EBITDA: analytically flawed and resulted in the chronic overvaluation of businesses

Investors in public companies have historically evaluated them on reported earnings.

By contrast, private buyers of entire companies have valued them on free cash flow.



Historical

In the latter half of the 1980s, entire businesses were bought and sold almost as readily as securities, and it was not unreasonable for investors in securities to start thinking more like buyers and sellers of entire businesses.

In a radical departure from the historical norm, many stock and junk-bond buyers in the latter half of the 1980s replaced earnings with cash flow as the analytical measure of value.

In their haste to analyze free cash flow, investors in the 1980s sought a simple calculation, a single number, that would quantify a company's cash-generating ability.  The cash-flow calculation the great majority of investors settled upon was EBITDA.

Virtually all analyses of highly leveraged firms relied on EBITDA as a principal determinant of value, sometimes as the only determinant.  

Even non-leveraged firms came to be analysed in this way since virtually every company in the late 1980s was deemed a potential takeover candidate.  

Unfortunately EBITDA was analytically flawed and resulted in the chronic overvaluation of businesses.





How should cash flow be measured?

Before the junk-bond era investors looked at two components: 

• after tax earnings, (that is the profit of a business); plus 
• depreciation and amortization minus capital expenditures (that is, the net investment or disinvestment in the fixed assets of a business.)

The availability of large amounts of non-recourse financing changed things.  

Since interest expense is tax deductible, pretax, not after-tax, earnings are available to pay interest on debt; money that would have gone to pay taxes goes instead to lenders. 

A highly leveraged company thus has more available cash flow than the same business utilizing less leverage.


Notwithstanding, EBIT is not necessarily all freely available cash.

• If interest expense consumes all of EBIT, no income taxes are owed.
• If interest expense is low, however, taxes consume an appreciable portion of EBIT.

At the height of the junk-bond boom, companies could borrow an amount so great that all of EBIT (or more than all of EBIT) was frequently required for paying interest.  

In a less frothy lending environment companies cannot become so highly leveraged at will. 

• EBIT is therefore not a reasonable approximation of cash flow for them.  
• After-tax income plus that portion of EBIT going to pay interest expense is a company's true cash flow derived from the ongoing income stream.

Depreciation

Cash flow, also results from the excess of depreciation and amortization expenses over capital expenditures.  It is important to understand why this is so. 

• When a company buys a machine, it is required under GAAP to expense that machine over its useful life, a procedure known in accounting as depreciation.  
• Depreciation is a noncash expense that reduces net reported profits but not cash.  
• Depreciation allowances contribute to cash but must eventually be used to fund capital expenditures that are necessary to replace worn out plant and equipment.  
• Capital expenditures are thus a direct offset to depreciation allowances; the former is as certain a use of cash as the latter is a source.  

The timing may differ: a company may invest heavily in plant and equipment at one point and afterward generate depreciation allowances well in excess of current capital spending. 

• Whenever the plant and equipment need to be replaced, however cash must be available.  
• If capital spending is less than depreciation over a long period of time, a company is undergoing gradual liquidation.

Amortization

Amortization of goodwill is also a noncash charge but,conversely, is more of an accounting fiction than a real business expense. 

When a company is purchased for more than its tangible book value, accounting rules require the buyer to create an intangible balance-sheet asset known as goodwill to make up for the difference, and then to amortize that goodwill over forty years. 

• Amortization of goodwill is thus a charge that does not necessarily reflect a real decline in economic value and that likely need not be spent in the future to preserve the business. 
• Charges for goodwill amortization usually do represent free cash flow.

Why was EBITDA used?

It is not clear why investors suddenly came to accept EBITDA as a measure of corporate cash flow. 

• EBIT did not accurately measure the cash flow from a company's ongoing income stream.  
• Adding back 100% of depreciation and amortization to arrive at EBITDA rendered it even less meaningful.  

Those who used EBITDA as a cash-flow proxy, for example, either ignored capital expenditures or assumed that businesses would not make any, perhaps believing that plant and equipment do not wear out.  

• In fact, many leveraged takeovers of the 1980s forecast steadily rising cash flows resulting partly from anticipate sharp reductions in capital expenditures.  
• Yet the reality is that if adequate capital expenditures are not made, a corporation is extremely unlikely to enjoy a steadily increasing cash flow and will instead almost certainly face declining results.

What is the required level of capital expenditure for a given business?

It is not easy to determine the required level of capital expenditures for a given business.  Businesses invest in physical plant and equipment for many reasons: 

• to remain in business, 
• to compete, 
• to grow and 
• to diversify.  

Expenditures to stay in business and to compete are absolutely necessary. 

Capital expenditures required for growth are important but not usually essential.

Capital expenditures made for diversification are often not necessary at all.  

Identifying the necessary expenditures requires intimate knowledge of a company, information typically available only to insiders.  

Since detailed capital-spending information are not readily available to investors, perhaps they simply chose to disregard it.

EBITDA by ignoring capital expenditures is flawed

Some analysts and investors adopted the view that it was not necessary to subtract capital expenditures from EBITDA because ALL the capital expenditures of a business could be financed externally (through lease financing, equipment trusts, nonrecourse debt, etc.). 

• One hundred percent of EBITDA would thus be free pretax cash flow available to service debt; no money would be required for reinvestment int he business.  

This view was flawed, of course. 

• Leasehold improvements and parts of a machine are not typically financeable for any company.  
• Companies experiencing financial distress, moreover, will have limited access to external financing for any purpose.   
• An over-leveraged company that has spent its depreciation allowances on debt service may be unable to replace worn-out plant and equipment and eventually be forced into bankruptcy or liquidation.

EBITDA:  a clear case of circular reasoning to justify high takeover prices

EBITDA may have been used as a valuation tool because no other valuation method could have justified the high takeover prices prevalent at the time. 

This would be a clear case of circular reasoning. 

• Without high-priced takeovers there we no upfront investment banking fees, no underwriting fees on new junk-bond issues, and no management fees on junk-bond portfolios.  
• This would not be the first time on Wall Street that the means we adapted to justify an end.  
• If a historically accepted investment yardstick proves to be overly restrictive, the path of least resistance is to invent a new standard.

Reflexivity: How stock prices can influence underlying values?

The Reflexive Relationship Between Market Price and Underlying Value

A complicating factor in securities analysis is the reflexive or reciprocal relationship between security prices and the values of the underlying businesses.

In The Alchemy of Finance, George Soros stated,
"Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values."  

In other words, Soros's theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business.  

Investors must not lose sight of this possibility.



Examples:

1.   Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital.  When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. 

• If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy.  The stock market says there is no problem, so there is no problem.   
• Example:  A company stock traded in the teens and the company was able to find buyers for newly issued securities.  If its stock price had been in the low single digits, however, it would have been unable to raise additional equity capital, which could have resulted in its eventual failure.  
• This is another, albeit negative form of self-fulfilling prophecy, whereby the financial markets' perception of the viability of a business influences the outcome.

2.   Another form of reflexivity exists when the managers of a business accept its securities' prices, rather than business fundamentals, as the determining factor in valuation.  

• If the management of a company with an undervalued stock believes that the depressed market price is an accurate reflection of value, they may take actions that prove the market right.  
• Stock could be issued in a secondary offering or merger, for example, at a price so low that it significantly dilutes the value of existing shares.

3.   As another example of reflexivity, the success of a reorganization plan for a bankrupt company may depend on certain values being realized by creditors. 

• If the financial markets are depressed at the time of reorganization, it could be difficult, perhaps impossible, to generate agreed values for creditors if those values depend on the estimated market prices of debt and equity securities in the reorganized company.  
• In circular fashion, this could serve to depress even further the prices of securities in this bankrupt company.

4.   The same holds true for a highly leveraged company with an upcoming debt maturity.  

• If the market deems a company creditworthy, the company will be able to refinance and fulfill the prophecy.  
• If the market votes thumbs down on the credit, however, that prophecy will also be fulfilled since the company will then fail to meet its obligations.

Conclusion:

Reflexivity is a minor factor in the valuation of most securities most of the time, but occasionally it becomes important. 

This phenomenon is a wild card, a valuation factor not determined by business fundamentals but rather by financial market themselves.

Risk and Return: Risk does not create incremental return, only Price can

While most other investors are preoccupied with how much money they can make and not at all with how much they may lose, value investors focus on risk as well as return.




Most investors seem confused about risk.

Some insist that risk and return are ALWAYS positively correlated, the greater the risk, the greater the return.  This is in fact, a basic tenet of the capital-asset-pricing model taught in nearly all business schools, yet it is not always true.

Others mistakenly equate risk with volatility, emphasizing the "risk" of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments.

A positive correlation between risk and return would hold consistently only in an efficient market.

• Any disparities would be immediately corrected; this is what would make the market efficient.  

In inefficient markets it is possible to find investments offering high returns with low risk.  These arise

• when information is not widely available, 
• when an investment is particularly complicated to analyze, or 
• when investors buy and sell for reasons unrelated to value.  

It is also common place to discover high risk investments offering low returns.  

• Overpriced and therefore risky investments are often available because the financial markets are biased toward overvaluation and because it is difficult for market forces to correct an overvalued condition if enough speculators persist in overpaying.  
• Also, unscrupulous operators will always make overpriced investments available to anyone willing to buy; they are not legally required to sell at a fair price.

Risk and return must be assessed independently for every investment.

Since the financial markets are inefficient a good deal of the time, investors cannot simply select a level of risk and be confident that it will be reflected in the accompanying returns.  

Risk and return must instead be assessed independently for every investment.

In point of fact, greater risk does not guarantee greater return.

• To the contrary, risk erodes return by causing losses.  
• It is only when investor shun high-risk investments, thereby depressing their prices, that an incremental return can be earned which more than fully compensates for the risk incurred.  

By itself risk does not create incremental return, only price can accomplish that.  

Value Pretenders

A broad range of strategies make use of value investing as a pseudonym.  Many have little or nothing to do with the philosophy of investing originally espoused by Graham.

The long-term success of true value investors such as Buffett at Berkshire Hathaway and others, attracted a great many "value pretenders," investment chameleons who frequently change strategies in order to attract funds to manage.

• These value pretenders are not true value investors, disciplined craftspeople who understand and accept the wisdom of the value approach.  
• Rather they are charlatans who violate the conservative dictates of value investing, using inflated business valuations, overpaying for securities, and failing to achieve a margin of safety for their clients.

These investors, despite (or perhaps as a direct result of ) their imprudence, are able to achieve good investment results in times of rising markets.

• During the latter half of the 1980s, value pretenders gained widespread acceptance, earning high, even spectacular returns.  
• Many of them benefited from the overstated private-market values that were prevalent during those years; when business valuations returned to historical levels in 1990-, however, most value pretenders suffered substantial losses.

To some extent, value like beauty, is in the eye of the beholder; virtually any security may appear to be a bargain to someone.  

• It is hard to prove an overly optimistic investor wrong in the short run since value is not precisely measurable and since stocks can remain overvalued for a long time.  
• Accordingly, the buyer of virtually any security can claim to be a value investor at least for a while.

Many true value investors fell into disfavour during the late 1980s.  

• As they avoided participating in the fully valued and overvalued securities that the value pretenders claimed to be bargains, many of them temporarily underperformed the results achieved by the value pretenders.  
• The most conservative were actually criticized for their "excessive" caution, prudence that proved well founded in 1990.

Even today, many of the value pretenders have not been defrocked of their value-investor mantle.

Value Investing is Predicated on the Efficient Market Hypothesis being Wrong.

Value investing:  there is recurrent mis-pricing of securities

Investors should understand not only what value investing is but also why it is a successful investment philosophy.

At the very core of its success is the recurrent mis-pricing of securities in the marketplace.  

Value investing is, in effect, predicated on the proposition that the efficient-market hypothesis is frequently wrong. 

• If, on the one hand, securities can become undervalued or overvalued, which I believe to be incontrovertibly true, investors will thrive.  
• If, on the other hand, all securities at some future date become fairly and efficiently priced, value investors will have nothing to do.  

It is important, then, to consider whether or not the financial markets are efficient.




The efficient market hypothesis takes three forms.  

• The weak form maintains that past stock prices provide no useful information on the future direction of stock prices.  In other words, technical analysis (analysis of past price fluctuations) cannot help investors.  
• The semi-strong form says that NO published information will help investors to select undervalued securities since the market has already discounted all publicly available information into securities prices.  
• The strong form maintains that there is no information, public or private, that would benefit investors.  

Implication of efficient market hypothesis

Of the three forms of the efficient market hypothesis, I believe that only the weak form is valid.  Technical analysis is indeed a waste of time.

As to the other forms:  yes, the market does tend to incorporate new information into prices - securities prices are neither random nor do they totally ignore available information - yet the market is far from efficient.

The implication of both the semi-strong and strong forms is that fundamental analysis is useless.  Investors might just as well select stocks at random.



Investors applying disciplined analysis can identify inefficiently priced securities and achieve superior returns while taking below-average risks.

There is simply no question that investors applying disciplined analysis can identify inefficiently priced securities, buy and sell accordingly, and achieve superior returns. 

Specifically by finding securities whose prices depart appreciably from underlying value, investors can frequently achieve above-average returns while taking below-average risks. 

The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks, distressed bonds, and other less-popular investment fare.

While hundreds of investment analysts follow IBM, few, if any, cover thousands of small-capitalization stocks and obscure junk bonds.  Investors are more likely, therefore, to find inefficiently priced securities outside the Standard and Poor's 100 than within it.

Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, thereby creating pricing inefficiencies.




Efficient-market theory is at odds with the reality of how the financial markets operate.

Is it reasonable to expect that in the future some securities will continue to be significantly mispriced from time to time?

I believe it is.

The elegance of the efficient-market theory is at odds with the reality of how the financial markets operate.




Buffett's "The Superinvestors of Graham and Doddsville"

If the markets were efficient, then how could so many investors, identifiable by Buffett years ago as sharing a common philosophy but having little overlap in their portfolios, all have done so well?

Buffett's "The Superinvestors of Graham and Doddsville" demonstrates how nine value investment disciples of Benjamin Graham, holding varied and independent portfolios, achieved phenomenal investment success over long periods. 

His view is that the only thing the many value investors have in common is a philosophy that dictates the purchase of securities at a discount from underlying value.

 The existence of so many independent successes is so inconsistent with the efficient-market theory.

The Merits of Bottom-Up Investing

Top-down approach

Many professional investors employ a top-down approach.  This involves making a prediction about the future, ascertaining its investment implications, and then acting upon them.

• This approach is difficult and risky, being vulnerable to error at every step.  
• Practitioners need to accurately forecast macroeconomic conditions and then correctly interpret their impact on various sectors of the overall economy, on particular industries, and finally on specific companies. 
• It is also essential for top-down investors to perform this exercise quickly as well as accurately, or others may get there first and, through their buying or selling, cause prices to reflect the forecast macroeconomic developments, thereby eliminating the profit potential for latecomers.

By way of example, a top-down investor must be

• correct on the big picture, 
• correct in drawing conclusions from that, 
• correct in applying those conclusions to attractive areas of investment, 
• correct in the specific securities purchased and 
• finally, be early in buying these securities.

The top-down investor thus faces the daunting task of predicting the unpredictable more accurately and faster than thousands of other bright people, all of them trying to do the same thing.

• It is not clear whether top-down investing is a greater-fool game, in which you win only when someone else overpays, or a greater-genius game, winnable at best only by those few who regularly possess superior insight.  
• In either case, it is not an attractive game for risk-averse investors.

There is no margin of safety in top-down investing. 

• Top-down investors are not buying based on value; they are buying based on a concept, theme, or trend.  
• There is no definable limit to the price they should pay, since value is not part of their purchase decision.  
• It is not even clear whether top-down-oriented buyers are investors or speculators.  If they buy shares in businesses that they truly believe will do well in the future, they are investing.  If they buy what they believe others will soon be buying, they may actually be speculating.

Another difficulty with a top-down approach is gauging the level of expectations already reflected in a company's current share price. 

• If you expect a business to grow 10% a year based on your top-down forecast and buy its stock betting on that growth, you could lose money if the market price reflects investor expectations of 15% growth but a lower rate is achieved.  
• The expectations of others must therefore be considered as part of any top-down investment decision.

Bottom-up strategy

By contrast, value investing employs a bottom-up strategy by which individual investment opportunities are identified one at a time through fundamental analysis. 

Value investors search for bargains security by security, analysing each situation on its own merits.

An investor's top-down views are considered only in so far as they affect the valuation of securities.




A bottom-up strategy is in many ways simpler to implement than a top-down one.

• While a top-down investor must make several accurate predictions in a row, a bottom-up investor is not in the forecasting business at all.  
• The entire strategy can be concisely described as "buy a bargain and wait."   
• Investors must learn to assess value in order to know a bargain when they see one.  
• Then they must exhibit the patience and discipline to wait until a bargain emerges from their searches and buy it, regardless of the prevailing direction of the market or their own views about the economy at large.

Differences between Bottom-up and Top-down investors


One significant and not necessarily obvious difference between a bottom-up and top-down strategy is the reason for maintaining cash balances at times. 

• Bottom-up investors hold cash when they are unable to find attractive investment opportunities and put cash to work when such opportunities appear.  
• A bottom-up investor chooses to be fully invested only when a diversified portfolio of attractive investments is available.
• Top-down investors, by contrast, may attempt to time the market, something bottom-up investors do not do.  
• Market timing involves making a judgment about the overall market direction; when top-down investors believe the the market will decline, they sell stocks to hold cash, awaiting a more bullish opinion.

Another difference between the two approaches is that bottom-up investors are able to identify simply and precisely what they are betting on.  The uncertainties they face are limited:

• what is the underlying business worth; 
• will that underlying value endure until shareholders can benefit from its realization; 
• what is the likelihood that the gap between price and value will narrow; and, 
• given the current market price, what is the potential risk and reward?

Bottom-up investors can easily determine when the original reason for making an investment ceases to be valid. 

A disciplined investor can reevaluate the situation and, if appropriate, sell the investment: 

• when the underlying value changes, 
• when management reveals itself to be incompetent or corrupt or 
• when the price appreciates to more fully reflect underlying business value.   

Huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid.  

In investing it is never wrong to change your mind.  It is only wrong to change your mind and do nothing about it.

Top-down investors, by contrast, may find it difficult to know when their bet is no longer valid. 

• If you invest based on a judgement that interest rates will decline but they rise instead, how and when do you decide that you were wrong?  
• Your bet may eventually prove correct, but then again it may not.  
• Unlike judgements  about value that can easily be reaffirmed, the possible grounds for reversing an investment decision that was  made based upon a top-down prediction of the future are simply not clear.  

Three central elements to a value-investment philosophy.

There are three central elements to a value-investment philosophy.

• First, value investing is a bottom-up strategy entailing the identification of specific undervalued investment opportunities.
• Second, value investing is absolute-performance, not relative-performance oriented.
• Finally, value investing is a risk-averse approach; attention is paid as much to what can go wrong (risk) as to what can go right (return).

Value investing is simple to understand but difficult to implement.

Value investors are not super-sophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value.


The hard part is

• discipline, 
• patience and 
• judgment.  

Investors need

• discipline to avoid the many unattractive pitches that are thrown, 
• patience to wait for the right pitch, and 
• judgement to know when it is time to swing.

Value Investing Shines in a Declining Market

Who's swimming naked?

When the overall market is strong, the rising tide lifts most ships.

Profitable investments are easy to come by, mistakes are not costly, and high risks seem to pay off, making them seem reasonable in retrospect.

As the saying goes, "You can't tell who's swimming naked till the tide goes out."



Torpedo stocks

A market downturn is the true test of an investment philosophy. 

Securities that have performed well in a strong market are usually those for which investors have had the highest expectations.

When these expectations are not realized, the securities, which typically have no margin of safety, can plummet.

Stocks that fit this description are sometimes referred to as "torpedo stocks," a term that describes the disastrous effect owning them. 

For example, the previous share price of a company had reflected investor expectations of high earnings growth.  When the company subsequently announced a decline in first-quarter earnings, the stock was torpedoed.



Securities owned by value investors are often unheralded or just ignored.

The securities owned by value investors are not buoyed by such high expectations.  To the contrary, they are usually unheralded or just ignored. 

In depressed financial markets, it is said, some securities are so out of favour that you cannot give them away.

Some stocks sell below net working capital per share and a few sell at less than net cash (cash on hand less all debt) per share; many stocks trade at an unusually low multiple of current earnings and cash flow and at a significant discount to book value.



A notable feature of value investing is its strong performance in periods of overall market decline. 

Whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's margin of safety is high.

Stock and bond prices may anticipate continued poor business results, yet securities priced to reflect those depressed fundamentals may have little room to fall further. 

Moreover, securities priced as if nothing could go right stand to benefit from a change in perception.  

• If investors refocused on the strengths rather than on the difficulties, higher security prices would result.  
• When fundamentals do improve, investors could benefit both from better results and from an increased multiple applied to them. 
• The higher multiple reflected a change in investor psychology more than any fundamental developments at the company.

What is an appropriate margin of safety?

Even among value investors, there is ongoing disagreement concerning the appropriate margin of safety.



Some highly successful investors increasingly recognize the value of intangible assets.

Some highly successful investors, including Buffett, have come increasingly to recognize the value of intangible assets - broadcast licenses or soft-drink formulas, for example - which have a history of growing in value without any investment being required to maintain them.  Virtually all cash flow generated is free cash flow.



The problem with intangible assets, is that they hold little or no margin of safety. 

The most valuable assets of Dr Pepper/Seven-Up, Inc., by way of example, are the formulas that give those soft drinks their distinctive flavours.  It is these intangible assets that cause Dr Pepper/Seven-Up, Inc., to be valued at a high multiple of tangible book value.  If something goes wrong - tastes change or a competitor makes inroads - the margin of safety is quite low.



Tangible assets, by contrast, are more precisely valued and therefore provide investors with greater protection from loss.  

Tangible assets usually have value in alternate uses, thereby providing a margin of safety.  If a chain of retail stores becomes unprofitable, for example, the inventories can be liquidated, receivables collected, leases transferred, and real estate sold.  If consumers lose their taste for Dr Pepper, by contrast, tangible assets will not meaningfully cushion investors' losses.

The Importance of a Margin of Safety

Benjamin Graham has no interest in paying $1 for $1 of value; only interested in buying at a substantial discount from underlying value.

Benjamin Graham understood that an asset or business worth $1 today could be worth 75 cents or $1.25 in the near future.

He also understood that he might even be wrong about today's value.

Therefore Graham had no interest in paying $1 for $1 of value.  There was no advantage in doing so, and losses could result.

Graham was only interested in buying at a substantial discount from underlying value.

By investing at a discount, he knew that he was unlikely to experience losses.

The discount provided a margin of safety.



Investors need a margin of safety

Because investing is as much an art as a science, investors need a margin of safety.

A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for 

• human error, 
• bad luck, or 
• extreme volatility 

in a complex, unpredictable, and rapidly changing world. 

According to Graham, "The margin of safety is always dependent on the price paid.  For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price."

Buffett described the margin of safety concept in terms of tolerances:  "When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it.  And that same principle works in investing."



What is the requisite margin of safety for an investor? 

The answer can vary from one investor tot he next.

• How much bad luck are you willing and able to tolerate?  
• How much volatility in business values can you absorb?  
• What is your tolerance for error?  

It comes down to how much you can afford to lose.

Most investors do not seek a margin of safety in their holdings.

Institutional investors who buy stocks as pieces of paper to be traded and who remain fully invested at all times fail to achieve a margin of safety.

Greedy individual investors who follow market trends and fads are in the same boat.

The only margin investors who purchase Wall Street under-writings or financial-market innovations usually experience is a margin of peril.  

Should investors worry about the possibility that business value may decline?

1.  Should investors worry about the possibility that business value may decline? 

Absolutely.



2.  Should they do anything about it? 

There are three responses that might be effective.

• First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.
• Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions.  This means that normally selective investors would probably let even more pitches than usual go by.
• Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value.  In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all.  If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

What is a relative-performance orientation?

Relative performance involves measuring investment results, not against an absolute standard, but against broad stock market indices, such as the Dow Jones Industrial Average or Standard & Poor's 500 Index, or against other investors' results.

Most institutional investors measure their success or failure in terms of relative performance.

Money managers motivated to outperform an index or a peer group of managers may lose sight of whether their investments are attractive or even sensible in an absolute sense.



Who is to blame for this short-term investment focus? 

Is it the fault of managers who believe clients want good short-term performance regardless of the level of risk or the impossibility of the task? 

Or is it the fault of clients who, in fact, do switch money managers with some frequency? 

There is ample blame for both to share.



There are NO winners in the short-term, relative-performance derby. 

Attempting to outperform the market in the short run is futile since near-term stock and bond price fluctuations are random and because an extraordinary amount of energy and talent is already being applied to that objective. 

The effort only distracts a money manager from finding and acting on sound long-term opportunities as he or she channels resources into what is essentially an unwinnable game. 

• As a result, the clients experience mediocre performance.  
• The overall economy is also deprived, as funds are allocated to short-term trading rather than long-term investments.  
• Only brokers benefit from the high level of activity.

Institutional investors should strive to achieve good absolute returns.

Institutional investment process should focus on maximizing returns under reasonable risk constraints.  

If more institutional investors strove to achieve good absolute rather than relative returns, the stock market would be less prone to overvaluation and market fads would less likely be carried to excess.  Investments would only be made when they presented a compelling opportunity and not simply to keep up with the herd.

Investment success requires an appropriate mind-set

Investing is a serious business, not entertainment.

If you participate in the financial markets at all, it is crucial to do so as an investor, not as a speculator, and to be certain that you understand the difference.

Investors must be able to distinguish Pepsico from Picasso, and understand the difference between an investment and a collectible (speculation).

When your hard-earned savings and future financial security are at stake, the cost of not distinguishing is unacceptably high.

Investments and Speculations: Similarities and One critical difference.

Financial-market participants can be divided into two groups,

• investors and 
• speculators.

Similarly, assets and securities can often be characterised as either

• investments or 
• speculations.

Both typically fluctuate in price and thus appear to generate investment returns.

But there is one critical difference:

Investments throw off cash flow for the benefit of the owners; speculations do not.

The return to the owners of speculations depends EXCLUSIVELY on the vagaries of the RESALE MARKET.



Examples:

Investments, even very long-term investments, will eventually throw off cash flow:

• A machine makes widgets
• A building is occupied by tenants who pay rent
• Trees on a timber property are eventually harvested and sold.

By contrast, speculations, like collectibles, throw off no cash flow; the only cash they generate is from their eventually sale.  

• The future buyer is likewise dependent on his or her own prospects for resale.
• The value of collectibles, therefore, fluctuates solely with supply and demand.  
• Collectibles have not historically been recognized as stores of value, thus their prices depend on the vagaries of taste, which are certainly subject to change.
• The apparent value of collectibles is based on circular reasoning: people buy because others have recently bought.  This has the effect of bidding up prices, which attracts publicity and creates the illusion of attractive returns.  Such logic can fail at any time.

Earning Power

It is properly defined as a rate of earnings which is considered as "normal," or reasonably probable, for the company or particular security.

It should be based both upon the past record, and upon a reasonable assurance that the future will not be vastly different from the past. 

Hence companies with highly variable records or especially uncertain futures may not logically be thought of as having a well defined earning power.

However, the term is often loosely used to refer to the average earnings over any given period, or even to the current earnings rate.


Benjamin Graham



Comment:

Invest for the long term earning power of the company to give you compounded returns over many years.

Total Assets and Total Liabilities

The totals of assets and liabilities appearing on the balance sheet supply only a rough indication of the size of the company.   Balance sheet totals may be readily inflated by excessive values set upon intangibles, and in many cases also the fixed assets are arrived at a highly exaggerated figure.

On the other hand, we find that in the majority of strong companies, the good will which constitutes one of their most important assets either does not appear upon the balance sheet at all or is given but a nominal valuation (usually $1).  There was once a practice of writing down the fixed assets, or plant account, to virtually nothing in order to save depreciation charges.  Hence it is a common occurrence to find that the true value of a company's assets is entirely  different from the balance sheet total. 

The size of a company may be measured in terms either of its assets or of its sales.  In both cases, the significance of the figure is entirely relative, and must be judged against the background of the industry.  The assets of a small railroad will exceed those of a good sized department store. 

From the investment standpoint - especially that of a buyer of high-grade bonds or preferred stocks - it may be well to attach considerable importance to large size.  This would be true particularly in the case of industrial companies, for in this field the smaller enterprise is more subject to sudden adversity than is likely in a railroad or public utility. 

Where the purchase is made for speculative profit, or long-term capital gains, it is not so essential to insist upon dominant size, for there are countless examples of smaller companies prospering more than large ones.  After all, the large companies themselves presented the best speculative opportunities while they were still comparatively small.


Benjamin Graham

Balance Sheets in General

A balance sheet shows how a company stands at a given moment.  There is no such thing as a balance sheet covering the year 2018; it can only be for a single date, for example, 31st December, 2018.

A single balance sheet may give some indications as to the company's past, but this may be studied intelligently only in the income accounts and by a comparison of successive balance sheets.

A balance sheet attempts to show how much a corporation has and how much it owes.  What it has is shown on the asset side; what it owes is shown on the liability side.

The assets consist of the physical properties of the company, money it holds or has invested, and money that is owed to the company.  Sometimes, there are also intangible assets, such as good-will, which are frequently given an arbitrary value.  The sum of these items makes up the total assets of the company, shown at the bottom of the balance sheet.

On the liability side are shown not only the debts of the company, but also reserves of various kinds and the equity or ownership interest of the stockholders.  Debts incurred in the ordinary course of business appear as accounts payable.  More formal borrowings are listed as bonds or notes outstanding.  Reserves, may sometimes be equivalent to debt, but frequently they are of a different character.

The stockholders' interest is shown on the liability side as Capital and Surplus.  It is often said that these items appear as liabilities because they stand for money owed by the corporation to its stockholders.  It may be better to consider the stockholders' interest as representing merely the difference between assets and liabilities, and that it is placed on the liability side for convenience to make the two sides balance.

The total assets and the total liabilities are thus, always equal on a balance sheet, because the capital and surplus items are worked out at whatever figure is needed to make the two sides balance.



Also read:

The Reserves of a company is purely a paper entry.

https://myinvestingnotes.blogspot.com/2009/10/in-order-to-provide-bonus-issue.html

Accounting, the language of business.

Whether you are a disciple of Ben Graham, a value investor, or a growth or momentum investor, you can agree that a stock;s price must relate to its financials.

From time to time investors ignore basic numbers like book value, cash flow, interest, and various ratios that fundamentally value common stock.  It is especially common during periods of exuberance or fear that investors depart from the fundamental methods of successful investing.

A sound understanding of how to read the basic financials should keep investors focused and thereby avoid costly mistakes, and also helps to uncover hidden values of the stock market.

Ben Graham's principle of always returning to the financial statements will keep an investor from making huge mistakes, and without huge mistakes the power of compounding can take over.

Concept of Interest Coverage is akin to Concept of Margin of Safety

INTEREST COVERAGE

Interest Coverage:  This is the number of times that interest charges are earned, found by dividing the (total) fixed charges into the earnings available for such charges (either before or after deducting income taxes).

Interest Coverage
=  Earnings (before or after income tax) / total interest charges



MARGIN OF SAFETY

Margin of Safety, in general, is the same as "interest coverage."

Formerly used in a special sense, to mean the ratio of the balance after interest, to the earnings available for interest.

Margin of Safety
= Balance of earnings after interest / Earnings available for interest.

For example:

Interest  $100
Earnings  $175

Interest cover $175/$100 = 1.75x
Balance after interest = $175 - $100 = $75

The margin of safety (in this special sense) becomes
= $75 / $175
= 42.86%

Understand the Intrinsic Value

Intrinsic Value is the "real value" behind a security issues, as contrasted with its market price. 

Generally a rather indefinite concept; but sometimes the balance sheet and earnings record supply dependable evidence that the intrinsic value is substantially higher or lower than the market price.


Benjamin Graham

iCapital.Biz Berhad price chart since listing

iCapital.biz performance over the last 14 years

iCapital.biz was listed at the end of 2005 with a NAV of around RM 1.00.

On 24th October, 2019, its NAV was RM 3.21 and its share price on 25th October, 2019 was 2.42 per share.

Over the last 14 years, it gave 1 dividend of 9 sen per share.

Over the course of the last 14 years your investment in icapital.biz grew from $1.00 to $3.30, its compound annual growth rate, or its overall return, is 8.90%.


Share price fluctuations of iCapital.biz over the last 14 years

iCapital.biz traded at a premium to its NAV in its early years of listing. It was trading at high price of RM 2.48 in the early days of January 2008.

Its price crashed with the Global Financial Crisis. The premium to its NAV disappeared and it was trading at a huge discount to its NAV when its share price crashed to 1.06 in October 2009.

Since then, its share price has climbed upwards steadily over the years and always trading at a discount to its NAV.

On 25.10.2019, icapital.biz is priced at RM 2.42 per share.



So, who are the winners or losers in this stock?

The initial shareholders who hold onto to their shares until today from listing are obvious winners.

The buyers of this stock in and around January 2008 were obvious losers. They would have bought at very high prices and at huge premium to its NAV too.

However, for those who held onto this stock even when bought in January 2008 for the long term and who continued with a dollar cost averaging strategy over the years, they might still be winners overall.  This requires discipline and a firm investing philosophy.

Those who bought into icapital.biz from October 2008 when its price was the lowest and at any time subsequently and held till today are also winners, provided they bought below 2.42 per share.

Yes, there are obvious winners in this stock but they have to be in this stock long term and have done continuous buying of the stock over time (dollar cost averaging) when the price was obviously not too high.



Are there more winners or losers in this stock?

I believe the majority of players in the stock market are short-term traders. As traders, they are in at the time when the stock enjoys some popularity and they are out when the stock appears disfavoured. 

Thus, they are likely to be in the stock at the time when the prices were high and out when the prices dropped; they bought high and sold low.

I think icapital.biz is no different from other stocks in the Bursa. Though over the long term, icapital.biz has delivered positive returns, for those who have bought and sold icapital.biz stocks over the years, on an aggregate, there were more losers than winners.


The risk in investing is not the stock.  It is the person staring back at you in the mirror:  YOURSELF.




Suggested further reading:
https://myinvestingnotes.blogspot.com/2019/04/the-party-effect-or-recency-bias.html
No One is Immune from The Party Effect or Recency Bias

Some Ideas on Managing Portfolios

Portfolio management is more than the sum of the purchase of attractive stocks.

Here is a view on the overall lines of action on managing portfolio:

• The first step (optional) involves trying to acquire some idea about where we are in the cycle.
• Diversification
• Stock selection should be bottom-up.
• Pay particular attention to the weight of stocks in the portfolio.
• Changing weights.
• Sectoral efforts.

1. Where are we in the cycle? (Optional)

This involves trying to acquire some idea about where we are in the cycle.

Should we be moving towards defensive stocks, or - on the contrary - starting to be more aggressive, if we judge the declines to have been sufficient?

It is helpful to analyse the message coming from the types of stocks that interest us, so as to draw the right conclusions about what is going on. If some stocks in a sector have taken a particular hammering, it is likely we will be at the bottom of the cycle in that sector.

Overall market developments will also give us some insights. If there have been lots of very strong rises, we will be heading towards the end of a cyclical expansion, while after a series of large losses, we will doubtless be close to the bottom.

However, there is no guarantee that our analysis of the cycle will be successful.

If we are able to have some degree of clarity on the overall or sectoral cycle, then the next step is to consider which types of stocks will us in this context.

We need to buy the most aggressive stocks during low points in the cycle, even if it can be challenging to overcome the mental barriers to do so in such a negative environment. And vice-versa at the top of the cycle.

Designing the appropriate strategy for the general or sector cycle can be what adds most value to a portfolio.



2 Diversification

Our portfolio should be prepared to withstand any situation, be it a market collapse or a boom, inflation or deflation, for all possibilities. It must be agile and resilient against any eventuality.

We also have to insulate the portfolio from our own errors, whether they be our view of the cycle or our choice of companies. We have to envisage how our portfolio would be affected by the opposite scenario to what we are expecting; how it would survive.

Diversification is the clearest way to prepare the portfolio for any eventuality. Having at least 10 stocks gives us a reasonable amount of diversification. If we are managing on behalf o others, it can be helpful to hold a few more, creating a portfolio of some 20 - 30 stocks. After that, there need to be strong arguments for increasing the number of stocks.


3. Stock selection should be bottom-up.

Stock selection is the first step in managing portfolios. Avoid wasting time on companies which do not stand up to greater scrutiny. It is also important to be very flexible: avoiding slipping into generic asset allocation, both for sectors and regions. If we don't understand a certain business or new technologies, it is best to avoid them.


4. Pay particular attention to the weight of stocks in the portfolio.

Over the years, we got it wrong on a number of stocks. We must be very sure of our investment if we are going to assign it a high weight in our fund, never doing so if the company is indebted.

It is extremely difficult to discern and accept investment errors: we always end up giving the benefit of the doubt to the company, since after investing so much time studying it, we find it deeply unsatisfying to sell and think that we are throwing it away. One of the ways to get around this problem is by only having small exposures to the more dubious stocks.


5. Changing weights.

One of the ways to add value in asset management is by changing the size of positions in stocks. The argument for continually adjusting is one of simple probabilities: if a stock in a portfolio rises by 10% and another falls by 10%, then there has been a relative movement of 20% which we can capitalize on. The logical thing to do, once we have studied the movements, is to lower our position in the stock that has gained value and increase it in the one that has fallen.

Some investors prefer to wait until the stock has reached the target price before offloading the entire position, or take other approaches. However, it is highly likely that our simple approach increases the potential of the fund, since it is unlikely the valuations of the particular shares have moved in the same proportion.


6. Sectoral effort.

We should focus on attractive sectors. it is impossible to be on top of every sector. As unspecialised generalists we should discriminate between sectors that are worth following - which form the focus of our efforts - while leaving the rest to one side. Not all sectors are equally attractive all the time, and it take years for the level of interest to shift.

We should devote the bulk of our resources, especially time, to the most attractive sectors. We should keep an eye on other sectors, being aware of their existence, but they should not eat up our time for the moment. By moving from less attractive to more attractive sectors we avoid wasting time, which is an extremely scarce resource in investment analysis. There will be time in the future to return to sectors left to one side.

Indebtedness

We should steer clear of businesses that are highly indebted, since they can negate our estimates of future earnings.

Debt improves the return on capital, but the increased volatility from interest payments can become impossible to bear.

The limit for acceptable levels of debt depends on the stability of the business; the more stable - with an easy to predict outlook (toll road, electricity networks, etc.) - the more manageable the debt.

The undeniable advantage of working without debt or other liabilities is that we can withstand any situation with the necessary peace of mind.

Debt requires us to be more precise with our predictions that is desirable, especially given the near impossibility of correctly forecasting what will happen and the inevitability of devastating surprises.

Although indebtedness doesn't directly impact on the valuation, it is important to be very aware of a company's debt levels, analysing its capacity to pay back debt: size, term, restrictions, etc.

How bonds with negative yields work and why this growing phenomenon is so bad for the economy

PUBLISHED WED, AUG 7 2019


KEY POINTS

About a quarter of the global bond market, or about $15 trillion worth of bonds, offer negative interest rates.

U.S. bonds are still paying something, but could go negative if there’s a recession.

Negative interest rates encourage government borrowing.





Imagine if I came to you with a deal.  Give me $10 today and I’ll return $9 to you in a decade or so.
No way right?  This is happening all around the world and on increasing basis.

Maybe you didn’t go to Harvard Business School, but perhaps you recall an early lesson from your Junior Achievement class that tells you this is not how it’s supposed to work.

You are supposed to put your money in the bank and be rewarded with interest. This is supposed to be wiser than trading your precious allowance at the candy store for an awesome, yet fleeting sugar rush.

Nicholas Colas, co-founder of DataTrek, put it plainly enough: “Bonds are supposed to pay the owner of capital something to pry the money out of their hands.”

Nevertheless, some really smart investors around the world now have invested about $15 trillion in government bonds that offer negative interest rates, according to Deutsche Bank. That represents about a quarter of the global bond market.


This financial insanity is overtaking the world because bond prices are skyrocketing as stock prices are tanking. As more money flows into bonds, their yields go down — even below zero in some cases.

The good news is that U.S. Treasurys, while hovering near all-time lows, still pay at least something. The 10-year was yielding 1.62 percent on Wednesday. Still, that’s low enough to stymie financial educators as they try to convince children that they should put off instant gratification and save at least some of their allowances.

Some market observers are now warning that the U.S. could be paying negative bond rates, too, if there’s another recession. Currently, our central bank, the Federal Reserve, has set its benchmark rate at 2.25%. When the economy turns south, the Fed typically lowers rates by as much as 5 percentage points to reignite borrowing and spending.

But where else can it go after it hits zero?

Paying any government to take your money is as irresponsible as feeding children nothing but candy bars. It’s what you might call a “moral hazard,” but this term seems to have been eliminated from the economics texts following the bailouts of reckless financial institutions in the 2008 financial crisis.

Negative interest rates, and even super-low interest rates, are only going to encourage more government borrowing. This in turn allows politicians to make all kinds of grandstanding promises — until one day when the debt pile gets too big, interest rates return to historically normal levels, and taxes go up to pay for it all.

So why does this happen?

Institutional money have investing guidelines they have to follow while shepherding all their billions. Those guidelines often require them to buy bonds. The demand for these bonds is rising sharply — so they take the deal of the day.

In the end, it’s not a good sign for the economy.



https://www.cnbc.com/2019/08/07/how-bonds-with-negative-yields-work-and-why-this-growing-phenomenon-is-so-bad-for-the-economy.html?__source=facebook%7Cmain&fbclid=IwAR15vbqWZbZc1qxFjw4gZscoU7Z2u7kcRKe5m7qGSWwD0q80RSwEWJxqRBs

Capital Allocation by the Managers: Study their track record and their decision-making processes.

So you have bought a good company at a decent price.  You have completed the essential part of choosing your favourite stocks.

By definition, this company generates a lot of earnings and the managers have significant flexibility in terms of how they allocate this money, with a wide range off options available to them.  

It is important that the capacity to generate value through competitive advantages is also matched by an appropriate allocation of earned profit

Appropriate allocation of earned profit by the managers include:

1.  Shares buyback and cancellation of shares. #
2.  Dividends
3.  Investments in assets for growth.
4.  Acquisition of other companies to increase the company's competitive advantage.

The board should decide between these options based on the highest executed return and consequent value creation for the shareholder.

The only way you can get a fix on capital allocation is by studying the managers track record and the company's decision-making processes.  It comes down to both a quantitative and a qualitative analysis based on criteria, with experience being assigned a very high weight.

The greater the extent to which managers have shareholding interests, the more likely it is that their interest will be aligned with minority shareholders, but this step shouldn't be overlooked in any case.


# (The shareholders should ask of the management board that they give consideration to repurchasing and cancelling shares.  When you invested into the shares, you obviously believe the shares to be undervalued and this means that a cancellation would create value.  The management need not have to do it but this should be on their list.)

Companies to avoid

Avoid these companies described below.  That is not to say there are no good investments to be found, but the chances of this happening are much lower, increasing the risk of us running into a dud.

Some examples are as follows

1,  Companies with an excessive growth focus.

Growth is good and beneficial if it is the result of a job well done, which generates resources over time which are reinvested increasing the strength of the company, but this tends to be more the exception than the rule.  The obsession with high growth targets is extremely dangerous.   Once again there is an agency problem:  who are the company's management working for - themselves or the shareholders?  Growth is only a good thing if it is healthy.


2.  Companies which are constantly acquiring other companies.

If the acquisition is not focused on increasing the competitive advantage of the main business, it can end up becoming a rueful folly, or what Peter Lynch calls 'diworsification', diversifying to deteriorate.
Growth ca also ring with it two other problems:  first, more complex accounting can more easily conceal problems; and second, each acquisition eds up becoming bigger than the last, increasing the price and therefore the level of risk.

It is worth reiterating ow detrimental it can be when some mangers feel the pressure or the desire - after selling a substantial part of the company - to buy another of a similar size, instead of returning the money to the shareholders.


3.  Initial public offerings

According to a study, companies who float on the stock market via an IPO post 3% lower returns than similar companies after 5 years. 

There is a simple reason for this:  there are clear asymmetries in the information available to the seller and what we know as purchasers.  The seller has been involved with the company for years and abruptly decides to sell at a time and price of their choosing.  The transaction is so one[sided that there can only be one winner.

4.  Businesses which are still in their infancy.

Old age is an asset: the longer the company has been going, the longer it will last in the future.  A recent study shows that there is a positive correlation between the age of a company and its stock market returns.  It takes a  certain amount of time for a business to get on to a stable footing, depending on the level of demand and competition.  Until this happens, we are exposed to the high volatility inherent in any new business, with an uncertain final outcome.

5.  Businesses with opaque accounting.

Whenever there's significant potential for flexible accounting, being ale to trust in the honesty of the managers and/or owners is essential.

Long-term contractors in the construction sector, or in infrastructure or engineering projects, are examples where there is scope for flexible accounting, with latitude to delay accounting for payments or being forward income.

We can include banks and insurance companies in this category, where the margin for accounting flexibility is very significant and it is relatively simple to cover up a problem for a while, compounded by having highly leveraged balance sheets.

Prior to investing in these types of businesses, it is absolutely imperative to be certain we can trust the mangers or shareholders.  No one forces us to invest in them, so the burden of proof is on the company.

6.  Companies with key employees.

These are companies where the employees effectively control the business, but without being shareholders (the latter could even be positive).  For example,, many service companies reportedly have very high returns on capital, ut only because capital isn't necessary:  investment banks, law firms, some fund managers, consultancy companies, head-hunters, etc.

The creation of value in these businesses benefits these key employees, while the opportunities for external shareholders to earn attractive returns are limited, despite supposedly high returns on capital employed.

7.  Highly indebted companies.

"First give me back the capital, then return something on it."

Buffett also remarks that the first rule of investing is not losing money and the second and the third ..

Excess debt is one of the main reasons why investments lose value.  We do not need to flee from debt at every opportunity, when it is well used it can be very helpful, but it should not have much weight in a diversified portfolio. 

By contrast, markets don;t particularly like companies to hold cash rightly fearing that such financial well-being might lead to bad investment decisions. 

{To sleep well and to make the most of incorrect market valuation, ensure that over half of the companies in the portfolio have ample cash.  Do not be worried about excess cash, provided that capital is reliably allocated.}

8.  Sectors which are stagnant or experiencing falling sales.  

While it is not worth paying over the top for growth, on the flipside, falling sales can be very negative.  Quite often these companies can cross our radar because of the low prices at which they are trading but over the long term, time is not on our side with them..  Sometimes sales will recover but mostly the opportunity cost is to high, given that the situation can persist for sometime.

9.  Expensive stocks.

It is obvious but worth spelling out.  In reality, expensive companies have historically obtained the worst results, because good expectations are already priced in and because it is less likely that the price will jump from - say- a P.E ratio of 16 to 21 than from 9 to 14.

That is not to say that good results cannot be obtained from buying the above types of stocks, but it is an additional hurdle which some may preferred to avoid.


The above are not the only examples of companies to avoid,, but they are a good starting point.

The Possibility of Reinvesting More Capital in companies with High Returns on Capital

Bear in mind that the potential for companies with high returns on capital to reinvest a lot of capital are limited, since they tend not be be very capital intensive (e.g. Nestle Malaysia and Dutch Lady).

Furthermore, the market will probably be correctly pricing such gems which are capable of obtaining high returns over time, meaning we must wait for the right moment to acquire them at a reasonable price, because they are rarely gong to come cheap.

If some of these companies with high returns on capital in attractive sectors also offer a certain amount of growth, facilitating reinvestment of capital, then we are looking at a gem, with the added benefit of being coherent with our long term investment philosophy.

If a company can reinvest with a 20% return on investment over the next 20 years and we are able to buy the stock at a reasonable price, then the return on our investment will be close to this annual 20% over 20 years.

How can you begin to own a portfolio of quality companies?

Settling on Quality

There is no scientific way of finding the perfect combination off price and quality.

• Should we pay dearly for high quality?
• And anything for moderate quality?
• Obviously, paying little for quality would be ideal, but practically impossible.  

Uncovering real gems at an attractive price.  Over time, you will find the right balance.



A good set of businesses at an attractive price.

For example, your portfolio may have

• an average ROCE (the companies forming the portfolio) of over 40%, 
• with a free cash flow yield of over 10%  

How can you reach this point of owning a portfolio of quality companies?

You have to progressively sell off stocks that did not meet the new philosophy and to only buy those meeting the quality requirements.

It will be slow work, requiring you to sell off cheap companies (gruesome companies) and to fight against your attachment to them.

You have to be convinced that this is the right way to go and you go all in.




Searching for quality is not about blindly following formulas.

While these are a good starting point, they remove the essential human element which is of such importance to some investors.

It is not enough to find a high ROCE and low P/E ratio.

You have to understand where the profits are coming from and above all, where they are headed. This is essential and you need to spend most of your time doing this.

The possible purchase price can be readily found in the daily newspaper or in real time online, but analysing a specific sector and the company's competitive position is what enables you to determine the intrinsic value, which is neither as obvious nor as easy to identify.

This is the great enigma of investment and you have to begin deciphering it.

Share repurchases and subsequent cancellations.

Buffett has very clear ideas on share repurchases and subsequent cancellations.

Buybacks clearly make sense when

• there are no better alternative investment options and 
• the share is trading below the intrinsic or target business value.

The problem is that executives would rather increase company size via misplaced acquisitions,, leading to diworsification, diversifying to deteriorate, as Peter Lynch has wittily anointed it. 


Buffett believes that it only makes sense to use own shares to buy companies when you get more in return, which doesn't usually happen.

Shift to Quality

Graham was too focused on price at the expense of quality.  Of course, this is an oversimplification.   Graham also took account of other factors, such as growth or stable results, although he didn't put as much emphasis on them.  

Most investors today pay attention to other drivers, such as growth or business quality, assigning increasing weight to them over time.



Philip Fisher

Philip Fisher played a pivotal role in the transformation undergone by many investors.  It was under the influence of his partner, Charlie Munger, that Buffett first became attracted to Fisher's philosophy.

Fisher put his money on investing in long-term growth stocks, with very robust competitive advantages that were capable of being sustained and increased over time.  The price paid for them was not as important, since if the company performed well it would be able to sustain a high multiple.  

This idea is less intuitive and therefore harder to digest than simply buying something cheap; it means paying seemingly expensive prices for something that will only yield results after a period of time.

This is ultimately the road that Buffett has gone down.  Thus, most value investors are also indirectly indebted to Fisher to some degree or another.

For those who have maintained a certain unshakeable bias towards investing in cheap assets, whose quality was not always proven, it can be a challenge to change their ways, especially when this mix had produced good results.

Every investor develops at their own pace.  



Joel Greenblatt

Joel Greenblatt's short book, The Little Book That Beats the Market, gives empirical proof that quality shares bought at a good price will always outperform other stocks.  

To do so, he classifies each stock according to two criteria: 

• quality, measured by ROCE (return on capital employed) and 
• price, measured by the inverse P/E ratio (price to earnings, the price that we pay for each unit of earnings).  [You can also use FCF yield, that is, FCF/price, instead of inverse P/E].

Greenblatt uses a numerical classification for both return and price:  1, 2, 3,4,...., with 1 being the stock with the highest ROCE under the return criteria and 1 being the highest free cash flow under the price criteria.   He then adds the points obtained by each share in both rankings to produce a definitive classification, which he calls the 'magic formula'.  

• The companies with the lowest sum of both factors deliver the best long-term returns.  
• Furthermore, the same is true throughout the ranking; companies situated in the lowest 10% post a better return than the second 10%, the second decile outperforms the third, and so on until the last 10%.

The exceptional results obtained by Greenblatt is surprising, but logical:  good companies bought at reasonable prices should obtain better returns on the markets.

The problem with applying this approach is that the formulas deliver over the long term, but they can also underperform for relatively long periods, for example, three years  this makes it though for both professional and enthusiast investors to keep faith when things are not working.