess profits. If a firm’s FCF as a
percentage of sales is around 5 percent or better, you’ve found a cash
machine - as of mid-2003, only one-half of the S&P 500 pass this test.
Strong FCF is an excellent sign that  a firm has an economic moat.
b) What are the firm’s net margins? ROE? (Chapter 6)
c) ROA: 6-7%
d) ROIC and estimating a weighted average cost of capital (WACC)

2) If the firm has solid returns on capital and consistent profitablility, assess
the sources of the firm’s profits. Why is the company able to keep
competitors at bay? What keeps competitors from stealing its profits?
a) We need to determine why a firm has done such a great job of holding
on its profits and keeping the competition at arm length. The strategy
pursued at the company level is even more important. Research shows
that a firm’s strategy is roughly twice as important as a firm’s industry
when it’s trying to build an economic moat.
b) Key is never stop asking, “why?” why aren’t competitors stealing the
firm’s customers? Why cant a competitor charge a lower price for a
similar product or service? Why do customers accept annual price
c) Look at it from the customer’s perspective.

5 ways firm can build sustainable competitive advantage:
1. Create real product differentiation through superior technology or
2. Creating perceived product differentiation through a trusted brand
or reputation: not enough to look at whether consumers trust the
product or have emotional connection to the brand. The brand has
to justify the cost of creating it by actually making money for the
firm and sustaining a powerful brand usually requires a lot of
expensive advertising.
3. Driving costs down and offering a similar product or service at a
lower price: Low cost works well in commodity industries. Identify
the sources of these cost savings. Create cost advantages by either
inventing a better process or achieving a larger scale. Look at
business model.
4. Locking in customers by creating high switching costs
5. Locking out competitors by creating high barriers to entry or high
barriers to success: regulatory exclusivity

3) Estimate how long a firm will be able to hold off competitors, which is the
company’s competitive advantage period: economic moat – width and

4) Analyse the industry’s competitive structure. How do firms in this industry
compete with one another? Is it an attractive industry with many profitable
forms or a hypercompetitive one in which participants struggle just to stay

Analysing a company:
Growth: sources and sustainability, sales growth drives earnings growth. Profit
growth can outpace sales growth for a while if a company can cut costs or fiddle with
the financial statements. So look at sales growth. To grow sales: Sell more products,
raise price, sell new goods or services, acquisition( management can use the fog
created by constant acquisitions to artificially juice results, and this financial tinkering
can take a long time to come to light because its buried in the financial rejiggering and
true growth is impossible to figure out because cant determine organic growth)
Profitability: What kind of a return does the company generate on the capital it
invests. Look at revenue. Instead of profit. Look at RRP.
Financial health: How solid is the firm’s financial footing
Risks/bear case: Look at full story
Management: Who’s running the show
ROA: Asset turnover, sales divided by assets
Financial leverage: Assets/shareholders’ equity
ROE: net margin x asset turnover x financial leverage

2 caveats:
1) Banks always have enormous financial leverage ratios, so don’t be scared off by a
leverage ratio that looks high relative to a nonbank. In addition, because banks’
leverage is always so high, you want to raise the bar for financial firms-so look for
consistent ROEs above 12% or so.
2) Concerns firm with ROEs that look too good to be true, >40% is a no no. Firms
that have been recently spun off from parent firms, companies that have bought back
many of their shares, and co that have taken massive charges often have very skewed
ROEs because their equity base is depressed.
FCF: any firm that’s able to convert more than 5% of sales to FCF-just divide FCF by
sales to get this percentage- is doing a solid job at generating excess cash.

Putting ROE and FCF together:
One good way to think about the returns a company is generating is to use the
profitability matrix, which looks at a company’s ROE relative to the amount of FCF it
is generating.  High ROE+ High FCF

ROIC: puts debt and equity financing on an equal footing: removes the debt related
distortion that can make highly leveraged companies look very profitable when using
ROE. ROIC uses operating profits after taxes, but before interest expenses. Again, the
goal is to remove any effects caused by a company’s financing decisions-does it use
debt or equity?-so that we can focus as closely as possible on the profitability of the
core business.
ROIC= net profit after taxes/ invested capital
Invested capital= total assets-non interest bearing current liabilities (usually account
payable, accrued liabilities and other current liabilities)-excess cash (and maybe
goodwill if it is a large portion)
Financial leverage of 4,5 is risky.
For every $ of equity, there is $4/5 worth of assets. Means borrow $3/4.
After assessing growth, profitability and financial health, your next task is to look at
the bear case for the stock you’re analysing. List the potential negatives so that you
will have the confidence to hang on to the stock during a temporary rough patch as
well as the savvy to know when the rough patch might really be a serious turn for the
Look at the customers of the business as well.

Chapter 7: Management – 3 parts: compensation, character and operations.
Compensation: bulk of information is found in proxy statement. First look at how
much management pay itself. See if bonus driven, raw level of cash compensation to
see if it’s reasonable. $8m cash bonus is silly no matter what. Also, look at competing
firms to see what their CEOs are paid.

Other red flags
Were executives given ‘loans’ that were subsequently forgiven? (loans of this sort are
usually disclosed in the ‘other compensation’ column of the executive compensation
table in the footnotes.)
Do executives get perks paid for by the company that they should really be paying for

Does management hog most of the stock options granted in a given year, or do rank
and file employees share in the wealth? Generally, firms with more equitable
distribution schemes perform better over the long run. Most firms break out the
percentage of options granted to executives relative to the total granted in the proxy
Does management use stock options excessively? Even if they are distributed beyond
the executive suite, giving out too many options dilutes existing shareholders’ equity.
If a company gives out more than 1 or 2 percent of the outstanding shares each year,
they are giving away too much. Better if firm issues restricted stock instead of
options. Restricted stock has to be counted as an expense on the income statement
(options don’t, as of this writing), and restricted stock also forces the recipient to
participate on the downside if the stock falls.
If a founder or large owner is still involved in the company, does he or she also get a
big stock option grant each year?
Do executives have some skin in the game? Do they have substantial holdings of
company stock or do they tend to sell shares right after they exercise options? Large
unexercised option positions are cold comfort. You can find this information in the
footnotes of the proxy. Companies indicate executives percentage ownership
including options prominently in a table labeled ‘security ownership of certain
beneficial owners’, but they declare only how many actual shares are owned in the
Does management use its position to enrich friends and relatives?
Look for a section called ‘related-party transactions’. Does it pay money to family
members’ business.
Is the board of directors stacked with management’s family members or former
Is management candid about its mistake?
How promotional is management? Care about stock price or company?
Can CEO retain high-quality talent? How often do officers turn over?
Does management make tough decisions that hurt results but give a more honest
picture of the company? Management teams that use restricted stock grants instead of
options-because the former has to be expensed, while the latter doesn’t-or who
expense rather than capitalize items such as research and development or software
costs are the kind of folks who are more interested in running the business than
playing number games. Those are the people that you want.

Running the business

Dig out past M&A activity. Look at the share count over a long period of time. If the
number of shares outstanding has increased substantially because of aggressive
operations programs or frequent equity issuance, the firm is essentially giving away
part of your stake without asking you.
Follow-through: does it implement the plan?
Self confidence: do something different from their peers or from conventional
Flexibility: has management made decisions that will give the firm flexibility in the
future? Like not taking on too much debt and controlling fixed expenses (even in
good years), as well as issuing equity when the stock is high. Attaching call options to
debt, retiring high rate debt when the opportunity presents itself, and buy back stock
at low prices.

6 red flags
1) Declining cash flow: if cash from operations decline even as net income keeps
marching upwards or if cash from operations increase much more slowly than
net income. AR increased to a large percentage of sales. Inventories increase
2) Serial chargers: frequent chargers are an open invitation to accounting hanky
panky because forms can bury bad decisions in a single restructuring charge.
Poor decisions that might need to be paid for in future quarters all get rolled
into a single one-time charge in the current quarter, which improves future
3) Serial acquirers: acquisitive firms don’t spend as much time checking out their
targets as they should.
4) CFO or auditors leave the company: If a company fires its auditors after some
potentially damaging accounting issue has come to light, watch out.
5) The bills aren’t being paid:  One way to pump up its growth rate is to loosen
customers’ credit terms, which induces them to buy more products or services.
If they don’t get paid, it will come back to haunt them in the form of a nasty
write-down or charge against earnings. Track how A/R are increasing relative
to sales. On the credit front, watch the ‘allowance for doubtful accounts’. If
the amount doesn’t move up in sync with A/R, the company may be
artificially boosting its results by being overly optimistic about how many of
its new customers will pay its bill.
6) Changes in credit terms and account receivable: Check the company’s 10-Q
filing for any mentions of changes in credit terms for customers, as well as for
any explanation by management as to why A/R has jumped. ( Look in the
management’s discussion and analysis section for the latter and in the
accounting footnotes for the former.)
7) Gains from investments: an honest company breaks out these sales, however,
and reports them below the ‘operating income’ line on its income statement.
The problem arises when companies try to boost their operating results-

performance of their core business-by shoehorning investment income into
other parts of their financial statements. Finally, companies can hide
investment gains in their expense accounts by using them to reduce operating
expenses, which makes the firm look more efficient than it really is.
8) Pension pitfalls: If assets in the pension plan don’t increase quickly enough,
the firm has to divert profits to prop up the pension. To fund pension payments
to future retirees, companies shovel money into pension plans that then are
invested in stocks, bonds, real estate, and so forth. If a company winds up with
fewer pension assets than pension liabilities, it has an underfunded plan, and if
the company has more than enough pension assets to meet its projected
obligations to retirees, it has an overfunded plan. To see whether the company
has an over-or underfunded pension plan, go to the footnotes of a 10-K filling
and look for the note labeled ‘pension and other postretirement benefits’,
‘employee retirement benefits’, or some variation. Then look at the line
labeled ‘projected benefit obligation.’ This is the estimated amount the
company will owe to employees after they retire.
Second key number is ‘fair value of plan assets at the end of year’. If the
benefit obligation exceeds the plan assets, the company has an underfunded
pension plan and is likely to have shovel in more money in future, reducing
Pension padding: When stocks and bonds do really well, pension plans go
gangbusters. And if those annual returns exceed the annual pension costs, the
excess can be profits. Flowing gains from an overfunded pension plan through
the income statement is a perfectly legal practice that pumped up earnings at
GE. You should subtract it from net income when trying to figure out just how
profitable a company really is.
To find out how much profits decreased because of pension costs or increased
because of pension gains, go to the line in the pension footnote labeled either
‘net pension/postretirement expense’, ‘net pension credit/loss’. Companies
usually break out the contribution of pension costs to profits for the trailing
three years; therefore, you can see not only the absolute level of pension profit
or loss, but also the trend. Won’t see these numbers in the income statement.
9) Vanishing cash flow: you can’t count on cash flow generated by employees
exercising options.  The amount is labeled ‘tax benefits from employee stock
plan’ or ‘tax benefits of stock options exercised’ on the statement of cash
flows. When employees exercise their stock options, the amount of cash taxes
their employer has to pay declines. If the stock price takes a tumble, many
people’s options will be worthless and, consequently, fewer options will be
exercised. Fewer options are now exercised, the company’s tax deduction gets
smaller, and it has to pay more taxes than before, which means lower cash
flow. If you are analyzing a company with great cash flow that also has a high
flying stock, check to see how much of that cash flow growth is coming from
options-related tax benefits.
10) Overstuffed Warehouses

When inventories rise faster than sales, there is likely to be trouble on the horizon. 

Sometimes buildup is just temporary as a company prepares for a new product launch,
usually exception.
11) Change is bad: another way firm can make themselves look better is by changing
any one of a number of assumptions in their financial statements. Look skeptically on
any optional change that improve results. One item that can be altered is depreciation
expense (see if extend depreciation period). Firms can also change their allowance for
doubtful accounts. If it doesn’t increase at the same rate as accounts receivable, a firm
is essentially saying that its new customers are much more creditworthy than the
previous ones-which is pretty much unlikely. If the allowance declines as AR rises,
the company is stretching the truth even further. Current results are overstated. Firms
can also change things as basic as how expenses are recorded and when revenue is
12) To expense or not to expense
Company can fiddle with their costs by capitalizing them. Any time you see expenses
being capitalized, ask some hard questions about just how long that ‘asset’ will
generate an economic benefit.

Valuation- The basic
Stock market returns come from two key components: investment returns and
speculative returns. Investment returns is the appreciation of a stock because of its
dividend yield and subsequent earnings growth, whereas speculative return comes
from the impact of changes in the PE ratio.
Using Price Multiples wisely
Price to sales: current price of the stock divided by sales per share. Price-to-sales is
used for spotting recovery situations or for double checking that a company's growth
has not become overvalued. It comes in handy when a company begins to suffer
losses and, as a result, has no earnings (and no PE) with which investors can assess
the shares. Retailers, which typically have very low net margins, tend to have very
low P/S ratios.
Price to book: stock market value vs equity value. For service firms, P/B has little
meaning. Also can lead you astray for a manufacturing firm such as 3M, which
derives value from its brand name and innovative products. Another item to be wary
of is goodwill, which can inflate book value to the point that even the most expensive
firm looks like a value. Be highly skeptical of firms for which goodwill makes up a
sizable portion of their book value, The P/B may be low, but the bulk of the B could
disappear in a hurry if the firm declares the goodwill as ‘impaired’(firm admits that it
grossly overpaid for a past acquisition) and writes down its value. PB is also tied to

ROE in the same way PS is tied to net margin. Higher ROE will have a higher P/B
ratio. P/B is very good for valuing financial services firms because most financial
firms have considerable liquid assets on their balance sheets. Financial firms trading
below book value, investigate just how solid that book value is before investing.
PE ratio: A firm that is expected to grow quickly will likely have a larger stream of
future cash flows than one that is growing slowly, so it’s rational to pay more for the
shares (thus, higher PE ratio). On the flip side, a firm that is riskier has a good chance
of having lower future cash flows than we originally expected, so it’s rational to pay
less for the stock.
Has the firm sold a business or an asset recently? If the firm has recently sold off a
business or perhaps a stake in another firm, it’s going to have an artificially inflated E,
and thus a lower P/E. You need to strip out the proceeds from the sale before
calculating the P/E.
Has the firm taken a big charge recently? If the firm is restructuring or closing down
plants, earnings could be artificially depressed, which would push the P/E up. For
valuation purposes, it is useful to add back the charge to get a sense of the firm’s
normalized P/E.
Is the firm cyclical? Calculate a PE based on the current price relative to what you
think earnings per share will be at the next peak.
Does the firm capitalize or expense its cash flow generating assets? Firms that
expenses assets (R&D) will have lower earnings and thus higher PE in any given year
than a firm that capitalizes assets.
Is the E real or imagined? Forward PE is almost always lower than the trailing PE
because most companies are increasing earnings from year to year. Cannot count on
Don’t just look at the lower PEG ratio. Look at the capital that needs to be invested to
generate the expected growth, as well as the likelihood that those expectations will
actually materialize.
Say yes to yield
Earnings yield- used to compare with bonds.
Cash return- more useful than PE. Divide FCF by enterprise value. (Enterprise value
is simply a stock’s market capitalization plus its long term debt minus its cash). The
goal of the cash return is to measure how efficiently the business is using its capital-
both equity and debt-to generate cash flow. Essentially, cash returns tell you how
much FCF a company generates as a percentage of how much it would cost an
investor to buy the whole shebang, including debt burden. Cash return is a great first
step to finding cash cows trading at reasonable prices, but don’t use cash returns for
financial or foreign stocks. Not meaningful for banks and other firms that earn money
via BS.
Intrinsic value
As interest rates increase, so will discount rates. As a firm’s risk level increases, so
will its discount rate. Risk increase, discount rate will increase too.
Some factors that should be taken into account when estimating discount rates.
Smaller firms are riskier than larger firms.
Financial leverage
More debts are generally riskier than firms with less debt.
Tougher to forecast and level of risk increases.
Management/corporate governance
How much do you trust management?
Economic Moat
The wider the moat, the more likely it will be able to jeep competitors at bay and

generate a reliable stream of cash flows.
More riskier companies higher discount rate. (13-15)
Perpetuity values
We need perpetuity value because it’s not feasible to project a company’s future cash
flow out to infinity , year by year, and because companies have theoretically infinite
The most common way to calculate a perpetuity is to take the last cash flow (CF) that
you estimate, increase it by the rate at which you expect cash flows to grow over the
very long term (g), and divide the result by the discount rate (R) minus the expected
long term growth rate.
CF (1+g)
After that discount it to PV. Then add this discounted perpetuity value to the
discounted value of our estimated cash flows in years 1 through 10 to find total equity
value, and divide by the number of shares outstanding.


Say Clorox is worth $54, and the stock is trading at $45. If we buy the stock and
we’re exactly right about our analysis, the return we receive should be the difference
between $45 and $54 (20%) plus the discount rate of about 9%. That would be 29%,
which is darn good return. If you are not confident about a business, have a large
margin of safety before buying the shares. Great businesses are worth buying at
smaller discounts to fair value


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