myinvestingnotes.blogspot.my (Bullbear Buffett Stock Investing Notes)

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.

Showing posts with label RORC. Show all posts

Thursday 4 June 2009

Companies that can't profitably deploy retained earnings make lousy investments

By calculating the Return of Retained Capital RORC (click here: Return on Retained Capital Illustrated by Various Companies ), you can tell that H&R Block and Wrigley do an infinitely better job of allocating retained earnings than General Motors or Bethlehem Steel does.

In fact, if you had invested $100,000 in General Motors stock in 1990 and sold it at its high in 2000, you would have had a net profit of $141,025, which equates to an annual compounding return of approximately 9.1%.
If you had done the same with Bethlehem Steel, you would have had a loss of approximately $40,000.
If you had invested $100,000 in Wrigley's in 1990 and sold out at its high in 2000, you would have had a net profit of $566,666, which equates to an annual compounding return of approximately 20%.
With H&R Block you would have earned a net profit of $299,960, which equates to an annual compounding return of 14.8%.

So which stocks would you rather have owned from 1990 to 2000? The price-competitive businesses General Motors and Bethlehem Steel, or the durable-competitive-advantage businesses Wrigley's and H&R Block? It's not a tough choice.

Also Read:
Return on Retained Capital
Return on Retained Capital Illustrated by Various Companies
Companies that can't profitably deploy retained earnings make lousy investments
RORC provides a fast method of determining durable-competitive-advantage business

Return on Retained Capital Illustrated by Various Companies

Company A:

In 1989, earned $1.16 per share.
Between the end of 1989 and the end of 1999:

total earnings were $17.14 a share,
total dividends were $9.34 a share and
retained earnings were $7.80 per share ($17.14 - $9.34 = $7.80) to add to its equity base.
company's per share earnings increased from $1.16 to $2.56.

Interpretations:

We can attribute the 1989 earnings of $1.16 per share to all the capital invested and retained in the company up to the end of 1989.
We can also argue that the increase in earnings from $1.16 a share in 1989 to $2.56 a share in 2000 was due to the company's durable competitive advantage and management's doing an excellent job of investing the $7.80 a share in earnings that the company retained between 1989 and 1999.
If we subtract the 1989 per share earnings of $1.16 from the 1999 per share earnings of $2.56, the difference is $1.40 a share.
Thus, we can argue that the $7.80 a share retained between 1989 and 1999 produced $1.40 a share in additional income from 1999, for a total return of retained capital of 17.9% ($1.40 / $7.80 = 17.9%).

Company B

In 1990, earned $1 per share.

Between the end of 1990 and the end of 2000:

total earnings were $20.12 a share,
total dividends were $10.57 a share and
retained earnings were $9.55 per share ($20.12 - $10.57 = $9.55) to add to its equity base.
the company's per share earnings increased from $1 a share to $2.90.

Interpretations:

We can attribute the 1990 earnings of $1 per share to all the capital invested and retained in the company up to the end of 1990.
We can also argue that the increase in earnings from $1 a share in 1990 to $2.90 a share in 2000 was due to the company's durable competitive advantage and management's doing an excellent job of investing the $9.55 a share in earnings that the company retained between 1990 and 2000.
If we subtract the 1990 per share earnings of $1 from the 2000 per share earnings of $2.90, the difference is $1.90 a share.
Thus, we can argue that the $9.55 a share retained between 1990 and 2000 produced $1.90 a share in additional income from 1990, for a total return on retained capital of 19.9% ($1.90 / $9.55 = 19.9%).

Company C

In 1990, earned $42.96 per share.

Between the end of 1990 and the end of 2000:

total earnings were $42.96 a share,
total dividends were $10.30 a share and
retained earnings were $32.66 per share ($42.96 - $10.30 = $32.66) to add to its equity base.
the company's per share earnings increased from $6.33 a share to $8.50.

Interpretations:

This company kept $32.66 per shae of shareholders' earnings and allocated it so that per share earnings increased by $2.17.
This equates to a return on retained capital of 6.6% ($2.17 / $32.66 = 6.6%).
This is about what you would have earned had you left it in the bank.

Company D

In 1990, earned $0.82 per share.

Between the end of 1990 and the end of 2000:

total earnings were $4.93 a share,
total dividends were $0.80 a share and
retained earnings were $4.13 per share ($4.93 - $0.80 = $4.13) to add to its equity base.
the company's per share earnings had total losses of $7.48 a share.

Interpretations:

This means that management had to spend $7.48 a share in additional sums that they either borrowed or took from earnings retained during prior years.
Since this $7.48 in shareholder capital was depleted, rather than paid out as a dividend, this is added to the $4.13 in retained earnings, giving a total of $11.61 a share that was kept from shareholders.
Between 1990 and 2000, the company's per share earnings decreased from $0.82 a share to $0.25 a share. We can argue that the decrease in earnings was caused by the company being a price-competitive business that sucks up capital but does nothing to increase shareholders' wealth.
If we subtract the 1990 per share earnings of $0.82 from the 2000 per share earnings of $0.25 , the difference is a negative $0.57 a share.
Thus we can argue that the $4.13 a share retained between 1990 and 2000 and the $7.48 depleted during this period produced zero additional income.
The company is in a tough business (steel) in which to develop a competitive advantage.

Company A: H&R BLOCK

Company B: WM. WRIGLEY JR. COMPANY

Company C: GENERAL MOTORS

Company D: BETHLEHEM STEEL

Return on Retained Capital

A simple mathematical formula measures the capital requirements of maintaining a company's competitive advantage and management's ability to utilize retained earnings to improve shareholders' wealth. In essense this calculation takes the amount of earnings retained by a business for a certain period and measures its effect on the earning capacity of the company.

With a durable competitive advantage the company will be able to use its retained earnings either to:

expand its operations,
invest in new businesses,
and/or repurchase its shares.

All three should have a positive effect on per share earnings.

On the other hand, a price-competitive business would need to spend its retained earnings to maintain its business to the face of fierce competition from other companies in the same line of business, leaving little or nothing to invest in new operations and/or buying back its shares.

Companies that have a durable competitive advantage usually don't have to spend a high percentage of their retained earnings to maintain their operations. The key word here is maintain. In theory, the more durable a competitive advantage, the less a business has to spend to maintain it. Warren Buffett's perfect business would be one that spends zero on maintaining its competitive advantage. That would free every dollar it earns to be paid out as a dividend or reinvested in the business, which should, in theory, make its shareholders even wealthier.

Also Read:
Return on Retained Capital
Return on Retained Capital Illustrated by Various Companies
Companies that can't profitably deploy retained earnings make lousy investments
RORC provides a fast method of determining durable-competitive-advantage business

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My 18 points guide to Successfully compounding your money in Stocks

Be a good stock picker.
Think as a business owner.
Always look at value rather than the price. Do the homework.
Buy and hold is alright for selected stocks.
Compounding is your friend, get this to work its magic.
Mr. Market is there to be taken advantage of. Do not be the sucker instead. BFS;STS.
Always buy a lot when the price is low.
Never buy when the stock is overpriced.
It is alright to buy when the selected stock is at a fair price.
Phasing in or dollar cost averaging is safe for such stocks during a downtrend, unless the price is still obviously too high.
Do not time the market for such or any stocks.
By keeping to the above strategy, the returns will be delivered through the growth of the company's business.
So, when do you sell the stock? Almost never, as long as the fundamentals remain sound and the future prospects intact.
The downside risk is protected through only buying when the price is low or fairly priced.
Tactical dynamic asset allocation or rebalancing based on valuation can be employed but this sounds easier than is practical, except in extreme market situations.
Sell urgently when the company business fundamental has deteriorated irreversibly.
You may also wish to sell should the growth of the company has obviously slowed and you can reinvest into another company with greater growth potential of similar quality. However, unlike point 16, you can do so leisurely.
In conclusion, a critical key to successful investing is in your stock picking ability.

http://myinvestingnotes.blogspot.com/2012/07/my-18-points-guide-to-successfully.html

11 Lessons From Peter Lynch

Peter Lynch taught me:

1. Behind every stock is a company. Find out what it’s doing.
2. Never invest in any idea you can’t illustrate with a crayon.
3. Over the short term, there may be no correlation between the success of a company’s operations and the success of its stock. Over the long term, there’s a 100% correlation.
4. Buying stocks without studying the companies is the same as playing poker – and never looking at your cards.
5. Time is on your side when you own shares of superior companies.
6. Owning stock is like having children. Don’t get involved with more than you can handle.
7. When the insiders are buying, it’s a good sign.
8. Unless you’re a short seller, it never pays to be pessimistic.
9. A stock market decline is as predictable as a January blizzard in Colorado. If you’re prepared, it can’t hurt you.
10. Everyone has the brainpower to make money in stocks. Not everyone has the stomach.
11. Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

Lynch’s advice had a profound effect on my stock market approach. He taught me that investment success isn’t the result of developing the right macro-economic view or deciding when to jump in or out of the market. Success is about researching companies to identify those that are likely to report positive surprises.

Capital Expenditure

A great company with a Durable Competitive Advantage will have a ratio of Capital Expenditures to Net Income of less than 25%. Less is better.

Capital Expenditures are expenses on:
- fixed assets such as equipment, property, or industrial buildings
- fixing problems with an asset
- preparing an asset to be used in business
- restoring property
- starting new businesses

A good company will have a ratio of Capital Expenditures to Net Income of less than 50%.

A great company with a Durable Competitive Advantage will have a ratio of less than 25%.

Less is better.

Benjamin Graham's 113 Wise Words

The true investor scarcely ever is forced to sell his shares, and at all times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement."

Philip Fisher's Wise Words

"The refusal to sell at a loss, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process.

More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous."

(Common Stocks and Uncommon Profits)

The Ultimate Hold-versus-Sell Test

Here is the overriding primary test, followed by observations on why it is so critically important:

Knowing all that you now know and expect about the company and its stock (not what you originally believed or hoped at time of purchase), and assuming that you had available capital, and assuming that it would not cause a portfolio imbalance to do so, would you buy this stock today, at today's price?

No equivocation. Yes or no?

Answers such as maybe or probably are not acceptable since they are ways of dodging the issue. No investor probably buys a stock; they either place an order or do not.

Here is the implication of your answer to that critical test: if you did not answer with a clear affirmative, you should sell; only if you said a strong yes, are you justified to hold.

Some thoughts on Analysing Stocks (KISS)

Ideally a stock you plan to purchase should have all of the following charateristics:

• A rising trend of earnings dividends and book value per share.
• A balance sheet with less debt than other companies in its particular industry.
• A P/E ratio no higher than average.
• A dividend yield that suits your particular needs.
• A below-average dividend pay-out ratio.
• A history of earnings and dividends not pockmarked by erratic ups and downs.
• Companies whose ROE is 15 or better.
• A ratio of price to cash flow (P/CF) that is not too high when compared to other stocks in the same industry.

Margin of Safety Concept: Stocks should be bought like groceries, not like perfume

The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.

Chapter 20 - “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

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.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

myinvestingnotes.blogspot.my (Bullbear Buffett Stock Investing Notes)

Thursday 4 June 2009

Companies that can't profitably deploy retained earnings make lousy investments

Return on Retained Capital Illustrated by Various Companies

Return on Retained Capital

All equity security investments present a risk of loss of capital

The Ultimate Hold-versus-Sell Test

Some thoughts on Analysing Stocks (KISS)

Benjamin Graham

Sell the losers, let the winners run.

Investment Style

Warren Buffett

Political and Economic News

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