Tuesday 6 April 2010
Intrinsic value described by Ben Graham in Security Analysis.
In general terms,it (intrinsic value) is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulations or distorted by psychological excesses.
- Benjamin Graham and David Dodd
Before you risk your hard-earned money on a stock, you probably want to know the value you can expect to get in return. The value you assign to a stock, or that stock's intrinsic value, is the maximum amount that you are willing to pay now for future benefits, which could come from dividends or the potential sale of the stock at a realistic future price. It makes no sense to buy a stock when its intrinsic value is smaller than the current price.
Buffett cautions: "The calculation of intrinsic value, though, is not so simple ... intrinsic value is an estimate rather than a precise figure."
Nazir says SC proposal would severely hit M&As
Tuesday April 6, 2010
Nazir says SC proposal would severely hit M&As
By ELAINE ANG
elaine@thestar.com.my
PETALING JAYA: The Securities Commission’s (SC) proposed rule change on the assets and liabilities method of buying listed companies will result in a severe drop in merger and acquisition (M&A) activities in the country, said CIMB Group Holdings Bhd group chief executive Datuk Seri Nazir Razak.
“(The SC proposal) in its present form, absolutely, will cause a drop especially in mergers, not so much takeovers. Value is created by mergers,” he told a press conference to announce the group’s plans to set up a research institute to promote Asean integration yesterday.
The press conference was held on the sidelines of the 7th Asean Leadership Forum.
To recap, the SC had recently issued a consultative paper which proposed to raise the shareholder approval level in an acquisition via assets and liabilities from the current simple majority to 75% shareholder approval.
It also suggested an additional requirement that not more than 10% of shareholders present can object to the deal.
Under Section 132 (c) of the Companies Act, a buyer only needs a simple majority to take out the assets of the listed company.
This allows the buyer to circumvent the Takeover Code, where the threshold to take over a company and de-list it is higher at 90% acceptance of shares outstanding that are not owned by the offeror.
This is aimed at protecting the interests of minority shareholders by requiring a higher threshold of shareholder approval before a deal is done.
Nazir said if the bar was set too high there would be no deals.
“What we want is a framework to protect minorities but enables transactions to be done. In its present form, it is so prohibitive that you will see a very sharp drop in M&As.
“Is that good for the country and capital market?” he said.
Nazir highlighted the need to strike the right balance between the interests of the majority and minority shareholders.
“Minorities also profit a great deal from M&A activities. We have to be very sensible in evaluating the new proposals.
“I have heard comments that the higher the takeover threshold the better, especially for minorities. It is not true that the more power to minorities the better it is.
“Minorities also need deals, mergers and takeovers,” he said.
http://biz.thestar.com.my/news/story.asp?file=/2010/4/6/business/5997210&sec=business
Nazir says SC proposal would severely hit M&As
By ELAINE ANG
elaine@thestar.com.my
PETALING JAYA: The Securities Commission’s (SC) proposed rule change on the assets and liabilities method of buying listed companies will result in a severe drop in merger and acquisition (M&A) activities in the country, said CIMB Group Holdings Bhd group chief executive Datuk Seri Nazir Razak.
“(The SC proposal) in its present form, absolutely, will cause a drop especially in mergers, not so much takeovers. Value is created by mergers,” he told a press conference to announce the group’s plans to set up a research institute to promote Asean integration yesterday.
The press conference was held on the sidelines of the 7th Asean Leadership Forum.
To recap, the SC had recently issued a consultative paper which proposed to raise the shareholder approval level in an acquisition via assets and liabilities from the current simple majority to 75% shareholder approval.
It also suggested an additional requirement that not more than 10% of shareholders present can object to the deal.
Under Section 132 (c) of the Companies Act, a buyer only needs a simple majority to take out the assets of the listed company.
This allows the buyer to circumvent the Takeover Code, where the threshold to take over a company and de-list it is higher at 90% acceptance of shares outstanding that are not owned by the offeror.
This is aimed at protecting the interests of minority shareholders by requiring a higher threshold of shareholder approval before a deal is done.
Nazir said if the bar was set too high there would be no deals.
“What we want is a framework to protect minorities but enables transactions to be done. In its present form, it is so prohibitive that you will see a very sharp drop in M&As.
“Is that good for the country and capital market?” he said.
Nazir highlighted the need to strike the right balance between the interests of the majority and minority shareholders.
“Minorities also profit a great deal from M&A activities. We have to be very sensible in evaluating the new proposals.
“I have heard comments that the higher the takeover threshold the better, especially for minorities. It is not true that the more power to minorities the better it is.
“Minorities also need deals, mergers and takeovers,” he said.
http://biz.thestar.com.my/news/story.asp?file=/2010/4/6/business/5997210&sec=business
Mastering The Art Of Value Investing
IN THE SPOTLIGHT | 26 MARCH 2010
Mastering The Art Of Value Investing
Simply put, the essence of value investing lies in buying stocks at less than their intrinsic value. The discount of the market price to the intrinsic value was what Benjamin Graham, father of value investing and Warren Buffett’s mentor, referred to as the ‘margin of safety’.Just like Buffett and Graham, Ken Chee and Clive Tan, co-founders and trainers of the increasingly popular Millionaire Investor Program, strongly believes in the beauty of value investing. More importantly, it was this common passion that brought them together on their value investing journey when they met at an entrepreneur program 4 years ago.
“Back then, we used to form a mastermind group of 8 and meet up once a month to study chapters after chapters of various investment books and subsequently put what we have learnt to use by analysing different companies,” Ken reminisced during an interview with Shares Investment (Singapore).
According to Ken, who has attained financial freedom at a tender age of 34, one of the most important reasons for developing the Millionaire Investor Program was to help create as many enlightened millionaires as possible via the platform of value investing. “Also, we have discovered that in order to retire comfortably at the age of 65 in Singapore, one should have an average of $1 million in cash, and hence its name,” he added.
Highlighting the fact that the Millionaire Investor Program is no get-rich-quick scheme, Ken said while there is a certain group of people yearning to make quick bucks in the equity market, there is also another group of individuals wanting to learn the proper way of investing. He further mentioned that a lot of people could not differentiate between trading and investing. “Trading is for institutions. It is not meant for retail folks, as most of them just do not have the technology and temperament to succeed,” Ken commented.
Gaining popularity amongst the investing public
Focusing On Fundamentals
A 3-day course from 9am to 9pm, the Millionaire Investor Program allows participants to better understand and grasp the key concepts of value investing through interesting games and tools. More specifically, the Millionaire Investor Program teaches participants on how to analyse real companies through interpreting financial statements not from the point of view of an accountant or an employee but from the point of view of an investor or business owner. To find out more about the program, you can visit their website at www.millionaire-investor.com.
“Accountants will treat assets as assets. However, based on our experience in managing businesses, we realised that some assets may not necessarily be assets, while some liabilities may not be liabilities,” explained Clive, who was a former high school teacher. Apart from the Millionaire Investor Program, Ken and Clive also own a branding consultancy company and a childcare business respectively.
And things don’t just stop there after one completes the 3-day program. There will be quarterly networking sessions, where graduates come back for reviews and discussions. Occasionally, the management of the listed companies will be invited down to share about their businesses and investment merits. “We also have plans to organise plant visits in the near future,” Clive remarked.
As fittingly put across by Ken, the strength of the Millionaire Investor Program lies in its weakest link. That is to say, for someone who practically knows nothing about equity investing, he or she will be able to understand the true meaning behind financial jargons such as profit and loss, assets, liabilities and PE ratio, to name a few.
Gone are the boring and dry lessons
In The Pipeline
Having established a firm footing on local shores, Ken and Clive are looking to bring the Millionaire Investor Program into regional markets. Notably, they will be holding their maiden program in Ho Chi Minh around April or May. Jakarta is another city that they are currently exploring.
On whether he believes in technical analysis, Ken pointed out that although technical indicators do provide a glimpse of market sentiment, more often than not, one could get confusing signals from various indicators.
Preferring to stick to analysing the fundamentals as opposed to predicting future market directions, Ken personally likes VICOM, citing the company’s ability to generate sustainable cash, low capital expenditure and lack of competitors as key reasons. “Another company worth looking at is Asia Pacific Breweries. If you had bought its shares in 2001 at around $3, you would have gained an annual compounded return of 20%,” Ken exclaimed.
I guess for Ken and Clive, as well as other proponents of value investing, nothing beats buying into an undervalued company with a solid business model and watching its share price shoot through the roof. That, I suppose, is the beauty of value investing.
Do Dividend Plays Pay?
PERSPECTIVE | 12 MARCH 2010
Do Dividend Plays Pay?
Dividends matter and they matter a lot! Had you bought Singapore Post at the start of 2005 and held it till the end of February this year, inclusive of dividends, it would have compounded at 9.4% over the 5 odd years, against the Straits Times Index’s 5.6%.
During that time frame, Singapore Post’s management had been very generous, rewarding a total $0.357 per share to its shareholders. Stripped of those distributions, Singapore Post would have lagged the market badly, compounding at only a paltry 3.4%.
During that time frame, Singapore Post’s management had been very generous, rewarding a total $0.357 per share to its shareholders. Stripped of those distributions, Singapore Post would have lagged the market badly, compounding at only a paltry 3.4%.
This is not a case of cherry picking. In fact, a recent Citi Investment Research report noted that in the past 10 years, equities in Asia ex-Japan have generated a compounded total return of 5.9% per annum in US dollar terms, 46% of which came from dividends.
Dividend Matters
Some formulae are in order before proceeding further. Dividend yield, the most basic metric, is calculated by dividing total dividend per share paid out during a full financial year over the stock’s current market price.
Some formulae are in order before proceeding further. Dividend yield, the most basic metric, is calculated by dividing total dividend per share paid out during a full financial year over the stock’s current market price.
Dividend payout ratio (DPR) is more instructive as yield tends to fluctuate depending on the time of the day. This is calculated by dividing total dividend per share paid out during a full financial year over that respective year’s earnings per share (EPS).
Singapore Post, for example, paid out a total of 6.25 cents in dividends per share, when EPS was 7.7 cents in FY09. Be sure to exclude special dividends as they are one-off. Dividend payout ratio works out to about 0.8, which means 80% of FY09 profits were returned to shareholders. The importance of the dividend payout ratio will be elaborated later.
There are companies, particularly those of blue chip pedigree, that have a formal dividend policy stating the percentage of operating or net profit to be paid out. This can be found under the CEO/Chairman’s statement section of the annual report.
Even though a dividend policy is a legally binding commitment, companies that have one loathe changing it, as a downward revision or omission of dividends generally signals financial woes.
Even though a dividend policy is a legally binding commitment, companies that have one loathe changing it, as a downward revision or omission of dividends generally signals financial woes.
Finding Dividend Plays
To be able to consistently return profits to shareholders requires disciplined management as well as strong cash flow on the company’s side. These companies tend to be larger and/or more mature and are found mainly in the banking and finance, consumer staples, utilities and energy sectors.
To be able to consistently return profits to shareholders requires disciplined management as well as strong cash flow on the company’s side. These companies tend to be larger and/or more mature and are found mainly in the banking and finance, consumer staples, utilities and energy sectors.
Those that do have consistent and high dividend payout ratios – so called dividend plays – are likely past their growth phase. The stability in their earnings is generally accompanied by lower levels of R&D and capital expenditures. This is where we return to the dividend payout ratio.
Take the company’s return-on-equity (ROE) and multiply it by the earnings retention rate, which is one less the dividend payout ratio, and you will get the sustainable growth rate (SGR).
Again using Singapore Post as an example, based on FY09’s ROE of 59.2% and earnings retention rate of 18.8%, its sustainable growth rate works out to around 11.1%.
The sustainable growth rate is helpful in gauging whether a company’s growth plan is realistic based on its profits but it will not tell you whether a company has the opportunity to grow.
In this instance, if the opportunity exists and should Singapore Post want to grow its FY09 earnings by more than 11%, it would have to increase its net profit margins (this increases ROE) or fund future investments with debt or the issuance of new stock.
Books To Read
Modestly named “The Ultimate Dividend Playbook” by Josh Peters and “The Future for Investors” by Jeremy Siegel are great books to read for ideas and strategies on investing in dividend plays.
Modestly named “The Ultimate Dividend Playbook” by Josh Peters and “The Future for Investors” by Jeremy Siegel are great books to read for ideas and strategies on investing in dividend plays.
Peters’ book is very comprehensive and provides a detailed explanation on how to select and formulate a portfolio comprising of dividend plays, and the underlying mechanics. Be forewarned “The Ultimate Dividend Playbook” might be too textbook-ish for some and that it is focused mainly on American companies.
Siegel’s more readable account is a must-read for investors worried about the how the impending demographic age wave in developed world would impact future asset returns. While repeating his argument that common stocks are the best asset class in the long run, he highlights the importance of dividends and stock valuations as well as including international stocks in your portfolio.
For non-bookworms, the table below lists a few companies with a history of consistent dividend payments as well as relatively high yields. As usual, more research on the reader’s part should be done before investing.
*As of 10 MARCH 2010 Noon
*As of 10 MARCH 2010 Noon
The Bull Run may continue for quite some time but has become more vulnerable to a correction.
Time and time again, some investors have been forced to sell on the cheap when they read reports that there would be tightening in lending, plans to withdraw stimulus measures as well as valuations being overstretched.
Time and time again, some of them sell during a correction only to be caught flat-footed when a rebound occurs almost immediately. For example, they bought into a stock at $1, rode the bull market to $1.20 and sold at $1.10 when there was a correction. The share price immediately shot up to $1.15 before they even knew what happened and missed the next wave to $1.30. While some of them would have given up on this stock, there are others who jump back in at $1.30 only to sell it at $1.20 during the next correction.
They are scared, so they sell. This is human nature and there is nothing we can do about it unless we can stand firm and not sell if we are able to identify that we are in the midst of a Bull Run, so selling out for a small profit is never an option.
Yes, the Bull Run is still very much alive but has stalled after a spectacular rally from March.
Much of the easy money has been made and the investors are now treading in treacherous territory where the chances of a correction are high, especially when most people are sure that growth in 2010 will be sluggish.
Even US Federal Reserve Chairman Ben Bernanke has admitted that 2010 will not be a wonderful year. This has made investors sit up and rethink their strategy with some choosing to take profit or continue staying on the sideline until the clouds clear.
With several uncertainties still looming, it is no wonder that investors refuse to chase the rally preferring to sell every time the rally reaches a fresh recent high. However, they have to remember that they are still in a Bull Run that may continue for quite some time but has become more vulnerable to a correction - in particular a correction that has to be as deep as 10% - when economic fundamentals in the first quarter of 2010 cannot support the rally.
Share Investment
Issue 372
14/12/09 - 27/12/09
www.sharesinv.com
Read:
Time and time again, some of them sell during a correction only to be caught flat-footed when a rebound occurs almost immediately. For example, they bought into a stock at $1, rode the bull market to $1.20 and sold at $1.10 when there was a correction. The share price immediately shot up to $1.15 before they even knew what happened and missed the next wave to $1.30. While some of them would have given up on this stock, there are others who jump back in at $1.30 only to sell it at $1.20 during the next correction.
They are scared, so they sell. This is human nature and there is nothing we can do about it unless we can stand firm and not sell if we are able to identify that we are in the midst of a Bull Run, so selling out for a small profit is never an option.
Yes, the Bull Run is still very much alive but has stalled after a spectacular rally from March.
Much of the easy money has been made and the investors are now treading in treacherous territory where the chances of a correction are high, especially when most people are sure that growth in 2010 will be sluggish.
Even US Federal Reserve Chairman Ben Bernanke has admitted that 2010 will not be a wonderful year. This has made investors sit up and rethink their strategy with some choosing to take profit or continue staying on the sideline until the clouds clear.
With several uncertainties still looming, it is no wonder that investors refuse to chase the rally preferring to sell every time the rally reaches a fresh recent high. However, they have to remember that they are still in a Bull Run that may continue for quite some time but has become more vulnerable to a correction - in particular a correction that has to be as deep as 10% - when economic fundamentals in the first quarter of 2010 cannot support the rally.
Share Investment
Issue 372
14/12/09 - 27/12/09
www.sharesinv.com
Read:
BELIEVING A BULL MARKET
and also:
THRIVING IN EVERY MARKET
Value Investing Made Easy (Janet Lowe):
Value Investing Made Easy (Janet Lowe):
- THRIVING IN EVERY MARKET
- MR. MARKET
- SUITABLE SECURITIES AT SUITABLE PRICES
- PAYING RESPECT TO THE MARKET
- TIMING VERSUS PRICING
- BELIEVING A BULL MARKET
- THE PAUSE AT THE TOP OF THE ROLLER COASTER
- MAKING FRIENDS WITH A BEAR
- BARGAINS AT THE BOTTOM
- SIGNS AT THE BOTTOM
- BUYING TIME
- IF YOU ABSOLUTELY MUST PLAY THE HORSES
Monday 5 April 2010
A quick look at Integrax
Integrax Berhad Company
Business Description:
Integrax Berhad. The Group's principal activities are owning and operating 2 port facilities, Lumut Maritime Terminal (port facility for dry and liquid bulk, break bulk and containers) and Lekir Bulk Terminal (port facility for dry and liquid bulk) comprising Lumut Port. Other activities include providing tuggage services, and extracting and smelting mineral ore. Operations are carried out in Malaysia.
Wright Quality Rating: LAD0
A quick look at Integrax
http://spreadsheets.google.com/pub?key=tpsmR43G59-htWV9PkRJUgQ&output=html
In the year 2008, the company took an impairment on investment in its associates amounting to RM 30.189 million. This is a non-cash item. The company's long term borrowings continue to shrink yearly.
Despite good positive FCF and the company having a large amount of idle cash, it did not pay a dividend last year. This dividend cut is certainly not minority investor friendly. Ouch!
Business Description:
Integrax Berhad. The Group's principal activities are owning and operating 2 port facilities, Lumut Maritime Terminal (port facility for dry and liquid bulk, break bulk and containers) and Lekir Bulk Terminal (port facility for dry and liquid bulk) comprising Lumut Port. Other activities include providing tuggage services, and extracting and smelting mineral ore. Operations are carried out in Malaysia.
Wright Quality Rating: LAD0
A quick look at Integrax
http://spreadsheets.google.com/pub?key=tpsmR43G59-htWV9PkRJUgQ&output=html
In the year 2008, the company took an impairment on investment in its associates amounting to RM 30.189 million. This is a non-cash item. The company's long term borrowings continue to shrink yearly.
Despite good positive FCF and the company having a large amount of idle cash, it did not pay a dividend last year. This dividend cut is certainly not minority investor friendly. Ouch!
Buffett (1989): Human beings have this perverse tendency of making easy things difficult and one must not fall into such a trap.
In his 1989 letter, we got to know Warren Buffett's views on growth rates in a finite world and the mischief being played by investment bankers and promoters in order to justify a rather 'difficult to service' fund raising.
As the years have gone by, we have noticed that the master's letters have become lengthier and have come packed with even more investment wisdom. This has however, made it difficult to incorporate all the wisdom from one particular year in a single article.
In a section titled 'Mistakes of the First Twenty-five Years', the master has reviewed some of the major investment related mistakes that he has made in the twenty-five years preceding the year 1989. Let us go through those and try our best to avoid them if similar situations play themselves out before us:
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie (Buffett's business partner) understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements."
"Good jockeys will do well on good horses, but not on broken-down nags. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand."
It should be worth pointing out that in the early years of his career, the master bought into businesses based on statistical cheapness rather than qualitative cheapness. While he experienced success using this approach, the difficult time faced by the textile business made him realize the virtue of a good business i.e. businesses with worthwhile returns and profit margins and run by exceptional people. According to him, while one may make decent profits in an ordinary business purchased at very low prices, lot of time may elapse before such profits can be made. Hence, he feels that it is always better to stick with wonderful company at a fair price, as according to him, time is the friend of a good business and an enemy of a bad business.
"Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers."
The master's reluctance to invest in tech stocks during the tech boom is legendary and perfectly sums up what he intends to convey from the above paragraph. Invest in companies whose businesses are within your circle of competence and keep it easy and simple. According to him, human beings have this perverse tendency of making easy things difficult and one must not fall into such a trap
A quick look at LPI
LPI Capital Berhad Company
Description:
LPI Capital Berhad. The Group's principal activity is underwriting fire, motor, marine, aviation, transit and miscellaneous insurance. Other activities include investment holding and financing lease. It operates through 16 local branches nationwide and three regional offices, as well as a foreign branch in Singapore.
Wright Quality Rating: DBA5
A quick look at LPI
http://spreadsheets.google.com/pub?key=tFgB3uBzdaZ9JPTy6H5To5w&output=html
A gem amongst the insurance sector.
Description:
LPI Capital Berhad. The Group's principal activity is underwriting fire, motor, marine, aviation, transit and miscellaneous insurance. Other activities include investment holding and financing lease. It operates through 16 local branches nationwide and three regional offices, as well as a foreign branch in Singapore.
Wright Quality Rating: DBA5
A quick look at LPI
http://spreadsheets.google.com/pub?key=tFgB3uBzdaZ9JPTy6H5To5w&output=html
A gem amongst the insurance sector.
A quick look at Latexx
A quick look at Latexx
http://spreadsheets.google.com/pub?key=tCBaT5VvGDp2xCY3zXOPcLQ&output=html
Read an analyst who mentioned that this company may target an earning of RM 100 million in a year's time. How probable is this? Your speculative guess is as good as mine. ;-)
A quick look at Petronas Dagangan
Petronas Dagangan Berhad Company
Petronas Dagangan Berhad. The Group's principal activity is marketing petroleum products. Its core businesses include retail, commercial, liquid petroleum gas (LPG) and lubricant. Petroleum products offered include motor gasoline, aviation fuel, kerosene, diesel, fuel oil, bunker fuel, lubricants, liquefied petroleum gas (LPG) and asphalt. Operations are carried out in Malaysia.
Wright Quality Rating: CAB8
A quick look at Petdag
http://spreadsheets.google.com/pub?key=t_SoOyUzvrzDEX3zmYaLvhw&output=html
Current Year Prospects (2009/2010)
The Directors are of the opinion that demand conditions are anticipated to be challenging but market leadership is projected to be maintained with continuous strategic marketing efforts and initiatives. Profit for the current year is anticipated to be better than the previous financial year.
Petronas Dagangan Berhad. The Group's principal activity is marketing petroleum products. Its core businesses include retail, commercial, liquid petroleum gas (LPG) and lubricant. Petroleum products offered include motor gasoline, aviation fuel, kerosene, diesel, fuel oil, bunker fuel, lubricants, liquefied petroleum gas (LPG) and asphalt. Operations are carried out in Malaysia.
Wright Quality Rating: CAB8
A quick look at Petdag
http://spreadsheets.google.com/pub?key=t_SoOyUzvrzDEX3zmYaLvhw&output=html
Current Year Prospects (2009/2010)
The Directors are of the opinion that demand conditions are anticipated to be challenging but market leadership is projected to be maintained with continuous strategic marketing efforts and initiatives. Profit for the current year is anticipated to be better than the previous financial year.
A quick look at Oilcorp Bhd
|
A quick look at Oilcorp:
http://spreadsheets.google.com/pub?key=t10H1GNhzFFeFiZQ1ltzvsQ&output=html
Detour to take a look at this company to learn how it got into this mess.
Sunday 4 April 2010
A quick look at HaiO
A quick look at HaiO
http://spreadsheets.google.com/pub?key=tZTHquircxQhaACs6-m-uRA&output=html
Those who bought this stock the last 2 years would have been rewarded with multiple baggers of gains. It remained undervalued a year ago. Now that the story of HaiO is out in the market, the price of the stock has risen sharply.
The valuation today compared to exactly a year ago makes compelling comparison for the value investor. A year ago, its PE was 7 and now it is 11.8. Its dividend yield for last year was 7.49%, now it is nearer 2,24%.
Buffett (1989): His view on high growth rates, EBITDA and zero coupon bonds
We saw Warren Buffett make some significant dents in the efficient market theory and also got to know his take on arbitrage. Let us see what the master has to say in his 1989 letter to shareholders.
Have you ever wondered why despite such enormous wealth and infrastructure, the US economy canters at a mere 3%-4% growth rate per annum and why a country like India, which has very little infrastructure in comparison to the US, is galloping at 7%-8% rate. Or better still, what happened to the 40%-50% growth rates that the Indian IT companies notched up so successfully in the not so recent past? The master has the following explanation to these phenomena:
"In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor."
Indeed, in a world where resources are limited, consistently high growth rates would create pressure on those resources, thus resulting into either exhaustion of the resources or slowing down of growth. To better illustrate this point, let us return to the Indian IT industry. The demand for qualified IT professionals (a limited resource as we can produce only so much per year) has been so high in recent times that this has resulted in a disproportionate rise in salaries and attrition levels, thus impeding profit growth. Further, it is much easy to double revenues on a base of Rs 500 - Rs 600 m than on a base of Rs 50,000 m - Rs 60,000 m. Hence, those who are expecting these companies to grow at the same rate as in the past, might be in for some real surprise.
Another important topic that the master has touched upon in his 1989 letter is the gradual deterioration in the quality of representation of a company's true cash flow by certain promoters and their advisors in order to justify a shaky deal. While earlier, a company's cash flow, to justify its debt carrying capacity took into account its normal capex needs and modest reduction in debt per year, things had come to such a pass that EBITDA emerged as a substitute for a company's cash flow. Important to note that EBITDA not only excludes the normal capex needs of the company, but it was deemed enough to cover just the interest expense on debt and not the repayment of debt. This is what the master had to say on such practices:
"To induce lenders to finance even sillier transactions, they introduced an abomination, EBDIT - Earnings Before Depreciation, Interest and Taxes - as the test of a company's ability to pay interest. Using this sawed-off yardstick, the borrower ignored depreciation as an expense on the theory that it did not require a current cash outlay. Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. As businessmen, Charlie and I relish having competitors who are unable to fund capital expenditures."
Thus, since EBITDA does not even cover the normal capex needs of the company, the master advises investors to be wary of companies and investment bankers who rely on these yardsticks to justify a leveraged deal. The master also touches upon a special type of bond known as the zero coupon bonds and goes on to add that whenever the inherent advantage that these bonds offer (deferring interest payment and not recording them till the maturity of bonds) combine with lax standards for cash flow estimation like the EBITDA, it sure is a recipe for disaster. This is what he has to say on the combination of both:
"Whenever an investment banker starts talking about EBDIT - or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures - zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures."
Buffett (1988): Arbitrages and Efficient Market Hypothesis
From Warren Buffet's 1987 letter to shareholders, we got to know his preference for businesses that are simple and easy to understand. In the same letter, Buffett also explained the concept of 'Mr Market' in a rather detailed way. Let us now see what the master has to offer in his 1988 letter to shareholders.
The year 1988 turned out to be quite an eventful one for Berkshire Hathaway, the master's investment vehicle. While the year saw the listing of the company on the New York Stock Exchange, it also turned out to be the year when Buffett made what can be termed as one of its best investments ever. Yes, we are talking about the company Coca Cola. The letter too was not short on investment wisdom either. Although he did discuss previously touched upon topics like accounting and management quality, these are not what we will focus on. Instead, let us see what the master has to say on some novel concepts like arbitrage and his take on the efficient market theory.
For those of you who would have thought that Warren Buffett is all about value investing and extremely lengthy time horizons, the mention of the word 'arbitrage' must have come as a pleasant surprise or may be, even as a shock. However, the master did engage in 'arbitrage' but in very small quantities and this is what he has to say on it.
"In past reports we have told you that our insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents. We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long-term investments."
First of all, let us see how does he define arbitrage.
"Since World War I the definition of arbitrage - or "risk arbitrage," as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market. The major risk he usually faces instead is that the announced event won't happen."
Just as in his long-term investments, in arbitrage too, the master brings his legendary risk aversion technique to the fore and puts forth his criteria for evaluating arbitrage situations.
"To evaluate arbitrage situations you must answer four questions:
- (1) How likely is it that the promised event will indeed occur?
- (2) How long will your money be tied up?
- (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and
- (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?"
And how exactly does he differ from other arbitrageurs? Let us hear the answer in his own words.
"Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation. So far, Berkshire has not had a really bad experience. But we will - and when it happens we'll report the gory details to you."
"The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumors or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities."
Another important topic that the master touched upon in his 1988 letter was that of the Efficient Market Theory (EMT). This theory had become something like a cult in the financial academic circles in the 1970s and to put it simply, stated that stock analysis is an exercise in futility since the prices reflected virtually all the public information and hence, it was impossible to beat the market on a regular basis. However, this is what the master had to say on the investment professionals and academics who followed the theory to the 'Tee'.
"Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day."
In order to justify his stance, the master states that if beating markets would have been impossible, then he and his mentor, Benjamin Graham, would not have notched up returns in the region of 20% year after year for an incredibly long stretch of 63 years, when the market returns during the same period were just under 10% including dividends. Hence, despite evidences to the contrary, EMT continued to remain popular and forced the master to make the following comment.
"Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means US$ 1,000 would have grown to US$ 405,000 if all income had been reinvested. A 20% rate of return, however, would have produced US$ 97 m. That strikes us as a statistically significant differential that might, conceivably, arouse one's curiosity. Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don't talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians."
Buffett (1987): "If you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game."
We saw the master expand upon his concept of owner earnings and the only two basic jobs that he and his partner Charlie Munger engage in through his 1986 letter to his shareholders. Let us see what investment wisdom he brings to the table in his 1987 letter.
We are living in a fast changing world and every few years there comes a technology or a product that just brings about a revolution and spreads across the globe like a mania. Few examples that come to mind are the automobiles and aeroplanes in the US in the early 20th century or the recent Internet and dot-com mania. However, the fact that the companies in such revolutionary industries rake up equally impressive returns on the stock market is far from truth. While loss making abilities of the US auto companies and airliners are legendary, not less infamous either is the amount of wealth that has been destroyed in the Internet bubble at the cusp of the 21st century. No wonder this is what the master has to say on which companies end up winners in the stock market.
"Experience indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns."
"Berkshire's experience has been similar. Our managers have produced extraordinary results by doing rather ordinary things - but doing them exceptionally well. Our managers protect their franchises, they control costs, they search for new products and markets that build on their existing strengths and they don't get diverted. They work exceptionally hard at the details of their businesses, and it shows."
Indeed, with technology changing so fast in industries such as auto and Internet, it becomes really difficult to zero in on a company that will continue to exist ten years from now and in the process still give attractive returns. This is definitely not the case with a single product company existing in an industry, where more the things change more they remain the same.
In an era when investing in equities had been reduced to nothing more than moving in and out of companies based on their quotations, the master was a breed different from the rest. He did not let fluctuations in stock prices influence his investment decisions but rather viewed investments from the point of view of a business analyst, judging companies on the basis of their operating results and viewing stock market not as a guide but as a servant. Laid out below is what perhaps is one of the most lucid yet one of the most effective explanations of how one should view the stock market.
The master says, "Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.
Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.
Mr. Market has another endearing characteristic - he doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice - Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game."
Buffett (1986): The concept of Owners Earnings and Maintainance Capex
We got to know the master's views on his textile business. Let us go a year further and try to discuss what the guru has to say in his 1986 letter to shareholders.
The letter, as usual, though did contain quite a bit of commentary on the company's major businesses, it also had general investment related wisdom. This time around the master chose to speak on himself and his partner's role. This is what he had to say:
"Charlie Munger, our Vice Chairman, and I really have only two jobs. One is to attract and keep outstanding managers to run our various operations. This hasn't been all that difficult. Usually the managers came with the companies we bought, having demonstrated their talents throughout careers that spanned a wide variety of business circumstances. They were managerial stars long before they knew us, and our main contribution has been to not get in their way. This approach seems elementary - if my job were to manage a golf team - and if Jack Nicklaus or Arnold Palmer were willing to play for me - neither would get a lot of directives from me about how to swing."
"The second job Charlie and I must handle is the allocation of capital, which at Berkshire is a considerably more important challenge than at most companies. Three factors make that so -
- we earn more money than average;
- we retain all that we earn; and,
- we are fortunate to have operations that, for the most part, require little incremental capital to remain competitive and to grow.
The master's non-interference in the management of the businesses he owned is now almost legendary. But just like the companies he invested in, he made sure that the people he put in charge had outstanding track records. Once that was done, he would completely move out of their way and let them manage the business. Indeed, when a business with favorable economics is run by an exceptional manager, the last thing one would want to do is upset the applecart. Yet again, while the line of thinking is simple yet extremely effective, it must have stemmed from the master's own experience of managing the operations of the textile business of Berkshire Hathaway. Having been at the wheels for years, he must have realised how difficult it is to successfully run a business and deliver knock out performances year after year.
Berkshire Hathaway, from the time Buffett has been at the helm, has never paid dividends to shareholders. This is because the master has always felt that he would be able to find a better use of capital than paying out dividends. And find he did! The returns that the company has generated for its shareholders have vastly exceeded returns by any other American company. A very difficult task indeed, especially over a very long period of time. He is also very right in saying that a company that earns above average returns and retains all earnings is likely to see its economics deteriorate much faster than a company retaining only 5% if the retained capital is not put to good use. In the end, the honours should definitely go to the company that makes the most effective use of capital.
The master rounded off the 1986 letter by introducing a concept of owner earnings, the one he frequently uses to evaluate companies. It is nothing but
(a) reported earnings plus
(b) depreciation, depletion, amortization, and certain other non-cash charges minus
(c) the average annual amount of capitalised expenditures for plant and equipment that the business needs to fully maintain its long-term competitive position and current volumes.
While owner earnings looks similar to cash flow after capex and working capital needs, it does not take into account capex and working capital investment required for generating more volumes but instead takes into account capex that is required to maintain just the steady state operations. In other words, what we call as the maintenance capex. Since inflationary pressures can make maintenance capex look very large, analysts who do not consider it are bound to overestimate the worth of the company. In fact, this is what he has to say on those who do not consider the all-important (c) item in their evaluations.
"All of this points up the absurdity of the 'cash flow' numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract (c). Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids - forever state-of-the-art, never needing to be replaced, improved or refurbished. Indeed, if all US corporations were to be offered simultaneously for sale through our leading investment bankers - and if the sales brochures describing them were to be believed - governmental projections of national plant and equipment spending would have to be slashed by 90%."
Buffett (1985): Energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks in a chronically leaking boat
With volatility being the order of the day, we as investors indeed need some calming influence so as to help us stay rational and make sense of the crisis that has gripped the global capital markets currently. And what better way to do this than to turn to the man who answers to the name of Warren Buffett and who arguably, is one of the world's best practitioner of the art of rationality and objective thinking.
In the following few paragraphs, let us see what the master offers by way of investment wisdom in his 1985 letter.
This letter like his previous letters touches upon a variety of topics, some covered before while others brand new. What we would like to reproduce here is the biggest and the best of them all. The year 1985 was the year when the master finally chose to shut down his textile business by liquidating all of company's assets. While going through the brief history of the business and explaining his rationale behind the sale, the master has systemically busted some of the biggest myths related to investing and shown us why one should prefer business that generate returns with as little capital employed as possible. He has also shown why reliance on book values and replacement costs while valuing a company could turn to be dangerous.
While the discourse is indeed exhaustive, we believe that every sentence is worth its weight in gold. Laid out below is an edited account of his textile business shutdown:
"In July we decided to close our textile operation, and by year end this unpleasant job was largely completed. The history of this business is instructive.
When Buffett Partnership Ltd., an investment partnership of which I was general partner, bought control of Berkshire Hathaway 21 years ago, it had an accounting net worth of US$ 22 m, all devoted to the textile business. The company's intrinsic business value, however, was considerably less because the textile assets were unable to earn returns commensurate with their accounting value. Indeed, during the previous nine years (the period in which Berkshire and Hathaway operated as a merged company) aggregate sales of US$ 530 m had produced an aggregate loss of US$ 10 m. Profits had been reported from time to time but the net effect was always one step forward, two steps back.
We felt, however, that the business would be run much better by a long-time employee whom we immediately selected to be president, Ken Chace. In this respect we were 100% correct: Ken and his recent successor, Garry Morrison, have been excellent managers, every bit the equal of managers at our more profitable businesses.
We remained in the business for reasons that I stated in the 1978 annual report (and summarized at other times also): "(1) our textile businesses are very important employers in their communities, (2) management has been straightforward in reporting on problems and energetic in attacking them, (3) labor has been cooperative and understanding in facing our common problems, and (4) the business should generate modest cash returns relative to investment." I further said, "As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital."
It turned out that I was very wrong about (4). Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.
The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage.
Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.
But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company's capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.
Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. (Comment: Gruesome business) After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers.
My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
There is an investment postscript in our textile saga. Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.
The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about US$ 13 m, including US$ 2 m spent in 1980-84, and had a current book value of US$ 866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps US$30 to US$ 50 m.
Gross proceeds from our sale of this equipment came to US$ 163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for US$ 5,000 apiece in 1981 found no takers at US$ 50. We finally sold them for scrap at US$ 26 each, a sum less than removal costs."
Conclusion: The master's liquidation of his textile business shows what could potentially lie in store for a business with a rather poor economics, despite the presence of an excellent management. Thus, while Buffett was able to correct his mistake by devoting some of the textile company's capital to other more profitable businesses, no such luxuries await small investors. Hence, they can do their investment returns a world of good by refusing to invest in such businesses, no matter how cheap they might look based on book value and replacement costs.
How to Make Money The Buffett Way
http://www.equitymaster.com/ptmail/sep09/buffet_newsubs.html
Stop wasting so much time and energy trying to find 'that' perfect stock. Instead discover...
How to Make Money
The Buffett Way
Simply put, we will be identifying companies that are doing simple businesses that can be easily understood, have consistent earnings history and sustainable growth path, are managed by honest and competent people, and whose stocks are available at attractive prices with an adequate margin of safety.
After all, Buffett has made his entire fortune - US$ 37 bn at last count - following these very principles of investing.
And he's achieved tremendous success with not one, not two, but several stocks that have multiplied several times over a number of years.
Like his investment in Coca-Cola, where every 100 dollars he invested in 1988 now stands at nearly 1,500 dollars...or simply put, an investment that has multiplied 15 times in around 21 years! See this...
Data Source: Yahoo Finance
Among other reasons, the key factor that prompted Buffett to buy Coca-Cola (as he later clarified) was that he believed in the simplicity and sustainability of its business.
But before that...
You know, the 15 times return on Coca-Cola is just among the lesser returns that Buffett has made over the years. Washington Post, the newspaper company that he started acquiring in 1973, has till date multiplied his money a whopping 81 times! And this is keeping out the significant dividends that the company has paid out over these years.
Data Source: Yahoo Finance
As per the reasoning he later offered, Buffett bought Washington Post simply because the company, apart from doing good business, was selling at a much lower price than its true business value.
'The Value Investor' will emulate Buffett's mantra of buying stocks when they are selling cheap as compared to their true worth.
Another of Buffett's investments that turned extremely successful was 'Gillette', the shaving products major. Buffett's simple reasoning to buy Gillette can be summed up in his own words - "I go to sleep in peace every night realising that every morning when I wake up, millions of men will wake up with me and shave."
Not to mention that Buffett multiplied his investment in Gillette almost 9 times in 14 years.
So How Can Buffett's Teachings Help You Build A Portfolio
That Can Multiply Your Wealth Several Times
Over The Next Five To Ten Years?
Now For Your Biggest Question...
"Why Should I Do This?"
Okay, let us put it the other way - what could be the opportunity loss for you for not practicing 'The Value Investor' strategy and otherwise following the herd?
See this chart...
Data Source: Berkshire Hathaway's 2008 annual report
The above chart depicts the increase in book value per share of Buffett's company Berkshire Hathaway vis-Ã -vis the performance of S&P 500 during the period 1964 to 2008.
While the S&P 500 multiplied by around 42 times during this period, Berkshire's book value multiplied 3,400 times!
Stop wasting so much time and energy trying to find 'that' perfect stock. Instead discover...
The Buffett Way
And he's achieved tremendous success with not one, not two, but several stocks that have multiplied several times over a number of years.
 |
Among other reasons, the key factor that prompted Buffett to buy Coca-Cola (as he later clarified) was that he believed in the simplicity and sustainability of its business.
You know, the 15 times return on Coca-Cola is just among the lesser returns that Buffett has made over the years. Washington Post, the newspaper company that he started acquiring in 1973, has till date multiplied his money a whopping 81 times! And this is keeping out the significant dividends that the company has paid out over these years.
 |
As per the reasoning he later offered, Buffett bought Washington Post simply because the company, apart from doing good business, was selling at a much lower price than its true business value.
'The Value Investor' will emulate Buffett's mantra of buying stocks when they are selling cheap as compared to their true worth.
Another of Buffett's investments that turned extremely successful was 'Gillette', the shaving products major. Buffett's simple reasoning to buy Gillette can be summed up in his own words - "I go to sleep in peace every night realising that every morning when I wake up, millions of men will wake up with me and shave."
Not to mention that Buffett multiplied his investment in Gillette almost 9 times in 14 years.
That Can Multiply Your Wealth Several Times
Over The Next Five To Ten Years?
"Why Should I Do This?"
Okay, let us put it the other way - what could be the opportunity loss for you for not practicing 'The Value Investor' strategy and otherwise following the herd?
See this chart...
 |
The above chart depicts the increase in book value per share of Buffett's company Berkshire Hathaway vis-Ã -vis the performance of S&P 500 during the period 1964 to 2008.
While the S&P 500 multiplied by around 42 times during this period, Berkshire's book value multiplied 3,400 times!
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