September 11, 2017 |
I had released my Investor’s Manifesto couple of years back. Now, here is my fifteen-point stock valuation manifesto that I penned down a few months back though I have been using it as part of my investment process for a few years now.
It is evolving but is something I reflect back on if I ever feel stuck in my stock valuation process. You may modify it to suit your own process and requirements. But this in itself should keep you safe.
Read it. Print it. Face it. Remember it. Practice it.
- I must remember that all valuation is biased. I will reach the valuation stage after analyzing a company for a few days or weeks, and by that time I’ll already be in love with my idea. Plus, I wouldn’t want my research effort go waste (commitment and consistency). So, I will start justifying valuation numbers.
- I must remember that no valuation is dependable because all valuation is wrong, especially when it is precise (like target price of Rs 1001 or Rs 857). In fact, precision is the last thing I must look at in valuation. It must be an approximate number, though based on facts and analysis.
- I must know that any valuation method that goes beyond simple arithmetic can be safely avoided. If I need more than four or five variables or calculations, I must avoid that valuation method.
- I must use multiple valuation methods (like DCF, Dhandho IV, exit multiples) and then arrive at a broad range of values. Using just a single number or method to identify whether a stock is cheap or expensive is too much oversimplification. So, while simplicity is a good habit, oversimplifying everything may not be so.
- If I am trying to seek help from spreadsheet based valuation models to tell me whether I should buy, hold, sell, or avoid stocks, I am doing it wrong. Valuation is important, but more important is my understanding of the business and the quality of management. Also, valuation – high or low – should scream at me. So, I may use spreadsheets but keep the process and my underlying thoughts simple.
- I must remember that value is different from price. And the price can remain above or below value for a long time. In fact, an overvalued (expensive) stock can become more overvalued, and an undervalued (cheap) stock can become more undervalued over time. It seems harsh, but I cannot expect to fight that.
- I must not take someone else’s valuation number at face value. Instead, I must make my own judgment. After all, two equally well-informed evaluators might make judgments that are wide apart.
- I must know that methods like P/E (price to earnings) or P/B (price to book value) cannot be used to calculate a business’ intrinsic value. These can only tell me how much a business’ earnings or book value are priced at vis-à-vis another related business. These also show me a static picture or temperature of the stock at a point in time, not how the business’ value has emerged over time and where it might go in the future.
- I must know that how much ever I understand a business and its future, I will be wrong in my valuation – business, after all, is a motion picture with a lot of thrill and suspense and characters I may not know much about. Only in accepting that I’ll be wrong, I’ll be at peace and more sensible while valuing stuff.
- I must remember that good quality businesses often don’t stay at good value for a long time, especially when I don’t already own them. I must prepare in advance to identify such businesses (by maintaining a watchlist) and buy them when I see them priced at or near fair values without bothering whether the value will become fairer (often, they do).
- I must remember that good quality businesses sometimes stay priced at or near fair value after I’ve already bought them, and sometimes for an extended period of time. In such times, it’s important for me to remain focused on the underlying business value than the stock price. If the value keeps rising, I must be patient with the price even if I need to wait for a few years (yes, years!).
- Knowing that my valuation will be biased and wrong should not lead me to a refusal to value a business at all. Instead, here’s what I may do to increase the probability of getting my valuation reasonably (not perfectly) right –
- I must stay within my circle of competence and study businesses I understand. I must simply exclude everything that I cannot understand in 30 minutes.
- I must write down my initial view on the business – what I like and not like about it – even before I start my analysis. This should help me in dealing with the “I love this company” bias.
- I must run my analysis through my investment checklist. I have seen that a checklist saves life…during surgery and in investing.
- I must, at all cost, avoid analysis paralysis. If I am looking for a lot of reasons to support my argument for the company, I am anyways suffering from the bias mentioned above.
- I must use the most important concept in value investing – margin of safety, the concept of buying something worth Rs 100 for much less than Rs 100. Without this, any valuation calculation I perform will be useless. In fact, the most important way to accept that I will be wrong in my valuation is by applying a margin of safety.
- Ultimately, it’s not how sophisticated I am in my valuation model, but how well I know the business and how well I can assess its competitive advantage. If I wish to be sensible in my investing, I must know that most things cannot be modeled mathematically but has more to do with my own experience in understating businesses.
- When it comes to bad businesses, I must know that it is a bad investment however attractive the valuation may seem. I love how Charlie Munger explains that – “a piece of turd in a bowl of raisins is still a piece of turd”…and…“there is no greater fool than yourself, and you are the easiest person to fool.”
- I must get going on valuing good businesses…but when I find that the business is bad, I must exercise my options. Not a call or a put option, but a “No” option.
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