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

handicap

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

trouble.

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

itself.

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

increase?

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

features

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

depth

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

afloat.

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

worse.

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

themselves?

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

statement.

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

footnotes.

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

managers?

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?

Candor

Self confidence: do something different from their peers or from conventional

opinion.

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

result.

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

profits.

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

recognized.

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

that.

PEG

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.

Size

Smaller firms are riskier than larger firms.

Financial leverage

More debts are generally riskier than firms with less debt.

Cyclicality

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.

Complexity

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

lives.

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)

 (R-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.

MOS

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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