Keep INVESTING Simple and Safe (KISS)
****Investment Philosophy, Strategy and various Valuation Methods****
The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy. It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!****Warren Buffett: Rule No. 1 - Never lose money. Rule No. 2 - Never forget Rule No. 1.
Good businesses with that ‘protective moat’ that Warren Buffett likes have the ability to cope with inflation by raising prices. As he said in 1993:
‘The might of their brand names, the attributes of their products and the strength of their distribution systems gives them an enormous competitive advantage, setting up a protective moat around their economic activities. The average company, in contrast, does battle daily without any means of protection.’
BERKSHIRE HATHAWAY HOLDINGS
Stocks held by Berkshire Hathaway in 2002, as stated by Buffett in his letter to stockholders include:
The Coca Cola Company
American Express
The Gillette Company
H and R Block Inc
Moody’s Corporation
The Washington Post Company
Wells Fargo and Company
These are all companies with a unique or special product, or with a company brand name, or in a market domination position. They or their products have a loyalty (voluntary or otherwise) that means customers want or must come back.
Another desirable quality in non-commodity companies is repeat business. Customers drink their Coke, wear out their razor blades, or finish reading their Washington Post, and then, eventually have to replace it.
It is only rational to have an opinion on future growth. Otherwise, how could you ever choose a stock?
When forming that opinion, back up quantitative information with qualitative factors.
For example, ask what management is doing to make a positive impact on earnings.
According to Peter Lynch, there are 5 basic ways a company can increase earnings:
reduce costs;
raise prices;
expand into new markets;
sell more of its products to the old markets; or
revitalize, close or otherwise dispose of a losing operation.
When management is enacting growth-promoting activities, earnings may be temporarily flat. They often soon take a giant step up.
Benjamin Graham saw a vulnerability in a high growth rate and in high returns on capital - the two normally go together.
So what's there to worry about in good earnings? Exceptionally high earnings often attract rough competitors.
The good part is that high earnings lure enthusiastic new investors, who often bid the share into the stratosphere.
Comment:
Buy good quality growth companies.
Assess the quality of the business and the management.
Then do the valuation.
These are the basics of the QVM or QMV approach to investing.
Kinnel: You've said you look for "compounding machines." Would you explain what that means?
Akre: When I started in the investment business a good while ago, I was not trained for it in a traditional sense. I had been a pre-med major, and then I was an English major. So, I quite naturally had all kinds of questions about the investment business, and among them were the questions of what makes a good investor and what makes a good investment, and taking a look and studying different asset classes using data from what is now your subsidiary Ibbotson and other places. I came across the well-known piece of information that over the last roughly 90 years common stocks in the United States have had an annualized return that's in the neighborhood of 10%.
So, my question naturally was, well, what's important about 10%? What I concluded was that it had a correlation with what I believe was the real return on the owners' capital of all those businesses across all those years, all kinds of different balance sheets and business models--i.e., that the real return on owners' capital was a number that was probably in the low teens and therefore that kind of 10%-ish return correlated with that, and it caused me to posit that my return in an asset would approximate the ROE of a business given the absence of any distributions and given constant valuation. So, then, we say, well, if our goal is to have returns which are better than average, while assuming what we believe is the below-average level of risk, then the obvious way to get there is to have businesses that have returns on the owners' capital which are above that.
Early in the 1970s, I came across a book written by a Boston investment counselor, whose name was Thomas Phelps. And the book he wrote was called 100 to 1 in the Market. You probably know from the history books that Peter Lynch was around Boston in those days, and he was talking about things like "10-Baggers." But here was Thomas Phelps, who was talking about "100 to 1." He documented characteristics of these businesses that caused one to have an experience, where they could make 100 times their investment. The answer is, of course, it's an issue at the rate at which they compounded the shareholders' capital on a per unit of ownership basis and those that compounded the shareholders' equity at a higher rate had higher returns over long period of years. And so that's what comes into play is this issue of compounding compound machines, and we're often identified with this thing in our process that we call the three-legged stool. The legs of the stool have to do with the business models that are likely to compound the shareholders' capital at above-average rates, combined with leg two, people who run the business who are not only killers at running the business but also see to it that what happens at the company level also happens at the per share level--and then number three, where because of the nature of the business and the skill of the manager there is both history as well as an opportunity to reinvest all the excess capital they generate to reinvest that in places where they earn these above-average rates of return.
The most critical piece of that is the last leg, that reinvestment leg. Can you take all the extra capital you generate and reinvest it in ways that you can get continued earnings above-average rates of return? And that's at the core of what we're after in our investments.
Kinnel: On the sell-side, deterioration on those key fundamentals may lead you to sell, but do you also sell on valuation?
Akre: So, in response to your first observation, deterioration to any one of those three will certainly cause us to re-evaluate it. It won't automatically cause us to sell, but it will certainly cause us to re-evaluate it. Our notion is that if we don't get those three legs right where there develop differently in the future than they have in the past, theoretically our loss is the time value of money that it hasn't always been the case.But the deterioration of one of those legs or more than one of those legs diminishes the value of that compounding and, indeed, is likely to cause us to change our view. That's number one.
Number two, the issue of selling on valuation is way more difficult for us. And what we've said is that from a matter of life experience, if I have a stock that's at $40 and I think it's way too richly valued and I sell it with a goal of buying it back at $25, my life experience is it trades to $25.01 or trades through $25 and back up and it trades 200 shares there.The next time I look at it, it's $300, and I've missed the opportunity. It's my way of saying that the really good ones are too hard to find.
If I have one of these great compounders, I'm likely to continue to own it through thick and thin knowing that periodically, it's likely to be undervalued and periodically likely to be overvalued.The things that cause us to sell when one or more of the legs of the stool deteriorates. Occasionally, on a valuation basis, maybe we'll take some money off the table.
Lastly, if we're trying to continue to maintain a very focused portfolio, if we run across things that we think are simply better choices, then we may make changes based on that.
Warren Buffett loves high quality companies. He buys high quality business and holds them forever. Why? Because high quality companies do well in both good markets and bad markets.
GuruFocus' monthly Buffett-Munger Newsletter features the best Buffett-Munger bargains for today. These are companies of high quality, but that trade at far below their fair values.
Research shows that even in the "lost" decade from 2000 to 2009, high quality company stocks outperformed by more than 10% a year. GuruFocus' Buffett-Munger Screener is for high quality companies at reasonable prices.
In a recent interview Warren Buffett mentioned three companies that he finds attractive. Out of the three companies he mentioned, two of them are listed in GuruFocus' Buffett-Munger screener. Fortune magazine called this an "unintentional endorsement" from Warren Buffett.
The philosophy of investment in growth stocks parallels in part and in part contravenes the margin-of-safety principle.
The growth-stock buyer relies on an expected earning power that is greater than the average shown in the past.
Thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety.
In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past; in fact, security analysis is coming more and more to prefer a competently executed evaluation of the future.
Thus the growth-stock approach may supply as dependable a margin of safetyas is found in the ordinary investment— provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.
The danger in a growth-stockprogram lies precisely here.
For such favored issues the market has a tendency to setprices that will not be adequately protected by a conservative projection of future earnings.
(It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.)
The margin of safety is always dependent on the price paid.
It will be large at one price, small at some higher price, nonexistent at some still higher price.
If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.
A special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole.
Ref: The Intelligent Investor by Benjamin Graham CHAPTER 20 “Margin of Safety” as the Central Concept of Investment
However, the risk of paying too high a price for good-quality stocks—while a real one—is not the chief hazard confronting the average buyer of securities.
Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.
The purchasers view the current good earnings as equivalent to “earning power*” and assume that prosperity is synonymous with safety.
It is in those years that bonds and preferred stocks of inferior grade can be sold to the public at a price around par, because they carry a little higher income return or a deceptively attractive conversion privilege.
It is then, also, that common stocks of obscure companies can be floated at prices far above the tangible investment, on the strength of two or three years of excellent growth.
These securities do not offer an adequate margin of safety in any admissible sense of the term.
Coverage of interest charges and preferred dividends must be tested over a number of years, including preferably a period of subnormal business such as in 1970–71.
The same is ordinarily true of common-stock earnings if they are to qualify as indicators of earning power.
Thus it follows that most of the fair-weather investments, acquired at fair-weather prices, are destined to suffer disturbing price declines when the horizon clouds over—and often sooner than that.
Nor can the investor count with confidence on an eventual recovery—although this does come about in some proportion of the cases—for he has never had a real safety margin to tide him through adversity.
Ref: The Intelligent Investor by Benjamin Graham CHAPTER 20 “Margin of Safety” as the Central Concept of Investment
Like our fingerprints, we each have a unique investing style. Value investors analyse financial statements and competitive advantages, chartists study share price trends and momentum, while others aimlessly follow strategies that amount to throwing darts at the financial pages.
In my experience stocks with a reasonable chance of doubling over a period of, say, three to five years, have things in common.Let's analyse 10 signs to watch out for.
1. Out of favour. This is potentially a value investor's most financially rewarding situation - a stock that's out of favour and, with any luck, even hated. Many of our most lucrative investments have risen from the depths of despair.
Take Cochlear for example. In 2004 its woes included a change of chief executive, two profit downgrades, and an inquiry into its selling practices by the US Department of Justice - all within a 10-month period. The share price fell below $20, but eventually climbed above $80. Following the recent recall, could it double again?
2. Hidden progress. Often a business's progress will take some time before revealing itself in the financial statements. Macquarie Bank couldn't do a thing right in 2002 according to the media. But an astute understanding of the bank's lucrative management fee model revealed it contained significant underlying growth that almost caused its share price to reach $100. With the market currently fixated on Europe, is Macquarie being underestimated again?
3. New technology. In certain industries companies can generate significant cost savings by introducing new technology. We recommended Cabcharge in 2003 partly because it was improving its operating margins with the implementation of electronic payment systems in taxis. This former market darling has also found itself out of favour recently.
4. Investment in R&D. The benefits of undertaking research and development and investing in specialist skills can take years to manifest themselves. Philip Fisher, in his book Common Stocks and Uncommon Profits, suggests that the best companies to buy are those investing heavily in R&D today to provide the profits of the future. Healthcare device manufacturers such as Cochlear and ResMed are following this path.
5. Industry tailwinds. Many investors have struck gold with resources stocks benefiting from the emergence of China and India as rapidly industrialising nations. That has added significantly to world demand for a wide range of commodities, such as oil and iron ore. The recent falls in prices of resources stocks and commodity prices could provide opportunities.
6. Changes in industry structure or the number of competitors can provide opportunities for the remaining businesses. Coates Hire was one we missed many years ago, when its acquisition of Wreckair removed a competitor and helped consolidate the industry just as the resources and construction boom began.
7. Owner-managers. Then there's the owner-manager effect, with the most successful companies run by business builders with their own money on the line, like Gerry Harvey of Harvey Norman. And then there are the company-men with long and successful track records like Brian McNamee at CSL. Time and again, the stocks that double do so because the company has exceptional management.
8. Insider buying. While a strong leader with a vested interest in performance is a big positive, so is evidence that directors are buying the stock for their own portfolios. While there are many reasons why an insider might sell, there is generally only one reason they buy in meaningful amounts. They believe the stock will go up.
9. Financial strength. Flimsy balance sheets indicate weakness and invite disaster. Leighton used to boast a very strong financial position as it operates in a very cyclical industry. That allowed it to withstand the pressure of lean years and prosper in the fat ones. More recently, though, it was forced to raise capital after writing off assets and using debt to expand overseas.
10. Unrecognised by the market.Finally, look for quality companies that are simply unrecognised. With around 2,000 listed stocks, there will always be opportunities for investors to uncover rough diamonds.
Independent thinking
See? It's that simple. But it isn't really is it? Without genuinely independent thinking and a thorough understanding of the facts as you see them, even finding appropriate stocks is difficult, let alone having the courage to take advantage of opportunities when they present themselves.
But that's what value investing is all about. You have to be ruthless about where you spend your time, but success is all the sweeter when your homework uncovers a gem.
This article contains general investment advice only (under AFSL 282288). Nathan Bell is research director of Intelligent Investor.
Over a period of investment, I met with different types of friends. We are all searching for a Low Risk yet High Return investment which is in contrast with the classic 'Modern Portfolio Theory' written by Harry Markowitz.
Some are learning Technical Analysis. A number of theories have been developed in term of the searching of a good stock which has a upward movement or downward movement which they can predict and make use of. However, the cons of this analysis is you are hard to master it and there is still a risk involved which encourage you to 'Cut Lost' if the wind turns another way round.
Some are learning Fundamental Analysis. CFA is a good post graduation course allowing you to learn how to perform fundamental analysis from Global, Sector, and Industry to specific company by annual report. However, there is too many manipulation from the company which hinders you from making a great profit. Instead, some of the companies are trying to cheat the investors by creating a better outlook. So, which one is the best strategy to beat the overall market while enjoying lower risk?
In my previous post Margin of Safety, First thing in Investment, I always emphasize the margin of safety. One of the way we can find out the margin of safety is through searching a good company operates in a good industry and invest it in a good time.
While we try not to time the investment as we can reduce the timing risk by 'Dollar Cost Averaging', I always search for a well managed company in a good industry. ROE (a.k.a Returns On Equity) is the most important key performance indicator which I judge a good company compared against its peers. However, we also must look at its optimal corporate finance structure so that we can know the optimal debt levels it can operates at.
If you want to stay investing in long term, try to find out a good industry too. There is different industry performance in different countries. While Singapore is performing excellently in finance industry, Malaysia is good at the Agriculture & plantation and Islamic Finance. Of course, there are some industries which is less reflect during recession period such consumer industry as well as low cost leadership companies.
If you a serious investor, try to do your homework before invest in any company. Try to make the investment like invest in a business which you think it is the best company you can ever invest in. Of course, some diversification will allow you to sleep well without having worry too much in particular stock.
Long term investment does not necessarily means you have to hold the company for more than 10 years. However, this concept will keep you in mind that while investing a longer period of time in a good business company, you will enjoy a better returns as compared to other lower risk investment such as Fix Deposit, as the more homework and steadiness you performs, the better result you will get. In long run.
For those who are in business, they typically know that it is very hard to compete with others with exceptional result by doing a normal job. Their business profits will eventually gone down or up depending on the environment.
Hence, please treat your investment as your own business. Before you make any decision of investing, please ask yourself few questions:
1) Is this a good business?
2) How reliable of the top management?
3) Can I hold this investment for long term?
4) Can I buy more if the price goes down further?
If the answers for above questions are positive, what you can do is just wait for the opportunites to invest in to it.
And, please remember to hold it for long term. It is not easy to find a good monopoly business in this world. If you are doing a business, you will understand it.
Earning per share (EPS) manipulation might be the second oldest profession, but there is a relatively easy way for investors to protect themselves. This article will show you how to evaluate the quality of any kind of EPS, and find out what it's telling you about a stock.
Tutorial:Examining Earnings Quality Overview
The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors, accompanied by constantly mutating versions that seem to have come out of "Alice in Wonderland". Instead of Tweedle-Dee and Tweedle-Dum we have pro forma EPS and EBITDA. And, despite rumors to the contrary, the whisper number - the Cheshire cat of Wall Street - continues to exist as guidance.
To be fair, this situation cannot be totally blamed on management. Wall Street deserves as much blame due to its myopic focus on the near-term and knee-jerk reactions to 1 cent misses. A forecast is always only a guess - nothing more, nothing less - but Wall Street often forgets this. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions. (For background reading, check out Earnings Forecasts: A Primer.)
EPS Quality
High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated). But while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.
A low-quality EPS number does not accurately portray what the company earned. GAAP EPS (earnings reported according to Generally Accepted Accounting Principles) may meet the letter of the law but may not truly reflect the earnings of the company. Sometimes GAAP requirements may be to blame for this discrepancy; other times it is due to choices made by management. In either case, a reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions.
How to Evaluate the Quality of EPS
The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with theSEC.
To determine earnings quality, investors can rely on operating cash flow.The company can show a positive earnings on the income statement while also bearing a negative cash flow. This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected. "Cash is king" is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long. Want proof? Just look at how many of the dotcom wonders survived! (To learn more about what happened, see Why did dotcom companies crash so drastically?)
If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS, earnings are of a high quality because the company is generating more cash than is reported on the income statement. Reported (GAAP) earnings, therefore, understate the profitability of the company.
If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. In this case, EPS is of low quality because it does not reflect the negative operating results of the company and overstates what the true (cash) operating results.
An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.
However, if BS's operating cash flow per share were a negative 50 cents, it would indicate that the company really lost 50 cents of cash per share versus the reported $1. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The 50 cent negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.
If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was 50 cents more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment. (To learn more about this metric, check out Operating Cash Flow: Better Than Net Income?)
Trends Are Also Important
Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends. It is possible that an entire industry may generate negative operating cash flow due to cyclical causes. Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.
Evaluating trends will also help you spot the worst-case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, the need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. The appearance of growing GAAP EPS even though the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover. (To learn about why companies fudge cash flow, readCash Flow On Steroids: Why Companies Cheat.)
The Bottom Line
Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. Luckily, it is relatively easy for investors to evaluate the situation.
Fisher formulated a clear and sensible investing strategy (which I'll get to in a second), wrote one of the best investment books of all time, Common Stocks and Uncommon Profits, and made a good deal of money for himself and his clients.
His son wrote that Phil's best advice was
to "always think long term,"
to "buy what you understand," and
to own "not too many stocks."
Charles Munger, who is Buffett's partner, praised Fisher at the 1993 annual meeting of their company, Berkshire Hathaway Inc. (BRK/A): "Phil Fisher believed inconcentrating in about 10 good investments and was happy with a limited number. That is very much in our playbook. And he believed in knowing a lot about the things he did invest in. And that's in our playbook, too. And the reason why it's in our playbook is that to some extent, we learned it from him."
In addition to the warning against over-diversification — or what Peter Lynch, the great Fidelity Magellan fund manager, calls "de-worse-ification" — the book makes three important points:
(1) First, don't worry too much about price.(Quality first, Price second)
"Even in these earlier times [he's talking here about 1913],finding the really outstanding companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colorful practice of trying to buy them cheap and sell them dear."
In fretting about whether a stock is cheap or expensive, many investors miss out on owning great companies.My own rule is: quality first, price second.
(2) Second, Fisher says that investors must ask, "Does the company have a management of unquestionable integrity?"
(3) Finally, Fisher offered the best advice ever on selling stocks. "It is only occasionally," he wrote, "that there is any reason for selling at all."
Yes, but what are those occasions? They come down to this: Sell if a company has deteriorated in some important way. And Idon't mean price!
Fisher's view, instead, is to look to the business — the company itself, not the stock.
"When companies deteriorate, they usually do so for one of two reasons:
Either there has been a deterioration of management, or
the company no longer has theprospect of increasing the markets for its product in the way it formerly did."
A stock-price decline can be a key signal: "Pay attention! Something may be wrong!"But the decline alone would not prompt me to sell. Nor would a rise in price.
Time to sell? If you did, you missed another doubling.
"How long should you hold a stock? As long as the good things that attracted you to the company are still there."