The Five Rules for Successful Stock Investing 5

The Language of Investing

As an investor, you're mainly going to be interested in the balance sheet, the income statement, and the statement of cash flows. These three tables are your windows into corporate performance, and they're the place to start when you're analyzing a company.

The balance sheet is like a company's credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities) at a specific point in time. [...] 

The income statement, meanwhile, tells how much the company made or lost in accounting profits during a year or a quarter. Unlike the balance sheet [...] the income statement records revenues and expenses over a set period, such as a fiscal year. 

Finally, there's the statement of cash flows, which records all the cash that comes into a company and all of the cash that goes out. The statement of cash flows ties the income statement and balance sheet together.

Accrual accounting is a key concept for understanding financial statements. The income statement matches sales with the corresponding expenses when a service or a good is provided to the buyer, but the cash flow statement is concerned only with when cash is received and when it goes out the door.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

The Five Rules for Successful Stock Investing 4

Economic Moats

Investors often judge companies by looking at which ones have increased profits the most and assuming the trend will persist in the future. But more often than not, the firms that look great in the rearview mirror wind up performing poorly in the future, simply because success attracts competition as surely as night follows day. And the bigger the profits, the stronger the competition. That's the basic nature of any (reasonably) free market – capital always seeks the areas of highest expected return. Therefore, most highly profitable firms tend to become less profitable over time as competitors chip away at their franchises.

To analyze a company's economic moat, follow these four steps:

• 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.
• If the firm has solid returns on capital and consistent profitability, 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?
• Estimate how long a firm will be able to hold off competitors, which is the company's competitive advantage period. Some firms can fend off competitors for just a few years, and some firms may be able to do it for decades.
• Analyze the industry's competitive structure. How do firms in this industry compete with one another? Is it an attractive industry with many profitable firms or a hypercompetitive one in which participants struggle just to stay afloat?

Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

If a firm's free cash flow as a percentage of sales is around 5 percent or better, you've found a cash machine [...]. Strong free cash flow is an excellent sign that a firm has an economic moat.

Net margin is simply net income as a percentage of sales, and it tells you how much profit the firm generates per dollar of sales. In general, firms that can post net margins above 15 percent are doing something right.

Return on equity (ROE) is net income as a percentage of shareholders' equity, and it measures profits per dollar of the capital shareholders have invested in a company. [...] As a rule of thumb, firms that are able to consistently post ROEs above 15 percent are generating solid returns on shareholders' money, which means they're likely to have economic moats.

Return on assets (ROA) is net income as a percentage of a firm's assets, and it measures how efficient a firm is translating its assets into profits. Use 6 percent to 7 percent as a rough benchmark – if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.

Consistency is important when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time – not just for a year or two – that really makes a firm valuable. Five years is the absolute minimum time period for evaluation, and I'd strongly encourage you to go back 10 years if you can.

When you're examining the sources of a firm's economic moat, the key thing is to never stop asking, "Why?" Why aren't competitors stealing the firm's customers? Why can't a competitor charge a lower price for a similar product or service? Why do customers accept annual price increases? When possible, look at the situation from the customer's perspective. What values does the product or service bring to the customer? How does it help them run their own business better? Why do they use one firm's product or service instead of a competitor's?

In general, there are five ways that an individual firm can build sustainable competitive advantage:

1. Creating real product differentiation through superior technology or features
2. Creating perceived product differentiation through a trusted brand or reputation
3. Driving costs down and offering a similar product or service at a lower price
4. Locking in customers by creating high switching costs
5. Locking out competitors by creating high barriers to entry or high barriers to success

[...] although firms can occasionally generate enormous excess profits – and enormous stock returns – by staying one step ahead of the technological curve, these profits are usually short-lived. Unless you are familiar enough with the inner workings of an industry to know when a firm's products are being supplanted by better ones, be wary of firms that rely solely on innovation to sustain their competitive advantage.

[...] a strong brand can constitute a very wide economic moat. The wonderful thing about a brand is that as long as customers perceive your product or service as better than everyone else's, it makes relatively little difference whether it actually is different.

In general, firms can create cost advantages by either inventing a better process or achieving a larger scale.

If you can make it difficult – in terms of either money or time – for a customer to switch to a competing product, you can charge your customers more and make more money – simple in theory, but difficult in practice.

When you're looking for evidence of high customer switching costs, these questions should help:

• Does the firm's product require a significant amount of client training? If so, customers will be reluctant to switch and incur lost productivity during the training period.
• Is the firm's product or service tightly integrated into customers' businesses? Firms don't change vendors of mission-critical products often because the costs of a botched switch may far outweigh the benefits of using the new product or service.
• Is the firm's product or service an industry standard? Customers may feel pressure from their own clients – or their peers – to continue using a well-known and well-respected product or service.
• Is the benefit to be gained from switching small relative to the cost of switching?
• Does the firm tend to sign long-term contracts with clients? This is often a sign that the client does not want to frequently switch vendors.

Although patents and licenses can do a great job of keeping competitors at bay and maintaining high profit margins, they can also be ephemeral. If you're investigating a firm whose economic moat depends solely on a single patent or other regulatory approval, don't forget to investigate the likelihood of that approval disappearing unexpectedly.

Think about an economic moat in two dimensions. There's depth – how much money the firm can make – and there's width – how long the firm can sustain above-average profits.

Although the attractiveness of an industry doesn't tell the whole story, it's important to get a feel for the competitive landscape. Some industries are just easier to make money in than others.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

The Five Rules for Successful Stock Investing 3

Seven Mistakes to Avoid

Unless you know how to avoid the most common mistakes of investing, your portfolio's returns won't be anything to get excited about. You'll find that it takes many great stock picks to make up for just a few big errors.

Loading up your portfolio with risky, all-or-nothing stocks – in other words, swinging for the fences on every pitch – is a sure route to investment disaster. For one thing, the insidious math of investing means that making up large losses is a very difficult proposition – a stock that drops 50 percent needs to double just to break even. For another, finding the next Microsoft when it's still a tiny start-up is really, really difficult. You're much more likely to wind up with a company that fizzles than a truly world-changing company, because it's extremely difficult to discern which is which when the firm is just starting out.

You have to be a student of the market's history to understand its future. Any time you hear someone say, "It really is different this time", turn off the TV and go for a walk.

It seems entirely logical, but the reality is that great products do not necessarily translate into great profits.

It's very tempting to look for validation – or other people doing the same thing – when you're investing, but history has shown repeatedly that assets are cheap when everyone else is avoiding them.

You'll do better as an investor if you think for yourself and seek out bargains in parts of the market that everyone else has forsaken, rather than buying the flavor of the month in the financial press.

Market timing is one of the all-time great myths of investing. There is no strategy that consistently tells you when to be in the market and when to be out of it, and anyone who says otherwise usually has a market-timing service to sell you.

The only reason you should ever 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 the shares a few months down the road.

Cash flow is the true measure of a company's financial performance, not reported earnings per share.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

The Five Rules for Successful Stock Investing 2

The Five Rules for Successful Stock Investing

Here are the five rules that we recommend:

1. Do your homework.
2. Find economic moats.
3. Have a margin of safety.
4. Hold for the long haul.
5. Know when to sell.

[...] perhaps the most common mistake that investors make is failing to thoroughly investigate the stocks they purchase. Unless you know the business inside and out, you shouldn't buy the stock. This means that you need to develop an understanding of accounting so that you can decide for yourself what kind of financial shape a company is in.

What separates a bad company from a good one? Or a good company from a great one? In large part, it's the size of the economic moat a company builds around itself. The term economic moat is used to describe a firm's competitive advantage.

The key to identifying wide economic moats can be found in the answer to a deceptively simple question: How does a company manage to keep competitors at bay and earn consistently fat profits? If you can answer this, you've found the source of the firm's economic moat.

Finding great companies is only half of the investment process – the other half is assessing what the company is worth. You can't just go out and pay whatever the market is asking for the stock because the market might be demanding too high a price. And if the price you pay is too high, your investment returns will likely be disappointing.

Always include a margin of safety into the price you're willing to pay for a stock. If you later realize you overestimated the company's prospects, you'll have a built-in cushion that will mitigate your investment losses. The size of your margin of safety should be larger for shakier firms with uncertain futures and smaller for solid firms with reasonably predictable earnings.

[...] not making money is a lot less painful than losing money you already have.

[...] if you don't use discipline and conservatism in figuring out the prices you're willing to pay for stocks, you'll regret it eventually. Valuation is a crucial part of the investment process.

Investing should be a long-term commitment because short-term trading means that you're playing a loser's game. The costs really begin to add up – both the taxes and the brokerage costs – and create an almost insurmountable hurdle to good performance.

Knowing when it's appropriate to bail out of a stock is at least as important as knowing when to buy one, yet we often sell our winners too early and hang on to our losers for too long.

Even the greatest companies should be sold when their shares sell at egregious values.

As an investor, you should always be seeking to allocate your money to the assets that are likely to generate the highest return relative to their risk. There's no shame in selling a somewhat undervalued investment – even one on which you've lost money – to free up funds to buy a stock with better prospects.

Don't sell just because the price has gone up or down, but give it some serious thought if one of the following things has happened: You made a mistake buying it in the first place, the fundamentals have deteriorated, the stock has risen well above its intrinsic value, you can find better opportunities, or it takes up too much space in your portfolio.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

The Five Rules for Successful Stock Investing 1

Introduction: Picking Great Stocks Is Tough

Successful investing is simple, but it's not easy.

Picking individual stocks requires hard work, discipline, and an investment of time (as well as money). Expecting to make a large amount of money with only a little effort is like expecting to shoot a great round of golf the first time you pick up a set of clubs. There's no magic formula, and there's no guarantee of success.

The basic investment process is simple: Analyze the company and value the stock. If you avoid the mistake of confusing a great company with a great investment – and the two can be very different – you'll already be ahead of many of your investing peers.

Your goal as an investor should be to find wonderful businesses and purchase them at reasonable prices. Great companies create wealth, and as the value of the business grows, so should the stock price in time. In the short term, the market can be a capricious thing – wonderful businesses can sell at fire-sale prices, while money-losing ventures can be valued as if they had the rosiest of futures – but over the long haul, stock prices tend to track the value of the business.

You have to [...] understand the businesses of the stocks you own if you hope to be a successful long-term investor. When firms do well, so do their shares, and when business suffers, the stock will as well.

Company fundamentals have a direct effect on share prices. This principle applies only over a long time period – in the short term, stock prices can (and do) move around for a whole host of reasons that have nothing whatsoever to do with the underlying value of the company. We firmly advocate focusing on the long-term performance of businesses because the short-term price movement of a stock is completely unpredictable.

Successful stock-picking means having the courage to take a stance that's different from the crowd. There will always be conflicting opinions about the merits of any company, and it's often the companies with the most conflict surrounding them that make the best investments. Thus, as an investor, you have to be able to develop your own opinion about the value of a stock, and you should change that value only if the facts warrant doing so – not because you read a negative news article or because some pundit mouths off on TV. Investment success depends on personal discipline, not on whether the crowd agrees or disagrees with you.

http://books.danielhofstetter.com/the-five-rules-for-successful-stock-investing/

Create a Portfolio You Don't Have to Babysit

Great Q&A starting @ 42 min. Very insightful

Published on 14 Jun 2012
In this special one-hour presentation, Morningstar director of personal finance Christine Benz and ETF expert Mike Rawson discuss how to build a low-maintenance, hands-free portfolio that will help you reach your financial goals.

Note to viewers: Filmed in late April 2012, this Morningstar presentation was part of Money Smart Week, a series of free classes and activities organized by the Federal Reserve Bank of Chicago and designed to help consumers better manage their personal finances. Morningstar is a Money Smart Week partner.

Download the presentation slides here:
http://im.mstar.com/im/moneysmartweek_presentation.pdf

How to Choose Dividend Stocks - Morningstar Video

Simple 10-Year DCF Valuation Model (Morningstar)

http://www.stock-picks-focus.com/intrinsic-value.html

Intrinsic Value - What a stock is worth?

Intrinsic Value - What a stock is worth?

Without knowing what a stock is worth- in other words its Intrinsic Value- how can you know how much you should pay for it? Stocks should be purchased because they are trading at some discount to their intrinsic value, not simply because they are priced at a higher or lower point than similar companies.

The big drawback of the ratios discussed in the Stock Valuation Basics section is that they are all based on price - they compare what investors are currently paying for one stock to what they are paying for another stock. Ratios do not, however, tell you anything about value, which is what a stock is actually worth. Comparing ratios across companies and across time can help us understand whether our valuation estimate is close to or far from the mark, but estimating the intrinsic value of a company gives us a better target.

Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book - The 5 Rules for Successful Stock Investing - tells us how we can go about calculating what a stock is really worth- in other words, its Intrinsic Value. His writings are the primary source for this article.

Having an intrinsic value estimate keeps you focused on the value of the business, rather than a piece of the stock - and that's what you want because, as an investor, you are buying a small piece of a business. Intrinsic valuation also forces you to think about the cash flows that a business is generating today and the cash it could generate in the future, as well as the returns on the capital that the firm creates. It makes you ask yourself, "If I could buy the whole company, what would I pay?

Second, having an intrinsic value gives you a stronger basis for making investment decisions. Without looking at the true determinants of value, such as cash flow and return on capital, we have no way of assessing whether a P/E of, for example 15 or 20 is too low, too high, or right on target. After all, the company with the P/E of 20 might have much lower capital needs and a less risky business than the company with the P/E of 15, in which case it might actually be the better investment.

Cash Flow, Present Value, and Discount Rates

What is a stock worth? Economists Irving Fisher and John Burr Williams answered this question for us more than 60 years ago. The value of a stock is equal to the present value of its future cash flows. No more and no less.

Companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some get re-invested in the business, and the rest is free cash flow. Remember we care about the free cash flow because that's the amount of money that could be taken out of the business each year without harming its operations. A firm could use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, which essentially converts a portion of each investor's interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and re-invest it in the business.

These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today.

Why are future cash flows worth less than the current ones? First, money that we receive today can be invested to generate some kind of return, whereas we cant invest future cash flows until we receive them. This is the time value of money. Second, there is a chance that we may never receive those future cash flows, and we need to be compensated for that risk, called the risk premium.

The time value of money is essentially the opportunity cost of receiving money in the future versus receiving it today, and is often represented by the interest rates being paid on government bonds. Its pretty certain that the government will be around to pay us our interest in a few years.

Of course, not many cash flows are as certain as those from the government, so we need to take an additional premium to compensate us for the risk that we may never receive the money we have been promised. Add the government bond rate to the risk premium, and we have what's known as a discount rate.

Now you can start to see why stocks with stable, predictable earnings often have such high valuations - investors discount their future cash flows at a lower rate, because they believe that there's a lower risk attached to the likelihood that those future cash flows will actually show up. Conversely a business with an extremely uncertain future should logically have a lower valuation because there is a substantial risk that the potential future cash flows will never materialise.

You can see why a rational investor should be willing to pay more for a company that's profitable now relative to one that promises profitability only at some point in the future. Not only does the latter carry a higher risk (and thus a higher discount rate), but the promised cash flows won't arrive until some years in the future, diminishing their value still further.

Changing discount rates and the timing of cash flows can have a telling effect on present value. In all three examples, below -StableCorp, CycliCorp, and RiskCorp -the sum of the undiscounted cash flows is about $32000.

 


However, the value of the discounted cash flows is quite different from company to company. In present value terms, CycliCorp is worth about $2700 less than StableCorp. That's because StableCorp is more predictable, which means that investors' discount rate isn't high. CycliCorp's cash flow increases by 20 percent some years and shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they are valuing its shares. As a result the present value of the discounted cash flows is lower.

The difference in the present value of the cash flows is even more acute when you look at RiskCorp, which is worth almost $8300 less than StableCorp. Not only are the bulk of RiskCorp's cash flows far off in the future, bu also, we are less certain that they will come to pass, so we assign an even higher discount rate.

This is the basic principle behind a discounted cash flow model. Value is determined by the amount, timing, and riskiness of a firm's future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock. That's all it really boils down to.

Calculating Present Value

To find the present value of a $100 future cash flow, divide that future cash flow by 1.0 plus the discount rate. Using a 10% discount rate, for example, a cash flow of $100 one year in teh future is worth $100/1.10. or $90.91. A $100 cash flow two years in the future is worth $100/(1.10x1.10), or $82.64. In other words, $82.64 invested at 10% becomes $90.91 in a year and $100 in 2 years. Discount rates are really just interest rates that go backwards through time instead of forwards.

Generalising the previous formula, if we represent the discount rate as R, the present value of a future cash flow (CF) in year N equals

Fun with discount rates

Now that we have the formula down, we need to figure out what factors determine discount rates for use in Intrinsic Value calculations. How do we know whether to use 7 percent or 10 percent?

Unfortunately, there is no precise way to calculate the exact discount rate that you should use in discounted cash flow (DCF) model, and academicians have filled entire journals with nothing but discussions on the right way to estimate discount rates for Intrinsic value calculations.

Here's what you want to know for practical purposes. As interest rates rise, so will discount rates. As a firm's risk level increases, so will its discount rate. Let's put these two together. For interest rates you can use the long-term average of treasury rates as a reasonable proxy. (Remember we use interest rate on treasuries to represent opportunity costs because we are pretty certain that the government will pay us our promised interest).

Now for risk, which is an even less exact factor to measure. Here are some factors that should be taken into account when estimating discount rates.

Size

Smaller firms are generally riskier than larger firms because they're more vulnerable to adverse events. They also usually have less diversified product lines and customer bases.

Financial Leverage

Firms with more debt are generally riskier than firms with less debt because they have a higher proportion of fixed expenses (debt payments) relative to other expenses. Earnings will be better in good times, but worse in bad times, with an increased risk of financial distress. Look at a firm's debt-to-equity ration, interest coverage, and a few other factors to determine the degree of a company's risk from financial leverage.

Cyclicality

Is the firm in a cyclical industry (such as commodities or automobiles) or a stable industry (such as breakfast cereal or beer)? Because the cash flows of cyclical firms are much tougher to forecast than stable firms, their level of risk increases.

Management/Corporate Governance

This factor boils down to a simple question: How much do you trust the folks running the shop? Although its rarely black or white, firms with promotional managers (who leave no opportunity to drum up stock prices through their media appearances), managers who draw egregious salaries, or who exhibit any of the other red flags are definitely riskier than companies with managers who do not display these traits.

Economic Moat

Does the firm have a wide moat, a narrow moat, or no economic moat? The stronger a firm's competitive advantage -that is, the wider its moat- the more likely it will be able to keep competitors at bay and generate a reliable stream of cash flows.

Complexity

The essence of risk is uncertainty. And its tough to value what you can't see. Firms with extremely complex businesses or financial structures are riskier than simple, easy-to-understand firms because there's a greater chance that something unpleasant is hiding in a footnote that you missed. Even if you think management is as honest as the day is long and that the firm does a great job running its operations, its wise to incorporate a complexity discount into your mental assessment of risk.

How should you incorporate all of these risk factors into a discount rate? There is no right answer.

Morningstar uses 10.5 percent as the discount rate for an average company based on the above factors and creates a distribution of discount rates based on whether firms are riskier or less risky than the average. A so mid-2003, firms such as Johnson and Johnson, Colgate and Wal-Mart fall at the bottom of the range at around 9 percent, whereas riskier firms such as Micron technology, JetBlue Airways, and E*Trade -top out at 13 percent to 15 percent.

The key is to pick a discount rate you are comfortable with. Don't worry about being exact -just think about whether the company you are evaluating is riskier or less risky than the average firm, along with how much riskier or less risky it is, and you will be fine.

Discount rates for the Indian market context

In the Indian market context we may use 15% as the discount rate for an average company (8 percent risk-free rate + 7 percent risk-premium). High-Quality companies may be discounted at a low rate of 12%, above-average companies at 13%, and poor quality companies may be discounted at a high of 18%.

Calculating Perpetuity Values

We have cash flow estimates, and we have a discount rate. We need one more element called a perpetuity value. We need a perpetuity because it's not feasible to project a company's future cash flows out to infinity, year-by-year, and because companies have theoritically finite 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 it to grow over the very long term (g), and divide the result by the discount rate (R) minus the expected long-term growth rate.

 

The result of this calculation than must be discounted back to present, using the method discussed for calculating present value. For example, suppose we are using a 10-year DCF model for a company with an 11 percent discount rate. We estimate that the company’s cash flow in year 10 will be $1 billion and its cash flow will grow at a steady 3 percent annual rate after that. (Three percent is generally a good number to use as your long-run growth rate because it’s roughly the U.S. gross domestic product [GDP] growth. If you are valuing a firm in a declining industry, you might use 2 percent).

Perpetuity Value = $ 1 billion x (1+ 0.03) / (0.11-0.03)

= $ 1.03 billion/ 0.08

= $ 12.88 billion

To get the present value of these cash flows, we need to discount them using the formula

 

where n is the number of years in the future, CFn is the cash flow in year n, and R is the discount rate. Plugging these numbers, N = 10, CFn = $12.88 billion, R= 0.11

Discounted Perpetuity Value = $12.88 bn/ (1+0.11)^10 = $12.88 bn/2.839 = $4.536 bn

Calculating Intrinsic Value

Now all that we need to do is add this discounted perpetuity value to the discounted value of our estimated cash flows in years 1 through 10, and divide by the number of shares outstanding.

 

That was a brief outline of the process. You can follow along by matching the following steps:

1. Estimate free cash flows for the next 4 quarters. This amount will depend on all of the factors discussed earlier -how fast the company is growing, the strength of its competitors, its capital needs, and so on. Using Clorox as an example, our first step is to see how fast free cash flow has grown over the past decade, which turns out to be 9% when we do the math. We could just increase the $600 million in free cash flow that Clorox generated in 2003 by 9 percent, but that would assume the future would be as rosy as in the past. Mega retailers like Wal-Mart -which now accounts for almost a quarter of Clorox sales -has hurt the bargaining power of consumer-product firms. So, let's be conservative and assume free cash flow increases by only 5 percent over the last year, which would work out to $630 million.

2. Estimate how fast you think free cash flow will grow over the next 5 to 10 years. Remember, only firms with very strong competitive advantages and low capital needs are able to sustain above-average growth rates for very long. If the firm is cyclical don't forget to throw in some bad years. We won't do this for Clorox because selling bleach and Glad bags is a very stable business. We will however be conservative on our growth rate because of the "Wal-Mart factor", and will assume free cash flow increases at 5 percent annually over the next decade.

3. Estimate a discount rate. Financially Clorox is rock-solid, with little debt, tons of free cash flow, and a non-cyclical business. So we will use 9% for our discount rate, which is meaningfully lower than the 10.5 percent average we discussed earlier. Clorox, is a predictable company, after all.

4. Estimate a long-run growth rate. Because people will still need bleach and trash bags in the future, and its a good bet that Clorox will continue to get a piece of that market, we can use the long-run GDP average of 3 percent.

5. That's it! We discount the first 10 years of cash flows, add that value to the present value of the perpetuity, and divide by the shares outstanding.

This is a very simple DCF model. The one used at Morningstar has about a dozen excel tabs, adjusts for complicated items such as pensions and operating leases, and explicitly models competitive advantage periods, among many other things. But a model doesn't need to be super complex to get you most of the way there and help you clarify your thinking.

The important thing is that we forced ourselves to think through these kinds of issues as discussed earlier, which we wouldn't have if we had just looked at Clorox's stock chart or if we had just said, "Sixteen times earnings seem reasonable". By thinking about the business, we arrived at a better valuation in which we have more confidence.

Valuing Clorox using a Discounted Cash Flow model

Margin of Safety

We have analysed a company, we have valued it - now we need to know when to buy it. If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. Any valuation and any analysis is subject to error, and we can minimise the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the Margin of Safety, a term first popularised by investing great Benjamin Graham.

Here is how it works. Let's say we think Clorox's intrinsic value is $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 percent) plus the discount rate of about 9 percent. That would be 29 percent, which is a pretty darn good return, all things considered.

But what if we are wrong? What if Clorox grows even more slowly than we had anticipated -may be a competitor takes market share - or the firm's pricing power erodes faster than we had thought? If that's the case, then Clorox's intrinsic value might actually be $40, which means we would have overpaid for the stock by buying it at $45.

Having a margin of safety is like an insurance policy that helps prevent us from overpaying - it mitigates the damage caused by overoptimistic estimates. If, for example, we had required a margin of safety of 20 percent before buying Clorox, we wouldn't have purchased the stock until it fell to $43. In that case, even if our initial analysis had been wrong and the fair value had really been $40, the damage to our portfolio wouldn't have been as severe.

Because all stocks aren't created equal, not all margins of safety should be the same. It's much easier to forecast the cash flows of, for example, Anheuser-Busch over the next 5 years than the cash flows of Boeing. One company has tons of pricing power, dominant market share, and relatively stable demand, whereas the other has relatively little pricing power, equal market share, and highly cyclical demand. Because I am less confident about my forecasts for Boeing, I'll want a larger margin of safety before I buy the shares. There's simply a greater chance that something might go wrong, and that my forecasts will be too optimistic.

Paying more for better businesses makes sense, within reason. The price you pay for a stock should be closely tied to the quality of the company, and great businesses are worth buying at smaller discounts to intrinsic value. Why? Because high-quality businesses - those that have wide economic moats - are more likely to increase in value over time, and it's better to pay fair price for a great business than a great price for a fair business.

How large should your margin of safety be? It ranges all the way from just 20 percent for very stable firms with wide economic moats to 60 percent for high-risk stocks with no competitive advantages. For above-average firms we would require a 25 percent margin of safety, while on average, we require a 30 percent to 40 percent margin of safety for most firms.

Having a margin of safety is critical to being a disciplined investor because it acknowledges that as humans, we are flawed. Simply investing in the stock market requires some degree of optimism about the future, which is one of the biggest reasons that buyers of stocks are too optimistic far more often than they're too pessimistic. Once we know this, we can correct for it by requiring a margin of safety for all of our share purchases.

Every approach to equity investing has its own warts. Being disciplined about valuation may mean that you will miss out on some great opportunities because some companies wind up performing better for longer periods of time than almost anyone could have anticipated. Companies such as Microsoft looked very pricey back in their heyday, and its unlikely that many investors who were very strict about valuation would have bought it early in their corporate lives.

Being disciplined about valuation would have meant missing those opportunities, but it also would have kept you out of many investments that were priced like Microsoft, but which wound up disappointing investors in a big way. Although we acknowledge that some high-potential companies are worth a leap of faith and a high valuation, on balance, we think its better to miss a solid investment because you are too cautious in your initial valuation than it is to buy stocks at prices that turn out to be too high.

After all, the real cost of losing money is much worse than the opportunity cost of missing out on gains. that's why the price you pay is just as important as the company you buy.

http://www.stock-picks-focus.com/intrinsic-value.html

The Five Rules for Successful Stock Investing

The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market

02.28.2010 · Posted in Stock Market

Product Description
The Five Rules for Successful Stock Investing

“By resisting both the popular tendency to use gimmicks that oversimplify securities analysis and the academic tendency to use jargon that obfuscates common sense, Pat Dorsey has written a substantial and useful book. His methodology is sound, his examples clear, and his approach timeless.”

–Christopher C. Davis Portfolio Manager and Chairman, Davis Advisors

Over the years, people from around the world have turned to Morningstar for strong, independent, and reliable advice. The Five Rules for Successful Stock Investing provides the kind of savvy financial guidance only a company like Morningstar could offer. Based on the philosophy that “investing should be fun, but not a game,” this comprehensive guide will put even the most cautious investors back on the right track by helping them pick the right stocks, find great companies, and understand the driving forces behind different industries–without paying too much for their investments.

Written by Morningstar’s Director of Stock Analysis, Pat Dorsey, The Five Rules for Successful Stock Investing includes unparalleled stock research and investment strategies covering a wide range of stock-related topics. Investors will profit from such tips as:
* How to dig into a financial statement and find hidden gold . . . and deception
* How to find great companies that will create shareholder wealth
* How to analyze every corner of the market, from banks to health care

Informative and highly accessible, The Five Rules for Successful Stock Investing should be required reading for anyone looking for the right investment opportunities in today’s ever-changing market.

• ISBN13: 9780471686170

Our Stock-Picking Track Record by Pat Dorsey, Morningstar

By Pat Dorsey, CFA| 1-26-2010 12:20 PM

Our Stock-Picking Track Record
Pat Dorsey takes a look back at the performance of our calls through the downturn and recovery, plus how our star ratings on wide-, narrow-, and no-moat stocks have played out.

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How Our Stock Calls Have Performed

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar. At Morningstar's Equity Research Department, we're sometimes accused of taking a bit of an academic focus towards equity research. We spend a lot of time on competitive analysis and cash flow projections, but at the end of the day, the purpose is to pick stocks that go up.

So, the question is, did we do this? How has our performance been in 2009 and over the past few years? We recently published an article looking at our performance in '09 and in the past several years. I wanted to recap some of the highlights for you.

One of the first ways we can look at our performance in general is basically comparing how cheap we thought stocks were in aggregate to how the market has done. On that score, we've done OK.

In '07 and '08, we thought stocks were mildly overvalued. In hindsight, they were more overvalued then we had projected them to be, but at least we weren't pounding the table and saying, "Go out and put all your money into the equity markets."

What we did get right was calling the market as significantly undervalued in late '08 and early '09 when the median price-to-fair value of all the stocks that we cover reached as low as about 0.6, meaning that we thought the median stock in our coverage universe was about 40% undervalued in late '08 and early '09. Of course, that turned out to be a pretty good call.

Close Full Transcript

We can also look at our valuation of popular indexes like the S&P 500 because, since we cover every stock in the S&P 500, we can basically take all of our fair values and roll them up into an aggregate value for the index. Well, before things really rolled over, we had a fair value of the S&P of about 1,500-1,600. That was certainly, in hindsight, too high. (Food for thought:  even the expert got it wrong!)

We quickly adjusted that downward in late '08 to a level of about 1,200-1,250, and I'm very proud of the fact that we actually held our ground. Throughout most of '09, we held our fair value for the S&P at about 1, 200 even as the market was cratering down towards 800, 700 and down to the intra-day number of the beast low on March nine of 666.

We held our ground that whole time that the fair value for the S&P of 1,200. I'm fairly glad that we didn't succumb to the temptation to hide under the covers and not call anything a buy. In fact, we called quite a few things buys at that point in time.

Those are two big ways to look at the overall performance of our stock calls. Another way is basically have our 5-stars, our buy-rated stocks, outperformed our 1-stars, sell-rated stocks? One way we do this is sort of look at it by moat. Look at it by

• wide-moat, 
• narrow-moat and 
• no-moat stocks.

And here again, the story is pretty good. If you look at our wide-moat stocks over pretty much all time periods--trailing three years, five years and last year--our 5-star, buy-rated, wide-moat stocks have beaten our entire coverage universe of wide-moat stocks and, of course have done much better than our 1-star, sell-rated, wide-moat stocks.

Same story on the narrow-moat side. Of course, narrow-moat companies are the kinds of companies that don't have quite as strong an advantage as wide-moat businesses, and they are still good businesses. And those are businesses where, again, our 5-stars have out-performed narrow moats in general, as well as our sell-rated, 1-star, narrow-moat stocks.

Now, on the no-moat side of things, the story's a little bit more mixed, frankly. We cover about 900 no-moat stocks. These are typically sometimes smaller, less well competitively advantaged businesses. Businesses that we think are very prone to the vicissitudes of the economy and don't really have strong economic moats. And our performance here has been a bit more skewed, basically. We have not really done a very good job of sorting out the buy-rated ones from the 1-star, no-moat stocks. I think there's a couple reasons for this.

One is, well, frankly these are harder companies to value at the end of the day. They tend to be more volatile. They tend to be less predictable. They tend to be more easily buffeted by macroeconomic events, so they're just harder to value. They've also more volatile. They tend to be a little bit more levered and smaller, on average. They're just tougher companies to get you arms around. And our 1-star, no-moat stocks actually did incredibly well in 2009.

So, if you had owned this portfolio of beaten-down retailers, auto parts companies and media firms, you would have made a ton of money in 2009. You would have also needed a titanium-lined stomach to have held them from the beginning of the year through the March lows, and I'm not quite sure how many people would have had the fortitude to do this. If you did, more power to you. But I think the perhaps better risk-adjusted way is to think about the 5-star, narrow-moat and wide-moat stocks.

Finally, our strategies have done fairly well over time. These are kind of real money portfolios. Again, you're seeing more conservative strategies, like our Morningstar StockInvestor Tortoise Portfolio, didn't do quite as well in 2009, but it also didn't lose nearly as much money as the market in 2008, where as our more aggressive portfolios, like the Morningstar StockInvestor Hare, did quite well in 2009, as taking risk was rewarded by the market .

And our Wide Moat Focus Index, which basically takes the 20 cheapest of our wide-moat stocks, basically has been knocking the cover off the ball. It was up about 46% in 2009 and is beating the market by about 500 basis points annualized over the past five years. Again, it's a very simple, mechanical strategy. It's simply looking at our wide-moat universe of about 160 companies and looking for the 20 cheapest and then rebalancing quarterly.

I think what that really shows is the value of a disciplined approach and having a watch-list sorting out a group of companies you think that have the economic sticking power to be around for the long haul and waiting and buying them when they're cheap. That's essentially all this strategy does.

So, that's a pretty comprehensive look at our performance in 2009 and over the past several years. Overall, pretty good. We could have done a better job with the no-moat stocks but again, these are just frankly harder companies to get your arms around. They tend to be a little bit riskier and those were some missed opportunities, but overall, I'm pretty pleased with the performance.

I'm Pat Dorsey and thanks for watching.
Video:
http://www.morningstar.com/cover/videocenter.aspx?id=323559