In order to be a successful investor, you need a proven, rational framework.

My Blueprint  

GregSpeicher

Ideas for Intelligent Investing

In order to be a successful investor, you need a proven, rational framework.

My Investing Blueprint has ten steps.

1. Search Broadly and Continually for New Investment Ideas.
2. Act Like an Owner.
3. Only Buy Things You Understand.
4. Buy Good Businesses.
5. Invest in Companies with Great Management.
6. Buy the Cheapest Business Available.
7. Focus on Your Best Ideas.
8. Practice Patience.
9. Avoid Stupid Mistakes.
10. Be a Learning Machine.

http://gregspeicher.com/?page_id=117

Click through the many good posts on each of these steps in this link.

Did Buffett indeed make a mistake by not selling Coke?

Lessons from Buffett’s Decision not to Sell Coke: “I talked when I should have walked”
Written by Greg Speicher on August 2, 2010

In his 2004 letter to the shareholders of Berkshire Hathaway, Warren Buffett admitted that he made a mistake by not selling certain stocks that were “priced ahead of themselves.” The episode contains some powerful lesson that we can use to improve our investment results. 

Let’s look at how the businesses of our “Big Four” – American Express, Coca-Cola, Gillette and Wells Fargo – have fared since we bought into these companies. As the table shows, we invested $3.83 billion in the four, by way of multiple transactions between May 1988 and October 2003. On a composite basis, our dollar-weighted purchase date is July 1992. By yearend 2004, therefore, we had held these “business interests,” on a weighted basis, about 12½ years.
 
In 2004, Berkshire’s share of the group’s earnings amounted to $1.2 billion. These earnings might legitimately be considered “normal.” True, they were swelled because Gillette and Wells Fargo omitted option costs in their presentation of earnings; but on the other hand they were reduced because Coke had a non-recurring write-off.
 
Our share of the earnings of these four companies has grown almost every year, and now amounts to about 31.3% of our cost. Their cash distributions to us have also grown consistently, totaling $434 million in 2004, or about 11.3% of cost. All in all, the Big Four have delivered us a satisfactory, though far from spectacular, business result.
 
That’s true as well of our experience in the market with the group. Since our original purchases, valuation gains have somewhat exceeded earnings growth because price/earnings ratios have increased. On a year-to-year basis, however, the business and market performances have often diverged, sometimes to an extraordinary degree. During The Great Bubble, market-value gains far outstripped the performance of the businesses. In the aftermath of the Bubble, the reverse was true.
 
Clearly, Berkshire’s results would have been far better if I had caught this swing of the pendulum. That may seem easy to do when one looks through an always-clean, rear-view mirror. Unfortunately, however, it’s the windshield through which investors must peer, and that glass is invariably fogged. Our huge positions add to the difficulty of our nimbly dancing in and out of holdings as valuations swing.
 
Nevertheless, I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked.
 
As the following charts show, of the big four, Coke and Procter & Gamble reached the most extreme levels of over-valuation. According to Value Line, Coke sold at an average P/E ratio of 47.5 during 1999, its peak being considerably higher.  Procter & Gamble sold at an average P/E of 30.8 during 1999.

(all graphs show quarterly prices and P/E ranges from 1/1/1996 to 7/30/2010)

American Express

Coca-Cola

Procter & Gamble

Wells Fargo

(click images to enlarge)

 
What lessons can be learned from this?
 
If you’ve read my investing blueprint you know that I am a strong proponent of patient business-like investing for the long-term. This is a proven way to create wealth. However, at a sufficiently high price, all assets – no matter what their level of quality – should be sold.
 
What is sufficiently high? When the price clearly exceeds all reasonable estimates of the Net Present Value of the business’s earnings after taking taxes into consideration. 

What can make this difficult is that the intrinsic value – the net present value of all future cash flows – of a truly great business may be strikingly high in relation to its current earnings. Consider that a 50-year bond with economics similar to those of Coke (ROE of 30% and a payout ratio of 66.67%) would have a net present value of 46x earnings, assuming a discount rate of 8%. (Here’s the data.)
https://spreadsheets.google.com/pub?key=0AqDABX1wIfxZdHJzb0tlZHh5Y1gwNUI3WXc0M0lLRXc&hl=en&output=html 
 
However, unlike a bond where the coupon is set and contractually obligated, a holder of equity has no future guarantee other than his judgment about the competitive advantages of the business.  At the peak of the bubble, Coke’s price appeared to more than fully reflect the next 50 years of earnings and then some.
 
Plus, the proceeds of the sale could have been redeployed in cheaper assets, thereby raising the intrinsic value of Berkshire Hathaway. The challenge is that, unless you have a specific immediate purchase in mind, you never know how long you will need to wait to re-invest the funds of a sale.
 
If you buy or hold an overvalued security it will materially impact your future performance. Many stocks purchased during the Internet Bubble have shown a large increase in earnings with no progress in the price of the stock.
 
Consider an example. In 1999, Microsoft earned $.70 a share, sold for an average P/E of 49.8 and traded between $34 and $60 per share. Ten years later during 2009, it earned $1.62 per share, more than doubling its earnings, but sold for an average P/E of 13.4 and traded no higher than 31.5. Lesson: don’t overpay – it’s costly!
 
Confirmation Bias
 
Beware of confirmation bias, which Wikipedia defines as, “a tendency for people to favor information that confirms their preconceptions or hypotheses whether or not it is true.” Buffett was long on record as saying that his favorite holding period was forever, going so far in his 1990 shareholder letter as to call Capital Cities/ABC, Coca-Cola, GEICO, and Washington Post his “permanent four”. The risk with confirmation bias is that you are liable to act irrationally even at the expense of your own interests.
 
How Much Cash Will You Get Back?
 
If you are a businesslike investor, you should actually expect that a business in which you invest will deliver more cash than you put in. This is how Buffett operates as is evident from the comments about how much of his cost for purchasing shares in the “Big Four” he had already received. This is a lesson in how to think in a businesslike fashion about investing.
 
“The glass is invariably fogged”
 
Investing – whether deciding on a new purchase or whether to hold an existing investment – is always a business of judgment fraught with many uncertainties: “the glass is invariably fogged.” Accept this and get on with it by putting a premium on hard work, exceptional research, and following a rational investing process with great discipline.
 
What are your thoughts? Did Buffett indeed make a mistake by not selling Coke?

Read below or add a comment...

1. M. Ofenheim

   August 3, 2010 at 4:19 pm

   I don’t believe he did make a mistake by selling Coke. I one thing I learned reading and listening to Buffett is that all currencies are a race to the bottom. A dollar will simply buy less in 20 years than it does today.

   I doubt Coke will outperform the S&P during the next 5-10 years, however a business like Coke is one of the few franchises in the world that possesses true pricing power. Coke will sell just as many cans, bottles and syrup, if not more and at a higher price due to natural inflation. As result the value of the business reflected in the total market cap should be preserved.

   Of course we need to add the following caveats:
   1. Is there Competant management?
   2. Are they enhancing the existing brands?
   3. Are they adding brands either thru internal development or fair valued purchases of outside businesses (i.e. Vitamin Water)?
   4. Are they increasing shareholder value (share buybacks, increasing dividends)?

   Reply
2. Drew Kennedy

   August 4, 2010 at 10:57 am

   Consider capital gains taxes before selling.

   Imagine you bought a company for $500, thinking its fair value is $1000. If the company is currently trading at $1500, you would say it is overvalued and might consider selling. If you sold, and the capital gains tax rate was 30%, then you would owe $450 in taxes and have $1050 after tax.

   By selling you gain the ability to invest the cash elsewhere. But if the business you are selling is Coca-Cola, Gillette, or American Express, it will be hard if not impossible to find a better business. Even if you know of similarly great businesses, there is no guarantee that they will be cheap.

   On the other hand, by selling you lose out on any dividends, and real business growth. You will also be losing purchasing power due to inflation (should you hold cash). Finally there is no guarantee the price will fall sufficiently to make the business a bargain once again.

   If the business is terribly overpriced, your taxes will be low, and you have better companies at cheaper prices to invest in, then the decision is that much easier.

   Reply
3. Drew Kennedy

   August 6, 2010 at 10:49 am

   My math was wrong.

   The tax of $450 was based on 1500-(1500*.30). I incorrectly included the total sales price and didn’t take into account the purchase cost.

   Reply

http://gregspeicher.com/?p=841

Behavioural finance

The moods of some 'investors' were decisively that of fear and panic the last few days.

What did you do to your portfolio the last few days when the market was trending downwards?

1.  Did nothing   
2.  Cashed out of all your stocks (100% cash)   
3.  Cashed out of some of your stocks   
4.  Bought some more stocks   
5.  Bought a lot more stocks   
6.  Switched your stocks from A to B.  

Why did you take the action that you did?

What were the thinking driving your behaviour?

Tactical asset allocation cannot be employed consistently

I personally feel that tactical asset allocation cannot be employed consistently for most parts of the market.  

However, this strategy can probably can be employed rationally at certain times when the market were obviously undervalued (1997/98, 2008/2009) or when it was highly overvalued  (bubble  in 1996/97). 

Therefore, in the long investment period that you are in, it is the rare occasions when you will be fully invested (80% equity:20% cash) or fully out of (50% equity: 50% cash) the market.  (My own asset allocation figures  ).  

Did you feel that the market was a bubble in 2008?  

http://myinvestingnotes.blogspot.com/2010/04/wealth-maximising-strategies-for-your.html
Wealth Maximising Strategies for your Portfolio

http://myinvestingnotes.blogspot.com/2010/06/overview-of-investment-strategies-and.html
Investment Strategies and Theories You Must Know for Greater Investment Success!

http://myinvestingnotes.blogspot.com/2009/07/buy-low-sell-high-approach.html
Buy-Low-Sell-High Approach

What to Do in a Down (Bear) Market?

The stock market often falls under the conditions of the so called bull and bear markets.  Intelligent investors are well familiar with the conditions of both and know exactly what to do. 

Under a down market you have several options.

- One of them is to sell immediately in order to minimize your losses.

- Another option is to let the market work its way through the problem with no action from your side.

- A third option is to benefit from the stock decline and add some more to your portfolio. But, this should be done only if you don't perceive that there is something wrong with the company that has led to the stock decline.


Final Piece of Advice

Never forget that it is important to base your decisions on knowledge not on feelings. This means that being educated about the company and the industry from which your stocks come from, the market conditions under which you operate will be of small importance to you.

Value Investing Opportunities in Uncertain Times

Where to find value? When to buy? When to hold? When to sell?

Warren Buffett interview on how he loves to do business

Listen to Warren Buffett's view on growth companies.

Warren Buffett Interview from India

Boney M

Lovely.

WARREN BUFFETT THE BILLIONAIRE NEXT DOOR GOES GLOBAL

Sucess and Failure: Lecture by Parag Parikh

Understanding Stock Market

Why is investing confusing?

What is the Right Way? Delay gratification. Think long term. There are no short cuts in life.

Behavioural Finance Solutions

Dale Carnegie ..... How to stop worrying. What is the worst that can happen if you take a decision. Analyze the facts and the situation: it may not be as bad as you think. Be prepared for the worst. GO AHEAD AND TAKE THE DECISION.

Understanding Stock Market (A+++)

Investment Basics: How To Start Investing With Little Or No Cash

Morningstar's Equity Valuation Methodology

Stock Strategist

Introducing Changes to Morningstar's Equity Valuation Methodology 

We've enhanced our methodology, which could result in modest fair value changes.

By Matthew Coffina, CFA | 05-17-12 | 

At Morningstar, we assign fair value estimates to around 1,800 companies across the globe. Each of these fair value estimates is based on a rigorous discounted cash flow (DCF) model built by one of our analysts using a standard Morningstar template. Occasionally, we find ways to improve our methodology. Over the next several months, we will be rolling out the sixth generation of our internal DCF template. In this article, we describe some of the key features of our updated valuation methodology.

Changes to our methodology may require adjustments to some of our fair value estimates, which you may notice in the coming months as analysts transition their companies to the new model. Some of these changes will tend to increase our fair value estimates, while others will cause our fair value estimates to decline.

Morningstar's Three-Stage Discounted Cash Flow Valuation
Our DCF model includes three stages of analysis. The first stage includes our forecasts for the next five to 10 years. In the first stage, analysts make explicit forecasts for all of a company's important financial statement items, such as revenue, operating costs, capital expenditures, and investments in working capital.

In the second stage, analysts are more limited. We take earnings from the last year of Stage I and assume that they grow at a constant rate. We determine the investment needed to achieve this growth by assuming a constant return on new investment. Analysts are responsible for choosing the growth rate, the rate of return on new investment, and the length of Stage II, but otherwise don't need to make explicit forecasts for individual financial statement lines.

Stage II assumptions are the primary vehicle for incorporating our analysis of economic moats in our fair value estimates. Companies with wide and narrow moats are expected to earn returns on new invested capital that exceed their cost of capital in Stage II. The wider the moat, the longer Stage II is likely to last. In general, we assume narrow-moat companies can earn excess returns on capital for at least 15 years, while wide-moat companies can earn excess returns on capital for at least 20 years.

Our model concludes with a third stage. In Stage III, all companies are assumed to be the same. Return on new invested capital is set equal to the weighted average cost of capital; every moat is eventually eroded--no company can earn excess returns forever. We also assume returns on existing invested capital remain constant in Stage III.

Our latest model includes several alternative Stage II-III methodologies, as well. These include terminal multiples (such as EV/Sales and EV/EBITDA) and the ability to enter the total value of cash flows beyond Stage I directly. These alternative approaches should only be used in special circumstances where the standard three-stage method would be inappropriate.

A change to our formulas for valuing Stage II and Stage III cash flows will have the largest downward effect on our fair value estimates, particularly for companies where a significant portion of value is concentrated in these later periods. This is because of more conservative assumptions for long-run reinvestment needs relative to previous versions of our model.

Estimating the Cost of Capital
We discount future cash flows using the weighted average cost of capital, which incorporates the cost of debt, equity, and preferred capital. The discount rate is a key assumption in any DCF model. While the cost of debt and preferred stock can be observed in the marketplace, the cost of equity presents a significant challenge. In the past, analysts have been allowed significant discretion in choosing a cost of equity (COE), but we have formalized our approach in the latest model.

The most common methodology for estimating the COE in practice is the Capital Asset Pricing Model (CAPM). However, we find that the CAPM raises more questions than it answers by replacing one unobservable input (the cost of equity) with three (the risk-free rate, the equity risk premium, and beta). Even among experts, there is significant disagreement about appropriate values for the equity risk premium and beta.

Since we believe our analytical advantage is in estimating cash flows rather than making precise estimates of inherently unknowable quantities, we have chosen a greatly simplified approach that still captures the essence of the CAPM. We will be assigning each of the companies in our coverage universe to one of four "systematic risk buckets." For companies based in the U.S. and several other developed markets, below-average systematic risk will correspond to an 8% COE, average to a 10% COE, above average to a 12% COE, and very high to a 14% COE. Some international markets will require that a premium be added to these values, currently ranging from -1% for Japan to +11% for Greece.

Holding all else equal, we expect our enhanced cost of capital methodology to result in modest increases to most fair value estimates. However, in some cases where companies are deemed to have above-average systematic risk, it is possible that the new methodology could result in slight downward pressure on some fair value estimates.

Accounting for the Time Value of Money
The final significant change to our methodology involves the time value of money. Discounted cash flow valuation produces an estimate of a company's worth as of a specific point in time. That value tends to increase over time as cash flows are earned and future cash flows are discounted less.

In the past, fair value estimates in our models have adjusted continuously, with the published fair value estimate representing the valuation as of the day of publication. Unfortunately, this means that our fair value estimates can become stale as time elapses between report updates. It can also make it difficult for analysts to parse the causes of a change in a fair value between altered assumptions and the time value of money.

We are enhancing our time value of money methodology so that in the future, our fair value estimates will refer to the end of the current fiscal year. Fair value estimates will be updated for time value of money only once per year, when we roll our models. This should make our fair value estimates more forward-looking as well as provide better clarity around the causes of fair value changes. In isolation, this change would tend to increase our fair value estimates modestly.

http://news.morningstar.com/articlenet/article.aspx?id=553332&pgid=stockarticle

Is Management in Your Corner?

Morningstar's new Stewardship Ratings for stocks can help reveal if management teams are working in shareholders' best interests or just their own.

http://www.morningstar.com/Cover/videoCenter.aspx?id=548155

How to Learn From When Buffett Sells

Adopting Buffett's very-long term perspective can help individual investors focus on what is important, says Morningstar's Paul Larson.

http://www.morningstar.com/Cover/videoCenter.aspx?id=548155

Should Berkshire Pay a Dividend?

Buffett authors weigh in on the possibility and wisdom of Berkshire Hathaway returning capital to shareholders.

http://www.morningstar.com/cover/videocenter.aspx?id=547398