Bullbear Buffett

Wednesday, 11 April 2012

Discounted Cash Flow (DCF) Explained in Two Minutes

A Buffett Disciple Shares His Secrets (Morningstar)

Low risk, high uncertainty situations.

Wall Street punishes uncertainties. The rewards can be very high for such low risk situations.

Intrinsic value described by Ben Graham in Security Analysis.

In a bull market, be prepared for the bear.

"It is not difficult to outperform the benchmark in a rising market. For the investor, it is more important to be with a portfolio that is defensive enough not to drop too much in a down market."

Value Investing - The Bottom Line

"You need to worry about where the company and the stock will be in three to five years. If you can buy something today with little chance of permanent impairment and a high likelihood that you'll double your money over the next five years, you should go ahead and do it."

- Seth Klarman

Start Early

Valuing a company using adjusted P/E

Average long-term P/E = 15

Company average long term P/E = 13 ( =$530m / $41m)

Market cap = $530 m
ttm Earnings = $41 m
$161 m in cash (no debt) or $4.75 per share

Cash-adjusted P/E is 9.[ = ($530m - $161m) / $41m]

Earnings yield ( 1/PE) of 11% is too cheap.

If company has a lot of debt, you wouldn't bother about the cash-adjusted P/E.

Simple DCF

Valuation

At the end of the day, every company is worth whatever the current value of all its future cash flows are discounted backward to today's terms.

It is a hint, not an answer. Based on a lot of assumptions, using conservative figures.

1st 10 years Cash flow. using OWNERS EARNINGS (FCF).
Cash flow beyond the 10th year (Terminal value): Assumes growth at 3% per year.
Add all the above discounted cashflows to get the present value..

Only the FCFs are hard data, all others are assumptions.

Time 14.13
http://www.youtube.com/watch?v=zA8udp8uRnw&feature=relmfu

Key Points about Risks

Risk unequivocally exist in investing in any stock ...

... but important to distinguish between volatility in stock price and business risk ...

... and my point is that none are large or imminent enough to explain why shares are so cheap.

Worthy of a look?

Not sexy, high growth or hot stock.

Warning: May not be in your "circle of competence."

Look at things that are temporary out of favour.

You wish to buy when the prices are falling or close to the bottom.

You should have a tough time trying to buy something that is NOT near its 52 weeks low.

Worthy of a look?

Moat? Thumbs Up

Cheap?

Margin of safety? Thumbs Up

Inside my circle! Thumbs Up

Outcome:

No list
Watch list
Yes list

A large percentage of companies are too difficult to analyse, they are outside your circle of competence.

Concentrated Ideas

"Wide diversification is only required when investors do not understand what they are doing."

- Warren Buffett

Note: Focus concentration of about 10% in each stock. Anything stock that is less than 5% may not be worth your effort.

Margin of Safety

"Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY."

- Ben Graham

Mr. Market

Stock prices are quotes from an emotionally unstable business partner.

Use or ignore them as you see fit.

Valuing a Business

"The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price."

- Warren Buffett

Moats

Low cost producer
Switching costs
Economies of scale
Intangibles
Regulatory
IP (Intellectual Property)
Network effects

Note: Most companies do not have moat. They can only survive and compete through being more efficient.

Circle of Competence

If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter.

Warren Buffett

Subscribe to: Posts (Atom)

My 18 points guide to Successfully compounding your money in Stocks

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

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

11 Lessons From Peter Lynch

Peter Lynch taught me:

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

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

Capital Expenditure

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

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

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

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

Less is better.

Benjamin Graham's 113 Wise Words

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

Philip Fisher's Wise Words

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

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

(Common Stocks and Uncommon Profits)

The Ultimate Hold-versus-Sell Test

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

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

No equivocation. Yes or no?

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

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

Some thoughts on Analysing Stocks (KISS)

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

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

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

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

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

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

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

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