A Random Walk Down Wall Street - Part One 3: Stocks and Their Value

Chapter 2. The Madness of Crowds

The psychology of speculation is a veritable theater of the absurd. Although the castle-in-the-air theory can well explain such speculative binges, outguessing the reactions of a fickle crowd is a most dangerous game. Unsustainable prices may persist for years, but eventually they reverse themselves.

I. the Tulip-Bulb Craze

1. In the early 17th century, tulip became a popular but expensive item in Dutch gardens. Many flowers succumbed to a nonfatal virus known as mosaic. It was this mosaic that helped to trigger the wild speculation in tulip bulbs. The virus caused the tulip petals to develop contrasting colored stripes or “flames”. The Dutch valued highly these infected bulbs, called bizarres. In a short time, popular taste dictated that the more bizarre a bulb, the greater the cost of owning it.

2. Slowly, tulipmania set in. At first, bulb merchants simply tried to predict the most popular variegated style for the coming year. Then they would buy an extra large stockpile to anticipate a rise in price. Tulip bulb prices began to rise wildly. The more expensive the bulbs became, the more people viewed them as smart investments.

3. People who said the prices could not possibly go higher watched with chagrin as their friends and relatives made enormous profits. The temptation to join them was hard to resist; few Dutchmen did. In the last years of the tulip spree, which lasted approximately from 1634 to early 1637, people started to barter their personal belongings, such as land, jewels, and furniture, to obtain the bulbs that would make them even wealthier. Bulb prices reached astronomical levels.

4. The tulip bulb prices during January of 1637 increased 20 fold. But they declined more than that in February. Apparently, as happens in all speculative crazes, prices eventually got so high that some people decided they would be prudent and sell their bulbs. Soon others followed suit. Like a snowball rolling downhill, bulb deflation grew at an increasingly rapid pace, and in no time at all panic reigned.


II. The South Sea Bubble

1. The South Sea Company had been formed in 1711 to restore faith in the government’s ability to meet its obligations. The company took on a government IOU ( I owe you: debt) of almost 10 million pounds. As a reward, it was given a monopoly over all trade to the South Seas. The public believed immense riches were to be made in such trade, and regarded the stock with distinct favor.

2. In 1720, the directors decided to capitalize on their reputation by offering to fund the entire national debt, amounting to 31 million pounds. This was boldness indeed, and the public loved it. When a bill to that was introduced in Parliament, the stock promptly rose from ￡130 to ￡300. 3. On April 12, 1720, five days after the bill became law, the South Sea Company sold a new issue of stock at ￡300. The issue could be bought on the installment plan - ￡60 down and the rest in eight easy payments. Even the king could not resist; he subscribed for stock totaling ￡100,000. Fights broke out among other investors surging to buy. The price had to go up. It advanced to ￡340 within a few days. The ease the public appetite, the company announced another new issue – this one at ￡400. But the public was ravenous. Within a month the stock was ￡550, and it was still rising. Eventually, the price rose to ￡1,000.

4. Not even the South See was capable of handling the demands of all the fools who wanted to be parted from their money. Investors looked for the next South Sea. As the days passed, new financing proposals ranged from ingenious to absurd. Like bubbles, they popped quickly. The public, it seemed, would buy anything.

5. In the “greater fool” theory, most investors considered their actions the height of rationality as, at least for a while; they could sell their shares at a premium in the “after market”, that is, the trading market in the shares after their initial issue.

6. Realizing that the price of the shares in the market bore no relationship to the real prospects of the company, directors and officers of the South Sea sold out in the summer. The news leaked and the stock fell. Soon the price of the shares collapsed and panic reigned. Big losers in the South Sea Bubble included Isaac Newton, who exclaimed, “I can calculate the motions of heavenly bodies, but no the madness of people.”

III. Wall street lays an egg

1. From early March 1928 through early September 1929, the market’s percentage increase equaled that of the entire period from 1923 through early 1928.

2. Price manipulation by “investment pools”: The pool manager accumulated a large block of stock through inconspicuous buying over a period of weeks. Next he tried to enlist the stock’s specialist on the exchange floor as an ally. Through “wash-sales” (buy-sell-buy-sell between manager’s allies), the manager created the impression that something big was afoot. Now, tip-sheet writers and market commentators under the control of the pool manager would tell of exciting developments in the offing. The pool manager also tried to ensure that the flow of news from the company’s management was increasingly favorable – assuming the company management was involved in the operation. The combination of tape activity and managed news would bring the public in. Once the public came in, the free-for-all started and it was time discreetly to “pull the plug”. Because the public was doing the buying, the pool did the selling. The pool manager began feeding stock into the market, first slowly and then in larger and larger blocks before the public could collect its senses. At the end of the roller-coaster ride the pool members had netted large profits and the public was left holding the suddenly deflated stock.

3. On September 3, 1929, the market averages reached a peak that was not to be surpassed for a quarter of a century. The “endless chain of prosperity” was soon to break. On Oct 24 (“Black Thursday”), the market volume reached almost 13 million shares. Prices sometimes fell $5 and $10 on each trade. Tuesday, Oct 29, 1929, was among the most catastrophic days in the history of the NYSE. More than 16.4 million shares were traded on that day. Prices fell almost perpendicularly.

4. History teaches us that very sharp increases in stock prices are seldom followed by a gradual return to relative price stability.

5. It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part One 2: Stocks and Their Value

Chapter 1. Firm Foundations and Castles in the Air

I. What is a random walk?

1. A random walk is one in which future steps or directions cannot be predicted on the basis of past actions. When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted. Investment advisory services earnings predictions, and complicated chart patterns are useless.

2. Market professionals arm themselves against the academic onslaught with one of two techniques, called fundamental analysis and technical analysis. Academics parry these tactics by obfuscating the RANDOM WALK theory with three versions (the “weak”, the “semi-strong,” and the “strong”).

II. Investing as a way of life today

1. I view investing as a method of purchasing assets to gain profit in the form of reasonably predictable income (dividends, interest, or rentals) and/or appreciation over the long term. It is the definition of the time period for the investment return and the predictability of the returns that often distinguish an investment from a speculation.

2. Just to stay even, your investments have to produce a rate of return equal to inflation.

3. Even if you trust all your funds to an investment adviser or to a mutual fund, you still have to know which adviser or which fund is most suitable to handle your money.

4. Most important of all is the fact that investing is fun. It’s fun to pit your intellect against that of the vast investment community and to find yourself rewarded with an increase in assets.


III. Investing in theory

1. All investment returns are dependent, to varying degrees, on future events. Investing is a gamble whose success depends on an ability to predict the future.

Traditionally, the pros in the investment community have used one of two approaches to asset valuation: the firm foundation theory or the castle-in-the-air theory.

2. The Firm-foundation theory: each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected. The theory stresses that a stock’s value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends. It stands to reason that the greater the present dividends and their rate of increase, the greater the value the stock; thus, differences in growth rates are a major factor in stock valuation.

3. The castle-in-the-air theory: it concentrates on psychic values. John Maynard Keynes argued that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.

4. Keynes described the playing of the stock market in terms readily understandable: It is analogous to entering a newspaper beauty-judging contest in which one must select the six prettiest faces out of a hundred photographs, with the prize going to the person whose selections most nearly conform to those of the group as a whole. The smart player recognizes that personal criteria of beauty are irrelevant in determining the contest winner. A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. Thus, the optimal strategy is not to pick those faces the player thinks are prettiest, or those the other players are likely to fancy, but rather to predict what the average opinion is likely to be about what the average opinion will be, or to proceed even further along this sequence.

5. The newspaper-contest analogy represents the ultimate form of the castle-in-the-air theory. An investment is worth a certain price to a buyer because she expects to sell it to someone else at a higher price.

6. The castle-in-the-air theory has many advocates, in both the financial and the academic communities. Robert Shiller, in his best-selling book Irrational Exuberance, argues that the mania in Internet and high-tech stocks during the late 1990s can only be explained in terms of mass psychology.


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

A Random Walk Down Wall Street - Part One 1: Stocks and Their Value

Preface

1. Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds.

2. The basic thesis of the book: the market prices stocks so efficiently that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that performs as well as those managed by the experts.

3. Through the past 30 years, more than two-thirds of professional portfolio managers have been outperformed by the unmanaged S&P 500 Index.

4. One’s capacity for risk-bearing depends importantly upon ones’ age and ability to earn income from noninvestment sources. It is also the case that the risk involved in most investments decreases with the length of time the investment can be held. Thus, optimal investment strategies must be age-related. 


A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf

The great investors tend to focus on the process more than the actual outcome.

Over time, the great investors tend to focus on the process more than the actual outcome.

If you have a simple, proven, repeatable system with the relevant mental models, the results will ultimately take care of themselves.

Having a sound philosophy and method will allow you to focus on the components that matter most to an investor's success.

By following this long enough, you will develop everlasting habits and positive feedback loops as you compound on your knowledge of investing and the businesses around you.

The more you invest now and get to know the underlying businesses and the stock market, the better you will be at investing long term.

What determines the returns from stocks?

Very long-run returns from common stocks are driven by two critical factors:

1.  the dividend yield at the time of purchase, and,
2.  the future growth rate of earnings and dividends.

In principle, for the buyer who holds his or her stocks forever, a share of common stock is worth the "present" or "discounted" value of its stream of future dividends.

A stock buyer purchases an ownership interest in a business and hopes to receive a growing stream of dividends.

Even is a company pays very small dividends today and retains most (or even all) of its earnings to reinvest in the business, the investor implicitly assumes that such reinvestment will lead to:

1.  a more rapidly growing stream of dividends in the future or
2.  alternatively to greater earnings that can be used by the company to buy back its stock.

The discounted value of this stream of dividends (or funds returned to shareholders through stock buybacks) can be shown to produce a very simple formula for the long-run total return for either an individual stock or the market as a whole:

LONG-RUN EQUITY RETURN
= INITIAL DIVIDEND YIELD + GROWTH RATE




From 1926 until 2010:

Common stocks provided an average annual rate of return of about 9.8%.
DY for the market as a whole on Jan 1, 1926 was 5%.
The long-run rate of growth of earnings and dividends was also about 5%.
DY + Growth rate gives a close approximation of the actual rate of return.


Over shorter periods

Over shorter periods, such as a year or even several years, a third factor is critical in determining returns.
This factor is the change in valuation relationships, namely, the change in the price-dividend or price-earnings multiple.
[P/Div and P/E tend to move (increase or decrease) in the same direction.]


Ref: A Random Walk Down Wall Street

A Guided Tour of the Market 13

Utilities

[...] utilities that provide electric service dominate the ranks of the publicly traded companies in the utilities sector. The electric utility business can be divided into essentially three parts: generation, transmission, and distribution.

[...] regulation is perhaps the single most important factor shaping the utility sector.

Regulated utilities tend to have wide economic moats because they operate as monopolies, but it's important to keep in mind regulation does not allow these firms to parlay this advantage into excess returns. In addition, regulation can (and often does) change.

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

A Guided Tour of the Market 12

Energy

Although energy can be harvested from myriad sources – coal, nuclear, hydroelectric, wind, solar – nothing can come close to challenging the dominance of oil and gas as a source of energy.

The profitability of the energy sector is highly dependent on commodity prices. Commodity prices are cyclical, as are the sector's profits. It's better to buy when prices are at a cyclical low than when they're high and hitting the headlines.

Keep an eye on reserves and reserve growth because these are the hard assets the company will mine for future revenue.

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

A Guided Tour of the Market 11

Industrial Materials

The industrial materials sector includes a broad array of companies, which make everything from the fragrances used in soap to bulldozers and heat-seeking missiles. The general business model is simple: Industrial materials companies buy raw materials and facilities to produce the inputs and machinery that other firms use to meet their customers' expected demand for goods.

We divide industrial materials into two groups: (1) basic materials such as commodity steel, aluminium, and chemicals and (2) value-added goods such as electrical equipment, heavy machinery, and some specialty chemicals. The primary difference is that commodity producers have little or no influence on the price of the products they produce. Makers of value-added industrial materials, on the other hand, may be specialized enough or improve a customer's business enough for the manufacturer to share part of that benefit in the form of a premium price.

Although basic materials industries do have significant barriers to entry – the cost of constructing a new steel, aluminium, or paper processing plant is steep – stiff price competition makes for mediocre profits at best.

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

A Guided Tour of the Market 10

Consumer Goods

The consumer goods sector is composed of industries such as food, beverages, household and personal products, and tobacco. Like anything large and old, it also moves slowly: Consumer goods markets typically grow no faster than the gross domestic product and sometimes even slower. Despite this slow growth, consumer goods stocks tend to be solidly profitable, fairly steady performers, which can make them excellent long-term holdings for your portfolio.

Consumer goods companies generate profits the old-fashioned way: They make products and sell them to customers, usually supermarkets, mass merchandisers, warehouse clubs, and convenience stores.

The handful of giant firms that dominate each consumer goods industry enjoy such massive economies of scale that it would be virtually impossible for a small new entrant to catch up.

The networks that manufacturers use to get their products on to shelves in the stores can be another competitive advantage that is very difficult for competitors to replicate.

Companies with brands that hold dominant market share are likely to stay in that position because shifts in share tend to be fairly small from year to year. Thus, whoever is number one right now is likely to remain in that position over the next several years.

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

A Guided Tour of the Market 9

Telecom

The telecom sector is filled with the kinds of companies we love to hate: They earn mediocre (and declining) returns on capital, economic moats are nonexistent or deteriorating, their future depends on the whims of regulators, and they constantly spend boatloads of money just to stay in place. [...] Because telecom is fraught with risk, we typically look for a large margin of safety before considering any telecom stock.

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

A Guided Tour of the Market 8

Media

Media companies generate cash by producing or delivering a message to the public. The message, or content, can take several shapes, including video, audio, or print.

Companies that rely on one-time user fees sometimes suffer volatile cash flows because they're heavily affected by the success of numerous individual products, such as newly released films or novels. While having a string of hits can result in a bonanza for the firm, the converse is also true: Several flops in a row can lead to disaster. This uncertainty can make it difficult to forecast future cash flows.

Subscription-based businesses are generally more attractive than one-time user fee businesses because subscription revenue tends to be predictable, which makes forecasting and planning easier and reduces the risk of the business. There is another advantage to subscriptions: Subscribers pay upfront for services that are delivered at a later date.

Companies with advertising-based models can enjoy decent profit margins, which are often enhanced by high operating leverage. The reason for the high operating leverage is that most of the cost in an advertising-based model is fixed. [...] However, advertising revenue streams can be somewhat volatile – advertising is one of the first costs that company executives cut when the economy turns south, which is why advertising revenue growth tends to move with the business cycle.

Media firms enjoy a number of competitive advantages that help them generate consistent free cash flows, with economies of scale, monopolies, and unique intangible assets being the most prevalent. Economies of scale are especially important in publishing and broadcasting, whereas monopolies come into play in the cable and newspaper industries. Unique intangible assets such as licenses, trademarks, copyrights, and brand names are important across the sector.

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

A Guided Tour of the Market 7

Hardware

The environment in the hardware sector makes it fiendishly difficult to build a sustainable competitive advantage because technological advances and price competition mean that the lion's share of hardware's benefits are passed to consumers, not the company creating the products.

In the hardware industry, network effects can arise because hardware often needs (1) to operate with other hardware and (2) to be maintained by people. The more a certain product becomes prevalent, the more other hardware needs to take heed of the product's characteristics and the more people (and time) are invested in learning to operate the product.

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

A Guided Tour of the Market 6

Software

Because technology buyers are inherently conservative and loath to buy products from a vendor that might go out of business and leave them stranded for basic service, companies are increasingly buying only from industry leaders.

Like database software, the ERP market isn't growing very fast because most large companies already have some type of ERP system installed.

Often, companies that dominate a smaller niche are more attractive investments than household names that serve larger markets.

License revenue is the best indication of current demand because it represents how much new software was sold during a given time. It's a very profitable source of revenue because software can be produced for almost nothing after it has been developed. Service revenue, which is the other major type of revenue that many software firms report, is less profitable because it's expensive to employ consultants to install software.

The low barriers to entry of the software industry contrast with high barriers to success – it's easy to start up a software firm, but it's much more difficult to create one that's still around after several years. Thus, look for software companies that have thrived during multiple business cycles and have solid results during both the peaks and valleys of IT spending.

The software industry is highly cyclical, with sales hinging on economic conditions and IT spending. The problem is that in good times software companies thrive, and in bad times they're some of the hardest hit. The primary reason for this cyclicality is that many corporations view software as a discretionary purchase that can be deferred in tough times. In other words, when the economy and business suffer, cutting IT spending is a quick way to buffer profit declines.

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

A Guided Tour of the Market 5

Asset Management and Insurance

With huge margins and constant streams of fee income, asset managers are perennial profit machines. However, these companies are so tied to the markets that their stock prices often reflect oversized doses of the current optimism or pessimism prevailing in the economy, which means it pays off to take a contrarian approach when you're thinking about when to invest.

Asset management firms run money for their customers and demand a small chunk of the assets as a fee in return. This is lucrative work and requires very little capital investment. The real assets of the firm are its investment managers, so typically compensation is the firm's main expense. Even better, it doesn't take twice as many people to run twice as much money, so economies of scale are excellent.

The single biggest metric to watch for any company in this industry is assets under management (AUM), the sum of all the money that customers have entrusted to the firm. Because an asset manager derives its revenue as a percentage of assets under management, AUM is a good indication of how well – or how badly – a firm is doing.

Investors should look for asset management companies that are able to consistently bring in new money and don't rely only on the market to increase their AUM. Look for new inflows (inflows higher than outflows) in a variety of market conditions. This is a signal that the asset manager is offering products that new investors want and that existing investors are happy with the products they have.

Given the commodity-like products of the life insurance industry, it is next to impossible for one insurer to successfully grow – without acquisitions – above the industry's long-term annual revenue growth rate.

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

A Guided Tour of the Market 4

Banks

[...] the heart and soul of banking is centered on one thing: risk management. Banks accept three types of risk: (1) credit, (2) liquidity, and (3) interest rate, and they get paid to take on this risk.

One of the biggest challenges to investing in banks is spotting credit quality problems before they blow up in investors' faces. To help avoid getting stuck with a bank that blows up, investors should pay close attention to charge-off rates and delinquency rates, which are seen as an indicator of future charge-offs.

Beware of super-fast growth. It's an axiom in the financial services industry that fast growth can lead to big troubles. Fast growth is not always bad – many of the best players have above-average growth rates – but any financial services company that's growing significantly faster than competitors should be eyed with skepticism.

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

A Guided Tour of the Market 3

Business Services

Because the business services sector is so varied, we divide it into three major subsectors based on how companies set up their businesses to make money. Specifically, we look at technology-based, people-based, and hard-asset-based subsectors.

Outsourcing makes sense to many business owners because it usually saves time and money, removes the hassle of dealing with noncore tasks, and allows management to focus on what's really important to the success of their company.

In business services, size does indeed matter. Companies can leverage size to boost both their top and bottom lines. By expanding the range of services offered, companies can increase total revenue per customer. By handling more volume – especially over fixed-cost networks – companies can lower unit costs and achieve greater profitability.

Size impacts the industry through branding as well. Often, brands play a major role in a business outsourcing purchase decision.

In general, technology-based businesses [...] require huge initial investments to set up an infrastructure that can be leveraged across many customers. These huge investments are a barrier to entry for new competitors.

Another desirable characteristic of technology-based businesses is the low ongoing capital investment required to maintain their systems. For firms already in the industry, the huge upfront technology investments have already taken place.

As a result of the high barriers to entry into technology-based businesses and long-term customer contracts, firms in this subsector tend to have wide, defensible moats.

The people-based subsector includes companies that rely heavily on people to deliver their services, such as consultants and professional advisors, temporary staffing companies, and advertising agencies. Investments can be attractive at the right price, but the model is generally less attractive than that of the technology-based subsector.

Brands, longstanding relationships with customers, and geographic scope can provide some advantages relative to competitors. But within most people-based industries, there are usually multiple competitors with similar strengths in these areas, and they tend to compete aggressively with one another.

Companies in the hard-asset-based subsector depend on big investments in fixed assets to grow their businesses.

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

A Guided Tour of the Market 2

Consumer Services

The only way a retailer can earn a wide economic moat is by doing something that keeps consumers shopping at its stores rather than at competitors'. It can do this by offering unique products or low prices. The former method is tough to do on a large scale because unique products rarely remain unique forever.

Because many consumer purchases other than food are discretionary (can be put off for later), it's not surprising that retail stocks generally outperform during periods of economic strength and underperform during times of economic weakness.

Demographic shifts and changes in the workforce make the long-term outlook for restaurants pretty bright. Eating food prepared by restaurants is becoming a more attractive alternative to home meal preparation – with both parents working in many households, there's little time to cook and even less for grocery shopping and cleanup. The economics of meal preparation are shifting in favor of eating out as well because families are getting smaller.

One of the best ways to distinguish excellent retailers from average or below-average ones is to look at their cash conversion cycles. The cash cycle tells us how quickly a firm sells its goods (inventory), how fast it collects payments from customers for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables).

If days in inventory and days in receivables illustrate how well a retailer interacts with customers, days payable outstanding shows how well a retailer negotiates with suppliers. It's also a great gauge for the strength of a retailer.

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

A Guided Tour of the Market 1

Over the long haul, a big part of successful investing is building a mental database of companies and industries on which you can draw as the need arises.

Health Care

Health care firms benefit from consistent demand. Even when the economy is in the tank, people still get sick and need doctors and hospitals. As a result, the health care sector has traditionally been a defensive safe haven.

Health care companies often benefit from economic moats in the form of high start-up costs, patent protection, significant product differentiation, and economies of scale. This makes it tough for new players to enter the market, particularly for drug companies with valuable patent rights, managed care organizations with large provider networks, or medical device firms with long clinical track records. These characteristics make for great profitability [...].

Size is another barrier to entry for drug companies. Developing a single drug can take 15 to 20 years to get through the entire research, development, and regulatory process and can cost hundreds of millions over that time frame.

Brand name drugs enjoy patent protection for 20 years from the date the company first completes the patent application. However, because a patent application is usually filed as soon as a drug is identified and not when it hits the market, drugs rarely enjoy 20 years of monopoly profits because a significant portion of the protected period is eaten up by trials and the approval process. Many drugs enjoy only 8 to 10 years of patent protection after they are launched in the marketplace.

Generic drug makers can charge much less because they don't have to recoup the $800 million in per drug research and development costs.

If you're considering buying shares in a drug company that depends on a specific drug for a significant percentage of its sales, don't bank on the money continuing to come in after the patent expires.

Drugs that treat conditions affecting a large percentage of the population typically have better potential than niche products. So do drugs that treat chronic conditions, because patients must continue taking the medication to stay healthy.

It might sound strange to view megablockbuster drugs as a negative, but they can become a disadvantage. If a drug's revenues become a large enough piece of the pie, a company's fate can be linked too heavily to that drug. Because that drug will eventually lose its patent protection, we think it's wise for investors to account for the single-product risk by demanding a slightly larger margin of safety.

Although the best biotech companies can generate enormous free cash flow [...] most are too speculative for all but the most aggressive investors. Picking successful firms requires a bit of skill, some understanding of the science, and a lot of luck.

As with the other health care sectors, the aging population and increase in life expectancy will drive sales growth in medical devices.

In addition to their attractive growth characteristics, device companies also typically boast wide economic moats. Economies of scale, high switching costs, and long-term clinical histories all serve as high barriers to new entrants.

Device firms are not without risk. Product cycles can be very short, so companies must spend heavily on research and development to keep up with their competitors.

Insurance and managed care firms are subject to intense regulatory pressure and widespread litigation, making them somewhat less attractive than some other health care industries. They typically don't have wide economic moats.

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

The Five Rules for Successful Stock Investing 12

The 10-Minute Test

With literally thousands of companies available to invest in, one of the toughest challenges for any investor is figuring out which ones are worth detailed examination and which ones aren't.

Does the firm pass a minimum quality hurdle? Avoiding the junk that litters the investment landscape is the first step in our 10-minute test. Companies with miniscule market capitalizations and firms that trade on the bulletin boards (or pink sheets) are the first ones to rule out. Also avoid foreign firms that don't file regular financials with the SEC [...]. Finally, recent initial public offerings (IPOs) are usually not worth your time. Companies sell shares to the public only when they think they're getting a high price, so IPOs are rarely bargains. Moreover, most IPOs are young, unseasoned firms with short track records. The big exception to this rule is firms that are spun off from larger parent companies.

Has the company ever made an operating profit? This test sounds simple, but it'll keep you out of a lot of trouble. Very often, companies that are still in the money-losing stage sound the most exciting [...] Unfortunately, stocks like this will also blow up your portfolio more often than not. They usually have only a single product or service in the pipeline, and the eventual viability of the product or service will make or break the company.

Does the company generate consistent cash flow from operations? Fast-growing firms can sometimes report profits before they generate cash – but every company has to generate cash eventually. Companies with negative cash flow from operations will eventually have to seek additional financing by selling bonds or issuing more shares. The former will likely increase the riskiness of the firm, whereas the latter will dilute your ownership stake as a shareholder.

Are returns on equity consistently above 10 percent, with reasonable leverage? Use 10 percent as a minimum hurdle. If a nonfinancial firm can't post ROEs over 10 percent for four years out of every five, for example, odds are good that it's not worth your time. For financial firms, raise your ROE bar to 12 percent.

Is earnings growth consistent or erratic? The best companies post reasonably consistent growth rates. If a firm's earnings bounce all over the place, it's either in an extremely volatile industry or it's regularly getting shellacked by competitors.

How clean is the balance sheet? Firms with a lot of debt require extra care because their capital structures are often very complicated.

Does the firm generate free cash flow? [...] Generally, you should prefer firms that create free cash to ones that don't and firms that create more free cash to ones that create less. [...] The one exception – and it's a big one – is that it's fine for a firm to be generating negative free cash flow if it's investing that cash wisely in projects that are likely to pay off well in the future.

How much "other" is there? Companies can hide many bad decisions in supposedly one-time charges, so if a firm is already questionable on some other front and has a history of taking big charges, take a pass.

Has the number of shares outstanding increased markedly over the past several years? If so, the firm is either issuing new shares to buy other companies or granting numerous options to employees and executives. The former is a red flag because most acquisitions fail, and the latter is not something you want to see because it means that your ownership stake in the firm is slowly shrinking as employees exercise their options. [...] However, if the number of shares is actually shrinking, the company potentially gets a big gold star. Firms that buy back many shares are returning excess cash to shareholders, which is generally a responsible thing to do.

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

The Five Rules for Successful Stock Investing 11

Valuation – Intrinsic Value

The value of a stock is equal to the present value of its future cash flows.

Companies create economic value by investing capital and generating a return. Some of that return pays operating expenses, some gets reinvested in the business, and the rest is free cash flow. We care about free cash flow because that's the amount of money that could be taken out of the business each year without harming its operations. A firm can use free cash flow to benefit shareholders in a number of ways. It can pay a dividend, which essentially converts a portion of each investor's interest in the firm to cash. It can buy back stock, which reduces the number of shares outstanding and thus increases the percentage ownership of each shareholder. Or, the firm can retain the free cash flow and reinvest it in the business.

These free cash flows are what give the firm its investment value. A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than the money we receive today. Why are future cash flows worth less than current ones? First, money that we receive today can be invested to generate some kind of return, whereas we can't invest future cash flows until we receive them. This is the time value of money. Second, there's a chance we may never receive those future cash flows, and we need to be compensated for that risk, called the "risk premium".

Value is determined by the amount, timing, and riskiness of a firm's future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock.

[...] the present value of a future cash flow in year n equals CFn/(1 + discount rate)^n.

If you really want to succeed as an investor, you should seek to buy companies at a discount to your estimate of their intrinsic value. Any valuation and any analysis is subject to error, and we can minimize the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the margin of safety [...].

Putting It All Together

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