Why Strong Buy doesn’t mean load up
12 Sep 11QBE Insurance and Macquarie Bank are incredible opportunities. So why do we recommend you allocate only a few percent of your portfolio to them?
Saturday 17 December 2011
How to value stocks and shares
This article shows how you can value any security - if you know how much it will pay, when it will pay it and the return you want to make.
Time value of money
The principle is known as the 'time value of money' and we can flesh it out with an example. We'll assume that all money earns interest at 8% a year and costs the same to borrow. On that basis, if I have $100 now, what will it be worth in 10 years' time?
The answer is: 100 x 1.0810 = $215.89. Now, if someone offered you $215.89 in 10 years' time, how much would you pay them now for it? The answer goes like this. The money you pay now is either money that won't be earning interest for you at 8% a year for the next 10 years, or it's money that you've borrowed and on which you must pay interest at 8% for the next 10 years. Either way, paying out money now costs you 8% a year until you get it back. So, to buy a cash flow of $215.89 in 10 years' time, you'd pay up to $100 because, if you'd kept the $100 (or not borrowed it), you'd have turned it into $215.89 over 10 years (or saved yourself that amount).
So the $215.89 in 10 years' time has a value of $100. If you paid more than that then you'd make a loss; if you paid less, then you'd make a profit; and if you paid a lot less, then you'd make a really good profit. That's value investing.
Why 8%, though? Good question. It was nothing more than a stab in the dark really. People will argue until the cows come home about the right figure to use. Essentially, it should represent the 'opportunity cost of capital'. So you'd come up with a different figure depending on what you might otherwise plan on doing with the money. If you would otherwise have put it into a term deposit paying 5%, you'd use 5%. If you might otherwise have put it to work in an exciting business venture on which you expected to make 15% a year, then you might use that figure (although anticipating a return of more than 10% is pretty optimistic by most standards).
Of course most securities have more than one cash flow to consider, which means that to get the total value you have to work out the value of each individual cash flow and then tot them all up. How much would you pay for a bond that promised to pay $7.50 at the end of each of the next nine years, and then $107.50 at the end of the tenth, assuming you wanted to make 6% a year? Looking at things from the other direction, what would be your annual return if you paid $106.73 for the bond?
Principle always the same
Doing all the sums is beyond the scope of this article (but the answers are $111.04 and 6.56% in case you want to check your working and, if you're hungry for more, take a look at the Investor's College articles of issue 110/Aug 02 and issue 163/Oct 04). But the principle is always the same: all cash flows have a value according to when they are going to be received and the 'opportunity cost' (otherwise known as the 'discount rate') you ascribe to them. To get the value of a set of cash flows, you just tot up the values of the individual components.
When you get a cash flow that repeats every year, forever, something really handy happens: the sum of all the individual cash flows simplifies down to just one cash flow divided by the discount rate. So if you have a security paying 10 cents a year, forever, and you decide you want a return of 8% a year, then the security's value is 10 cents divided by 8%, which is 125 cents.
And the sums even have the decency to remain pretty simple if you assume growing cash flows - at least if you assume that they grow at the same rate each year. In this case, you just divide the first cash flow by the difference between the discount rate and the growth rate (the growth effectively offsets part of the discount rate). So if you have a security paying 10 cents this year, growing forever at 4% per year, and you decide that you want a return of 8% per year, then the security is worth 10 cents divided by 4% (that is, the difference between 8% and 4%), which is 250 cents.
Paradox
So if you're aiming to make 8% a year, then an annual payment of 10 cents growing at 4% a year is worth exactly double the value of a flat 10 cents a year. A payment growing forever at 6% would be worth four times (250 cents) as much and, somewhat paradoxically, a payment growing at 8% or more would be worth an infinite amount.
This curious result is arrived at because you've assumed an opportunity cost below the growth you expect from your investment, even though that investment is itself an opportunity.
Paradoxes aside, this is hopefully beginning to sound rather like companies paying dividends - precisely because it is rather like companies paying dividends. But companies introduce problems because the cash they pay out is neither predictable nor grows steadily. And some companies don't pay out dividends at all.
Six classic investing mistakes
- 28 Jul 11
Six classic investing mistakes
Successful investing is as much about avoiding costly errors as it is about finding cheap stocks. Here are six of the best ways to go about losing money.
Done well, value investing is a successful, proven, and safe way to invest. The logic of the approach—buying an asset for less than its underlying value—is irrefutable, and the records of those that practice it are convincing (see Warren Buffett’s essay, The Superinvestors of Graham-and-Doddsville).
However, an understanding of the principles of value investing isn’t enough. In investing, mistakes are inevitable, and the key is to learn from them and avoid repeating them. Moreover, we can try and learn vicariously; through the experience of others.
Over the past 12 years, we at the Intelligent Investor have made plenty of mistakes, and have also had more than our fair share of successes. We’ve learnt from both. What follows is your opportunity to do likewise in six key areas.
KEY POINTS
- Value investing is successful but mistakes will be made
- Six of the most common ones explained
- Illustrated with recommendation case studies
1. Focusing only on the numbers
One of the most common investing mistakes, especially for the inexperienced, is to concentrate only on a stock’s financial data. Applying a price-to-earnings ratio, a book value multiple, or a discounted cash flow analysis can provide very precise estimates of value. But that’s not all there is to analysing stocks, as Gareth Brown’s cover story made clear with the return on equity measure (see ROE: Plusses and pitfalls).
The big four banks, for example, all carry forecast dividend yields of about 6% to 7%, and price-to-earnings ratios of around 10 to 12. Looking at the numbers, they’re closely matched.
| PER | Dividend yield | |
|---|---|---|
| Commonwealth | 12.6 | 6.1% |
| NAB | 12.7 | 6.6% |
| ANZ | 11.9 | 6.5% |
| Westpac | 10.6 | 7.1% |
When you consider the risks entailed by ANZ’s Asian expansion and NAB’s aggressive push for market share however, suddenly the numbers don’t seem to tell the whole story. These qualitative factors are the reason we favour Commonwealth Bank andWestpac over ANZ and NAB.
So, before looking at the numbers, make sure you truly understand the business that’s generating them.
2. Mistaking permanent declines for temporary ones
In the hunt for value, it’s often necessary to buy stocks with a few fleas. When businesses hit rough patches and earnings temporarily decline, it can be a great time to buy. This strategy led to successful Buy recommendations on Cochlear at $19.04 on 18 Mar 04, and Leighton Holdings at $7.83 on 11 May 04.
We have a positive recommendation on Aristocrat Leisure today for the same reason. While mismanagement, a poor product line-up, the strong Aussie dollar, and cyclical headwinds are all hurting Aristocrat in the short term, we expect this business to perform well in the long run.
The risk is if its current problems aren’t temporary. If Aristocrat’s profits stay permanently depressed, we'd have overpaid for this business, and be guilty of having mistaken Aristocrat’s structural decline for a cyclical one.
3. Buying low quality businesses
Owning high quality businesses over the long run is the key to successful investing. Our Masterclass special report on Warren Buffett details his incredible success employing this approach.
Unfortunately, high quality businesses are seldom cheap. Value investors therefore often end up with portfolios full of cheap but low quality stocks, entailing greater risk, more stress, and higher stock turnover.
In the past, Intelligent Investor also fell into this trap, covering too many small and dubious businesses. But with our new focus on blue chips and wonderful businesses trading at fair prices (see Christmas trimmings: introducing the nifty 50/50), you can now fill your portfolio with high quality businesses, especially if you’re patient and buy opportunistically.
4. Neglecting economic considerations
‘If you spend more than 13 minutes analysing economic and market forecasts, you’ve wasted 10 minutes.’ Ever since uttering that sentence, legendary fund manager Peter Lynch gave value investors a free pass to ignore the economy. Or so they thought.
Lynch’s advice does not mean that you can completely ignore the economy. It means that the success of your investments should never rely on specific, short-term economic forecasts. What’s the difference?
An investment in Rio Tinto, for example, hinges largely on the continued strength of China’s economy and its building and infrastructure boom. That’s an economic forecast we’re not willing to gamble on.
On the other hand, we’re aware that weak global economies and low stock prices are currently depressing Platinum Asset Management’s earnings to less than their long term average. That’s why it’s cheap. We don’t need to know when or why, but it’s a near certainty that stock prices, and Platinum’s profits, will rise eventually. An appreciation of cycles, rather than economic predictions, should underpin your stock purchases and disposals.
5. Ignoring the market
As a value investor, a healthy scepticism of the market’s wisdom is a necessity; whenever you buy something, it should be because you think the market is pricing it incorrectly.
When you’re right, the rewards of ignoring the market can be enormous. As our special report RHG: A value investing case study explains, the market wrote this stock down from $0.95 to $0.05 before our positive recommendations were vindicated.
| ‘There are two requirements for success in Wall Street. One, you have to think correctly; and secondly, you have to think independently.’ – Benjamin Graham |
But when you’re wrong, it can be a disaster. Backing ourselves over the market explains why we were far too late in pulling the pin on Timbercorp.
Share price movements should never influence your analytical process. But it is necessary to be aware of them; they can offer a timely prompt to reconsider your thinking, as we did recently with our downgrade of Harvey Norman. The market is often right. When you’re going against the grain, make sure you know why you disagree with the market and have good reason for doing so.
6. Mistaking price and value
If you’re aiming to buy stocks for less than their intrinsic value, a lower price can only mean better value, right? Wrong.
| Value trap: A value trap is a stock that has fallen in price and is thus mistakenly believed to be undervalued. |
Consider Telstra, which is trading close to its lowest ever price. By that simple logic, it should be more attractive than ever. But the decline of its traditional fixed-line business means it’s just not worth the high of $9.20 it hit more than a decade ago, nor the $4.80 or so it traded at in 2008.
It’s tempting to anchor to previous prices (see How anchoring sets you adrift). But they offer no clue regarding today’s value. The fact that a stock has fallen does not in itself make it cheap; only the difference between its intrinsic value and the price at which it trades does.
Avoiding these classic value investing mistakes will do wonders for your returns. In order to get the most out of this article, use this 6-point checklist to sift out these mistakes in your own portfolio. Moreover, ask yourself: 'Do I own quality stocks? Do I have an understanding of how various economic changes may impact my holdings? Do I own stocks where I don't fully understand its underlying businesses?'
Disclosure: Staff members own many of the stocks mentioned above. For a full list of holdings, see the Staff portfolio page of the website.
http://www.intelligentinvestor.com.au/investors-college/
Michael Burry’s 4 Must Read Investing Books
The Big Short by Michael Lewis featured the stories of the first individuals to bet against the US housing market before the 07/08 financial crisis. Michael Burry was said to be the first to do so.
Not only was Michael (Mike) Burry said to have been one of the first to do so, he was also one of the most dogmatic in his approach.
Michael Burry's 4 must read investment books
Originally a doctor, Michael Burry spent countless hours learning to be a stock market investor by writing a stock market blog and investing himself throughout the late 90′s and early 00′s. By the end of decade, he would be the instigator of billions of dollars of bets against the US housing market.
An intriguing character in the book who also turned an original $100,000 in his Scion Capital hedge fund into hundreds of millions, I spent some time trying to find excerpts from his early blog and forum posts.
One of the excerpts (including the 4 books he recommends to all those new to investing) is below:
Re: booksTo get started, I’d suggest the following four books:
- The Intelligent Investor by Graham
- Common Stocks and Uncommon Profits by Fisher
- Why Stocks Go Up and Down by Pike
- Buffettology by Buffett and Clark
If you read these books thoroughly and in that order and never touch another book, you’ll have all you need to know. Another book you might want to consider is Value Investing made easy by Janet Lowe – a quick read. I have a fairly extensive listing of books on my site, with my reviews of them, and links to purchase them at amazon [Michael Burry's site no longer live].My problem is I’ve read way too much. One book stated, “If you’re not a voracious reader, you’ll probably never be a great investor.” But sometimes I wish I had a more focused knowledge base so that my investment strategy wouldn’t get all cluttered up.Re: Security Analysis (Graham and Dodd) you can get a lot of the same info in a more accessible format elsewhere, but everyone says that Buffett’s favorite version is the 1951 edition. Yes there are differences, and the current version has a lot of non-Graham like stuff in it.Good Investing,Mike
For a full list of his comments and posts, you can visit this Michael Burry profile on Silicon Investor. http://www.siliconinvestor.com/profile.aspx?userid=690845
Michael Burry Profiled: Bloomberg Risk Takers
http://bloom.bg/oTqnej#ooid=AydDFvMjqk2DszwdQhDSgt4DJn280PSc
Michael Burry Profiled: Bloomberg Risk Takers
- July 20 Bloomberg) -- "Bloomberg Risk Takers" profiles Michael Burry, the former hedge-fund manager who predicted the housing market’s plunge. He forecast that the bubble would burst as early as 2007, and he acted on his conviction by betting against subprime mortgages. The former head of Scion Capital LLC was profiled in Bloomberg columnist and bestselling author Michael Lewis' book "The Big Short". (Source: Bloomberg)
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