The Five Rules for Successful Stock Investing 10

Valuation – The Basics

Even the most wonderful business is a poor investment if purchased for too high a price. To invest successfully means you need to buy great companies at attractive prices.

Investors purchase an asset for less than their estimate of its value and receive a return more or less in line with the financial performance of that asset. Speculators, by contrast, purchase an asset not because they believe it's actually worth more, but because they think another investor will pay more for it at some point. The return that investors receive on assets depends largely on the accuracy of their analysis, whereas a speculator's return depends on the gullibility of others.

Over time, the stock market's returns come from two key components: investment return and speculative return. [...] the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio. [...] over a long time span, the impact of investment returns trump the impact of speculative returns.

By paying close attention to the price you pay for a stock, you minimize your speculative risk, which helps maximize your total return.

The most basic ratio of all is the P/S ratio, which is the current price of the stock divided by sales per share. The nice thing about the P/S ratio is that sales are typically cleaner than reported earnings because companies that use accounting tricks usually seek to boost earnings.

The P/S ratio has one big flaw: Sales may be worth a little or a lot, depending on a company's profitability.

Although the P/S ratio might be useful if you're looking at a firm with highly variable earnings – because you can compare today's P/S with a historical P/S ratio – it's not something you want to rely on very much. In particular, don't compare companies in different industries on a price-to-sales basis, unless the two industries have very similar levels of profitability.

Another common valuation measure is price-to-book (P/B), which compares a stock's market value with the book value (also known as shareholder's equity or net worth) on the company's most recent balance sheet. The idea here is that future earnings or cash flows are ephemeral, and all we can really count on is the net value of a firm's tangible assets in the here-and-now.

When the market was dominated by capital-intensive firms that owned factories, land, rail track, and inventory – all of which had some objective tangible worth – it made sense to value firms based on their accounting book value. After all, not only would those hard assets have value in a liquidation, but also they were the source of many firms' cash flow. But now, many companies are creating wealth through intangible assets such as processes, brand names, and databases, most of which are not directly included in book value.

Another item to be wary of when using P/B to value stocks is goodwill, which can inflate book value to the point that even the most expensive firm looks like a value. When one company buys another, the difference between the target firm's tangible book value and the purchase price is called goodwill, and it's supposed to represent the value of all the intangible assets – smart employees, strong customer relationships, efficient internal processes – that made the target firm worth buying. Unfortunately, goodwill often represents little else but the desperation of the acquiring firm to buy the target before someone else did, because acquiring firms often overpay for target companies. Be highly skeptical of firms for which goodwill makes up a sizable portion of their book value.

A company that's trading at a lower P/E than its industry peers could be a good value, but remember that even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the P/E ratio. All else equal, it makes sense to pay a higher P/E for a firm that's growing faster, has less debt, and has lower capital reinvestment needs.

In general, comparing a company's P/E with industry peers or with the market has some value, but these aren't approaches that you should rely on to make a final buy or sell decision. However, comparing a stock's current P/E with its historical P/E ratios can be useful, especially for stable firms that haven't undergone major shifts in their business. If you see a solid company that's growing at roughly the same rate with roughly the same business prospects as in the past, but it's trading at a lower P/E than its long-term average, you should start getting interested.

Because risk, growth, and capital needs are all fundamental determinants of a stock's P/E ratio, higher growth firms should have higher P/E ratios, higher risk firms should have lower P/E ratios, and firms with higher capital needs should have lower P/E ratios.

When you're looking at a P/E ratio, you must be sure that the E makes sense. If a firm has recently sold off a business or perhaps a stake in another firm, it's going to have an artificially inflated E, and thus a lower P/E. Because you don't want to value the firm based on one-time gains such as this, you need to strip out the proceeds from the sale before calculating the P/E.

Don't rely on any single valuation metric because no individual ratio tells the whole story. Apply a number of different valuation tools when you're assessing a stock.

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The Five Rules for Successful Stock Investing 9

Avoiding Financial Fakery

Over time, increases in a company's cash flow from operations should roughly track increases in net income. If you see cash from operations decline even as net income keeps marching upward – or if cash from operations increases much more slowly than net income – watch out. This usually means that the company is generating sales without necessarily collecting the cash, and that's a very good recipe for a blowup down the road.

[...] firms that make numerous acquisitions can be problematic [...]. Aside from muddying the waters, acquisitions increase the risk that the firm will report a nasty surprise some time in the future, because acquisitive firms that want to beat their competitors to the punch often don't spend as much time checking out their targets as they should.

When inventories rise faster than sales, there's likely to be trouble on the horizon. Sometimes the buildup is just temporary as a company prepares for a new product launch, but that's usually more the exception than the rule. When a company produces more than it's selling, either demand has dried up or the company has been overly ambitious in forecasting demand. In any case, the unsold goods will have to get sold eventually – probably at a discount – or written off, which would result in a big charge to earnings.

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The Five Rules for Successful Stock Investing 8

Analyzing a Company – Management

Excellent management can make the difference between a mediocre business and an outstanding one, and poor management can run even a great business into the ground. Your goal is to find management teams that think like shareholders – executives that treat the business as if they owned a piece of it, rather than as hired hands.

Executives' pay should rise and fall based on the performance of the company. [...] Firms with good corporate governance standards won't hesitate to pay managers less in bad times and more in good times, and that's the kind of pattern you want to see as a shareholder.

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The Five Rules for Successful Stock Investing 7

Analyzing a Company – The Basics

Because [analyzing companies] can be a daunting task, I suggest that you break down the process into five areas:

1. Growth: How fast has the company grown, what are the sources of its growth, and how sustainable is that growth likely to be?
2. Profitability: What kind of returns does the company generate on the capital it invests?
3. Financial health: How solid is the firm's financial footing?
4. Risks/bear case: What are the risks to your investment case? There are excellent reasons not to invest in even the best-looking firms. Make sure you look at the full story and investigate the negatives as well as the positives.
5. Management: Who's running the show? Are they running the company for the benefits of shareholders or themselves?

You can't just look at a series of past growth rates and assume that they'll predict the future [...]. It's critical to investigate the sources of a company's growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that's generated by cost-cutting or accounting tricks.

In the long run, sales growth drives earnings growth. Although profit growth can outpace sales growth for a while if a company is able to do an excellent job cutting costs or fiddling with the financial statements, this kind of situation simply isn't sustainable over the long haul – there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottom line. In general, sales growth stems from one of four areas:

1. Selling more goods or services
2. Raising prices
3. Selling new goods or services
4. Buying another company

If you don't know how fast the company would have grown without acquisitions, don't buy the shares – because you never know when the acquisitions will stop. Remember, the goal of a successful investor is to buy great businesses, not successful merger and acquisition machines.

The first component of ROA (Return on Assets) is simply net margin, or net income divided by sales, and it tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business. The second component is asset turnover, or sales divided by assets, which tells us roughly how efficient a firm is at generating revenue from each dollar of assets. Multiply these two together, and you have return on assets, which is simply the amount of profits that a company is able to generate per dollar of assets. Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating assets into profits.

ROA helps us understand that there are two routes to excellent operational profitability: You can charge high prices for your products (high margins), or you can turn over your assets quickly.

Return on equity (ROE) is a great overall measure of a company's profitability because it measures the efficiency with which a company uses shareholders' equity – in other words, it measures how good the company is at earning a decent return on the shareholder's money.

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

The Five Rules for Successful Stock Investing 6

Financial Statements Explained

[...] reading financial statements is the foundation for analyzing companies.

The balance sheet [...] tells you how much a company owns (its assets), how much it owes (its liabilities), and the difference between the two (its equity). Equity represents the value of the money that shareholders have invested in the firm [...].

"Cash and equivalents" usually contains money market funds or anything that can be liquidated quickly and with minimal price risk, whereas "short-term investments" is similar to cash – usually, bonds that have less than a year to maturity and earn a higher rate of return than cash but would take a bit of effort to sell.

[...] accounts receivable are bills that the company hasn't yet collected but for which it expects to receive payment soon.

Comparing the growth rate of accounts receivable with the growth rate of sales is a good way to judge whether a company is doing a good job collecting the money that it's owed by customers.

You'll often see an "allowance for doubtful accounts" just after accounts receivable on the balance sheet. This is the company's estimate of how much money it's owed by deadbeat customers, and which it's consequently unlikely to collect.

There are several types of inventories, including raw materials that have not yet been made into a finished product, partially finished products, and finished products that have not yet been sold. 

Inventories are especially important to watch in manufacturing and retail firms, and their value on the balance sheet should be taken with a grain of salt. Because of the way inventories are accounted for, their liquidation value may very well be a far cry from their value on the balance sheet.

Inventories soak up capital – cash that's been converted into inventory sitting in a warehouse can't be used for anything else. The speed at which a company turns over its inventory can have a huge impact on profitability because the less time cash is tied up in inventory, the more time it's available for use elsewhere. You can calculate a metric called inventory turnover by dividing a company's cost of goods sold by its inventory level.

Noncurrent assets are assets that are not expected to be converted into cash or used up within the reporting period. The big parts of this section are property, plant, and equipment (PP&E); investments; and intangible assets.

The most common form of intangible assets is goodwill, which arises when one company acquires another. Goodwill is the difference between the price the acquiring company pays and tangible value – or equity – of the target company.

[...] the value of goodwill that shows up on the balance sheet is very often far more than the asset is actually worth.

Accounts payable: These are bills the company owes to somebody else and are due to be paid within a year.

Noncurrent liabilities are the flip side of noncurrent assets. They represent money the company owes one year or more in the future.

Retained earnings is a cumulative account; therefore, each year that the company makes a profit and doesn't pay it all out as dividends, retained earnings increase. Likewise, if a company has lost money over time, retained earnings can turn negative and is often renamed "accumulated deficit" on the balance sheet. Think of this account as a company's long-term track record at generating profits.

Be sure to check the "revenue recognition policies" buried in the financial statements so you know what you're looking at – companies can record revenue at different times depending on the business that they're in.

Cost of sales, also known as cost of goods sold, represents the expenses most directly involved in creating revenue, such as labor costs, raw materials (for manufacturers), or the wholesale price of goods (for retailers).

Gross profit is simply revenue minus cost of sales. Once you have gross profit, you can calculate a gross margin, which is gross profit as a percentage of revenue. Essentially, this tells you how much a company is able to mark up its goods.

[...] the more differentiated a company's products are, the more it can mark up its good over what it costs to manufacture them.

Selling, General, and Administrative Expenses (SG&A), also known as operating expenses, includes items such as marketing, administrative salaries, and, sometimes, research and development. (Research and development is usually broken out as a separate line item, as is marketing for firms that spend large amounts on advertising.) You'll often see a relationship between SG&A and gross margin – firms that are able to charge more for their goods have to spend more on salespeople and marketing. You can get a feel for how efficient a firm is by looking at SG&A as a percentage of revenues – a lower percentage of operating expenses relative to sales generally means a tighter, more cost-effective firm.

Depreciation and Amortization: When a company buys an asset intended to last a long time, such as a new building or a piece of machinery, it charges off a portion of the cost of that asset on its income statement over a series of years. This number is occasionally broken out separately on the income statement, but it's usually rolled into operating expenses. It's always included in the cash flow statement, though, so you can look there to see how much a company's net income was affected by noncash charges such as depreciation.

Nonrecurring Charges/Gains is the catch-all area where companies put all the one-time charges or gains that aren't part of their regular, ongoing operations, such as the cost of closing a factory or the gain from selling a division. Ideally, you'd want to see this area of the income statement blank most of the time.

Operating Income is equal to revenues minus cost of sales and all operating expenses. Theoretically, it represents the profit the company made from its actual operations, as opposed to interest income, one-time gains, and so forth. In practice, companies often include nonrecurring expenses (such as write-offs) in figuring operating income, and you have to add back one-time charges (or subtract one-time gains) yourself.

Interest Income/Expense represents interest the company has paid on bonds it has issued or received on bonds or cash that it owns.

Net Income represents (at least theoretically) the company's profit after all expenses have been paid. [...] Although net income is the number you'll most often see companies tout in their press releases, don't forget that it can be wildly distorted by one-time charges and/or investment income.

Number of Shares (Basic and Diluted) represents the number of shares used in calculating earnings per share; it represents the average number of shares outstanding during the reporting period. Basic shares include only actual shares of stock, and you should pretty much ignore it – the fact that it's still recorded in financial statements is more of a historical legacy than anything else. Diluted shares, however, include securities that could potentially be converted into shares of stock, such as stock options and convertible bonds. Given the amount of egregious granting of stock options that has occurred over the past several years, it's the diluted number that you'll want to look at, because you want to know the degree to which your stake in the firm could potentially be shrunk (or diluted) if all those option-holders convert their options into shares.

The cash flow statement strips away all the abstract, noncash items such as depreciation that you see on the income statement and tells you how much actual cash the company has generated. [...] The cash flow statement is divided into three parts: cash flows from operating activities, from investing activities, and from financing activities.

If you can't understand how a dollar flows from a company's customers back through to shareholders, something's amiss. Either the company's business model is too confusing or you need to do more digging before committing any of your money.

When you're evaluating a company's liabilities, remember that debt is a fixed cost. A big chunk of long-term debt can be risky for a company because the interest has to be paid no matter how business is doing.

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

The Five Rules for Successful Stock Investing 5

The Language of Investing

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

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

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

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

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

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

The Five Rules for Successful Stock Investing 4

Economic Moats

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

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

• Evaluate the firm's historical profitability. Has the firm been able to generate a solid return on its assets and on shareholders' equity? This is the true litmus test of whether a firm has built an economic moat around itself.
• If the firm has solid returns on capital and consistent profitability, assess the sources of the firm's profits. Why is the company able to keep competitors at bay? What keeps competitors from stealing its profits?
• Estimate how long a firm will be able to hold off competitors, which is the company's competitive advantage period. Some firms can fend off competitors for just a few years, and some firms may be able to do it for decades.
• Analyze the industry's competitive structure. How do firms in this industry compete with one another? Is it an attractive industry with many profitable firms or a hypercompetitive one in which participants struggle just to stay afloat?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Five Rules for Successful Stock Investing 3

Seven Mistakes to Avoid

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

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

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

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

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

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

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

The only reason you should ever buy a stock is that you think the business is worth more than it's selling for – not because you think a greater fool will pay more for the shares a few months down the road.

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

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

The Five Rules for Successful Stock Investing 2

The Five Rules for Successful Stock Investing

Here are the five rules that we recommend:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Five Rules for Successful Stock Investing 1

Introduction: Picking Great Stocks Is Tough

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

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

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

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

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

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

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

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

Technical Analysis - A Beginner's Guide

Past performance is no guarantee of future results.

Charts do not predict the future from the past.

They seek to find current buying and selling patterns in the past and plan their own course of action once those patterns end.

It is based on probabilities, not forecasting.




Why does it work?

Chart patterns are formed by the buying and selling actions of people, and people tend to act in a similar manner when faced with similar situations.

Some blame this on a self-fulfilling prophecy.

If enough investors believe in the significance of a chart pattern ending then they will act, and thus their actions will assure that the assumed result will occur.

But investors may not act the same way this time and the charts will tell us when that is the case quickly, before losses begin to mount.




Note that technical analysis expects to have losses.

It is in minimising those losses and recognizing when a winner has more room to go that there is success - read consistent profits - in a portfolio.

No other method of analysis includes as a standard feature the possibility that things will not work out as planned.  




Charts need not be adversarial with other forms of analysis.

Charts can be used as tools to help with the other forms of analysis.

Whether it is a sanity check on the fundamentals, or something that tips us off on changing fundamentals in a sector, charts will enhance investing results.

Charts are tools, not crystal balls.

They help investors find good investments and just as importantly avoid bad ones.

A picture is worth a thousand words and charts can be put into action to help investors make and keep money.


Ref:  Michael Kahn

The FOUR filters of Buffett

The FOUR filters of Buffett:

1.  You must understand the business of the company.
2.  The business must have a durable competitive advantage.
3.  The management must have talent and integrity.
4.  The price must be reasonable with a margin of safety.

Some may focus just on Filter 4 and still make money in their investing.

However, by incorporating Filters 1, 2 & 3 into their investing, they are less likely to encounter losses.  

Filters 1, 2 & 3 are there to prevent losses in your investing.  


[Nothing new, I have been following these for umpteen years.  My QMV method! ]      

In investing, it is just as important to know which companies to avoid.

In investing, it is just as important to know what are the companies you do not wish to invest in.

This is very important and if you are able to identify these companies that are not going to do well or that are going to do badly in their businesses, you can prevent yourself from a lot of future heart-aches and losses.

Being able to identify these companies that are going to do poorly over the long term, means you have the ability to also:

1.  identify those companies with good long term prospects, which you may choose to dwell in deeper into to prospect for your long term portfolio of stocks.

2.  identify those companies that are fundamentally poor which are presently exhibiting temporarily a period of exceptionally good results, so that you may avoid them.

These assessments are based mainly on the businesses of the companies.  Do not look at the stock prices for guidance, especially in the initial stages of your analysis of the companies prospects.

It is better to assess the quality of the business and the quality and integrity of the management first.

When you like what you analyse, then do a valuation of its intrinsic value.

Then determine at what price you will be willing to buy at with a margin of safety and a promise of satisfactory return.

Then look at the market price.  Looking at the market price to get guidance may bias you in your intrinsic value calculation.

ALL EQUITY SECURITY INVESTMENTS PRESENT A RISK OF LOSS OF CAPITAL

Investment performance is not guaranteed and future returns may differ from past returns. As investment conditions change over time, past returns should not be used to predict future returns. The results of your investing will be affected by a number of factors, including the performance of the investment markets in which you invest.

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.

SELL THE LOSERS, LET THE WINNERS RUN.

Losers refer NOT to those stocks with the depressed prices but to those whose revenues and earnings aren't capable of growing adequately. Weed out these losers and reinvest the cash into other stocks with better revenues and earnings potential for higher returns.

SOME THOUGHTS ON ANALYSING STOCKS (KISS)

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

• 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" as the Central Concept of Investment

The Intelligent Investor by Benjamin Graham

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?

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.

MARKET FLUCTUATIONS OF INVESTOR'S PORTFOLIO

Note carefully what Graham is saying here. 

It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% ("equivalent one-third") from their highest price -regardless of which stocks you own or whether the market as a whole goes up or down.

If you can't live with that - or you think your portfolio is somehow magically exempt from it - then you are not yet entitled to call yourself an investor.

KESM 7.6.2016

KESM Charts

Cyclical business

PE has expanded and contracted over the years.

Revenue growth is anaemic.

PBT and EPS have grown fast recently due to margin expansions for various reasons.

Its price was below RM 1 in recent years and has climbed to 6 before dropping to present levels recently.


Best time to be enthusiastic on cyclical stocks:


1.  When their PE is the highest in the cycle

2.  When their profit margins are the lowest in the cycle.

The company has about 50 m debts but is net cash positive.

Large capital expenditure expended last year.  

ROE is improving, was a single digit and now about 12%.

Its dividend is minuscule, DPO is about 15%.

DY at its present high price of 4.90 is about 1.6%.