Buying Shares---My summary in 1996 and later
BUYING SHARES THE STRATEGIC WAY---Remember for goodness S A K E S
1) The SECRET of making money in shares is to eliminate or minimize the risk; and the only way to reduce the risk is to buy the shares at a bargain. [What to buy and at What Price?]
· The SECRET of Sound Investment or of Successful Investment is the Margin of Safety
· Many things can go wrong with shares and when you BUY shares at a bargain, you have some margin of safety.
· Buy what is so cheap NOW that you almost can’t lose.
· Buy at a Discount is like buying Discounted items at supermarket.
· Bargains are normally found when the market declines or collapses.
· Bargains are normally found when the good company has a TEMPORARY setback.
· Bargains are normally found between October and December.
· You must always be ready and not be timid when great opportunities arise. Really good investment opportunities aren’t going to come along too often and won’t last too long, so you’ve got to be ready to act by buying large amount.
· “The most common cause of low prices is pessimism---sometimes pervasive, sometimes specific to a company or industry”--- said Buffett.
· Bargains are found when EGR> 1% PER.
· Best bargains are found when you have a steady and sustainable 20% EGR.
· It is hard to make money if you buy shares in a good company that is overpriced because it is everybody’s darling at that time.
· You will lose your hard-earned money when you take risk in buying shares with high PER in a bull market or bear market.
· Be greedy when market is fearful (Market Collapse) and fearful when market is greedy (Great Bull Run)
2) The ART of making money is to invest in good companies or franchises or toll-bridges or monopolies at a BARGAIN. [Constantly ask myself what is my objectives? What is my goal---Invest or Trade?]
· Invest not Bet or Speculate the market
· Betting or Speculating is like punting in the Casino.
· Soon after buying a share, there is the temptation to look for price appreciation in order to sell. That is speculation. But soon after buying a company, you look for price depreciation in order to buy more is investing.
3.) The KEY to making money is NOT to panic and SELL out in a market decline but to BUY more if the company’s fundamentals do not deteriorate. [What do you do when there is extreme fear in the Market?]
· You will lose money if you try to invest in good market and sell when the market declines i.e. Buy high, Sell low.
· You don’t lose money if you don’t sell when the market declines FURTHER e.g. The Great Crash of 19/10/87, Dow Jones declined another 508 points, but by June 1988, the market recovered some 400 points of the decline.
· When good shares are being dumped, they are great opportunities for buying, not occasions for panic to sell.
· The Key in investing is to assess the competitive advantage of any given company and, above all, the durability and sustainability of that competitive advantage.
· Market declines are as common as thunderstorms and the next BEAR market is rarely more than 3 or 4 years away.
· ln 70 yrs, there are 40 declines:
13 (1/3) of which, the declines are 33% or more
27 (2/3) “ “ “ “ 10% or more
· Market declines can last from 9 months to 2-3 yrs.
· Bull runs can go on for 3-5 yrs.
4) The ESSENCE of making money is to SELL when markets are significantly overvalued and irrationally over-exuberant. [When to Sell?]
· Don’t move in and out of one company to another. That’s a sure way to lose money.
· Most of the money Peter Lynch makes is in the 3 and 4 year he owns something.
· Hold on to a steady and consistent performer for 3 to 5 years.
· It pays to be patient (3-5 yrs) and to OWN successful companies.
· When you sell in desperation, you will always sell cheap.
· “Only buy shares that you would be perfectly happy to HOLD even if the market were to be shut down for 10 years” – Buffett
5) The START of making money is to DO your HOMEWORK and UNDERSTAND the companies you invest in. [What must you do at the START? What to buy?]
· A sure way to gamble your money away is to buy shares without doing your homework.
(1) High ROE > 20% average for last 4-5 yrs
(2) High EGR > 20% average for last 4-5 yrs i.e. c.EPS > 2 EPS last 4-5 yrs
(3) Low PER <20%
(4) Low PEG <0.75 i.e. EGR> 11/3 PER
(5) Something New
(6) Other competitive advantages
(1) High PER > 25 TO 30
(2) High PEG> 1.2 i.e. PER> 11/5 EGR
If you lack conviction in the implementation of your strategy, you will be a potential victim of the market. You will abandon all hope and sell out at a loss at the worst possible moment.
Investing in Shares is not complex but it is not easy. How come? It is not easy because if you do not START to do your home-work and understand what you are investing in, you will Definitely lose your hard earned money. At the same time, you have to be very clear what your philosophy, your goals and your objectives are, Before you commence investing. Constantly ask yourself: Am I investing or speculating or betting or actively trading?
Only then do you ask yourself 3 basic questions:
1. What to Buy and at what Price.
2. When to Sell and
3. What do you do when there is a big market decline?
Remember the word above: for goodness S A K E S
Buying Businesses the Warren Buffett Way
Do Stick to Business Tenets
· Is the business Simple and Understandable?
· What is the past operation like?
(Consistently profitable? Constant new management?)
· What is the future prospect?
(Good, favourable, projected cashflow?)
Do Look at Management Tenets
· Is the Management RATIONAL with its earning?
(Retained all for diversification, Retained partially for growth? Return all?)
· Is Management CANDID in its dealing and reporting?
· Is Management able to THINK INDEPENDENTLY?
(Avoid mindless incitation? Avoid herd reaction? Avoid institutional imperative?)
Don’t Forget the Financial Tenets
· Are you Concentrating on ROE and not EPS?
· Have you looked for high profit margin?
· Have you calculated the “owners’ earning?”
· To-date, is every dollar retained creating more than a dollar worth of market value?
Don’t Neglect the Market Tenets
· What is the VALUE of the business?
· Are you buying it at a significant discount to its value?
AN INTELLIGENT INVESTOR
· If you do not understand the businesses you are investing in, then you are in effect speculating.
· The most important decision an investor has to make is to determine how to allocate his savings. He needs to preserve his savings for future use. He invests his savings by :-
1) owning assets e.g. shares or properties and/or
2) lending his savings i.e. fixed deposit or buying bond
· His investment success depends very much on
1) eliminating those things he can get wrong, which are many and perplexing (predicting markets, economies and stock prices)
2) requiring him to get things right, which are few and simple (valuing a business)
· “An investor needs to do very few things right as long as he avoids big mistakes” - said Buffett.
· When Buffett purchases stocks, he focuses on 2 simple variables:-
1) the market price of the business and
2) the value of the business, which requires some calculation
· Buffett focuses on business fundamentals, management and prices.
· The safest strategy is to be very hard to please. Remember there are far more ways to lose than to win, and what you don’t own can’t hurt you. Insist on waiting for a stock to satisfy you completely, before you risk your capital. Since the investor doesn’t have to act, he should focus on not making avoidable mistakes.
· If all you want is to extract money from the stock market, then risk taking isn’t necessary.
You can reduce your risk greatly if you concentrate on only a few holdings, as it forces you to be more careful and thorough in your research.
· Buffett always searches for investment where the risk is eliminated or minimised. He is willing to take risks where the odds of total loss are low and the upside rewards are substantial.
· Buffett avoids risk.
First, he eliminates the financial risk associated with debt financing by EXCLUDING from his purchase those companies with high debt levels.
Second, business risk is reduced, if not eliminated, by focusing on companies with consistent and predictable earnings. “I put a heavy weight on certainty”, Buffett says. “If you do that, the whole idea of a risk factor doesn’t make any sense to me. Risk comes from not knowing what you’re doing”.
· If you ask a businessman what he thinks about when he purchases a company, the answer most often given is:- “How much CASH can be generated from the business’?” Similarly, an investor, who buys a portion of the company, should ask the same question.
· Buffett quoted John Maynard Keynes “As time goes on, I get more and more convinced that the right method in investments is to put fairly large sum into enterprises which one thinks one knows something about and in management of which one thoroughly believes. It is a mistake to think that one limit’s one risk by spreading too much between enterprises about which one knows little and has no special reason for special confidence. One’s knowledge and experience is definitely limited and there are seldom more than 2 or 3 enterprises at any time which I personally feel myself entitled to put full confidence”.
· In Buffett’s opinion, investors are better served if they concentrate on locating a few spectacular investments rather than jumping from one mediocre idea to another. One good buy a year, or even every few years, is enough so that they can prosper mightily.
· According to Buffett it is easier to buy and hold outstanding businesses than to constantly switch from “far-from great” businesses. He does not believe he has the talent to frequently buy and sell mediocre businesses that depend more on future market prices than the progress of the company’s economic fundamentals.
· Fisher taught Buffett that either the investment you hold is a better investment than cash or it is not. He is “quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business”. If the stock market does significantly overvalue a business, he will sell.
· Buffett explains “An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business”.
· A gradual buy-and-sell strategy, which tends to produce a round trip every 3 years or so, is, if consistently applied, substantially more profitable---although, of course, more trouble---than a buy-and-hold strategy, which ordinarily gives you simply the performance of the averages ---John Train.
· Buffett believes that unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market.
· In a severe bear market, prices can decline by 5O% within a few months.
· According to Buffett, if you expect to continue to purchase stocks throughout your life, you should welcome price declines as a way to stocks more cheaply to your portfolio.
· According to Buffett, as long as you feel good about the businesses you own, you should welcome lower prices as a way to profitably increase your holdings.
· What Buffett learned was banks were profitable businesses if management issued loans responsibly and curtailed cost. In most cases, banks fail when management foolishly issued loans that a rational banker would never have considered. It is not necessary to be numbered one in the industry if you are a bank, Buffett explains. What counts is how you managed your assets, liabilities and costs. Banking is very much a commodity business. In a commodity like business, the actions of management are frequently the most distinguishing trait of that business. In this respect, Buffett picked the best management team in banking - Wells Fargo.
· High inflation rates do not help companies to earn higher returns on equity. Knowing that, Buffett avoided businesses that will be hurt by inflation. Companies that require large amount of fixed assets to operate are hurt by inflation. Companies requiring little in fixed assets are, Buffett says, still hurt by inflation but hurt a little less. And the ones that are hurt the least are those with a significant amount of economic goodwill. Economic goodwill not only produces above-average returns on capital but its value tends to increase with inflation.
· Buffett recognized early that as the economic value of the businesses increases over time, so too will the price of the shares of those businesses.
· Buffett is convinced that, even though the market may temporarily ignore a company’s economic fundamentals, eventually the market will acknowledge a company’s good fortune.
· Buffett is always prepared, as he has said “Noah did not start building the Ark when it was raining”.
· The KEY to making money in shares is NOT to panic and SELL out in a market decline, but to buy more if the company’s fundamentals do NOT deteriorate.
· The right method in investments is to put fairly large sum of money into only enterprises which you think you know something about and in management of which you thoroughly believes.
· You must be financially and psychologically prepared to deal with the volatility of the market. If you cannot watch your share holding drops by 50%, without becoming panic-stricken and sell out, you should not be in the share market.
· The Warren Buffett Way of investing
(1) Don’t worry about the stock market.
(2) Don’t worry about the economy
(3) Buy a business not a stock
(4) Manage a portfolio of businesses
· Buffett had learned from Ben Graham that the KEY to Successful investing was the purchase of shares in good businesses when market prices were at a large discount from the underlying business values.
· Buy the business
(1) we can understand
(2) with a favorable long-term economics
(3) operated by honest and competent people and
(4) available at a very attractive price (purchase price per share much lower than the after-tax operating earning per share in the long-term)
[For example, we purchased our Washington Post stock in 1973 at $5.63 per share, and per-share operating earning in 1987 after taxes were $10.30. Similarly, our GEICO stock was purchased in 1976, 1979, and 1980 at an average of $6.67 per share, and after-tax operating earning per share last year was $9.01.]
· First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows.
Second, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.
· Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.
· The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.
· The worst business to own is one that consistently employs ever-greater amounts of capital at very low rates of return. [for example airline business]
· Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.
· Don’t buy mediocre business even if it is at a bargain price. Long-term the business will not give a good return. [For example, I searched for “bargains”---and had the misfortune to find some. My punishment was an education in the economics of short-line farm implement manufactures, third-place department stores, and New England textile manufactures.]
· My first mistake, of course, was in buying control of Berkshire. Though I knew its business---textile manufacturing---to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.
· Good jockeys will do well on good horses, but not on broken-down nags. Both Berkshire’s textile business and Hochschild, Kohn’s department store had able and honest people running them. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.
· In both business and investment it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult.
· If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention is a comfortable business at a comfortable price.
· When investing, we view ourselves as Business analysts---Not as market analysts, not as macroeconomic analysts and not even as security analysts
· Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. It will be disastrous if you fall under his influence.
· Investment Success will not be produced by arcane formulae, computer programs or the signals flashed by the price behavior of stocks and markets.
· We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.
· Sell the share if the market overvalued that share by a large margin.
· Prospective purchasers should much prefer sinking prices. So, smile when you read a headline that says “Investors lose as market falls.” Edit it in your mind to “Disinvestors lose as market falls—but investors gain.”
· There is a buyer for every seller and what hurts one must necessarily helps the other.
· The worst statement is “You can’t go broke for taking a profit.” Can you imagine a CEO using this line to urge his board to sell a star subsidiary? In our view, what makes sense in business also makes sense in stock: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.
· Charlie and I decided long ago that in an investment of a lifetime is very hard to make hundreds of smart decisions. We adopted a strategy that required our being smart only a very few times. Indeed, we’ll now settle of one good idea a year.
· The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”
· Arbitrage, over the years, requires wide Diversification. Another situation requiring wide Diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it is in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an Index Fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.
· Most investors, both institutional and individual, will find that the best way to own common stocks is through an Index Fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.
· If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.
· Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note the word “selected”: you don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however is vital
· Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earning are virtually certain to be materially higher five, ten and twenty years from now. You will find only a few companies that meet these standard---so when you see one that qualifies, you should buy a meaningful amount of stock.
· If you aren’t willing to own stock for ten years, don’t even think about owning it for ten minutes.
· Many investors have had experiences ranging from mediocre to disastrous. There are three primary causes: (1) high costs, usually because investors traded excessively or spend too much on investment management; (2) portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses and (3) a start-and stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.
· Every investor will make mistake. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.
· We continue to think that it is usually foolish to part with an interest in a business that is both understandable and durably wonderful. Business interests of that kind are simply to hard to find and replace.
· The true investor welcomes volatility. Ben Graham explained why in Chapter 8 of “The Intelligent Investor.” . . Wildly fluctuating market means that irrationally low price will periodically be attached to solid business.
· We will happily forgo knowing the price history of a company but will instead seek whatever information that will further our understanding of the company’s business.
· Just as Justice Steward found it impossible to formulate a valid test for obscenity but nevertheless asserted, “I will know it when I see it,” so also can investors---in an inexact but useful way---“see” the risks inherent in certain investments without reference to complex equations or price histories.
· The competitive strengths of a Coke or Gillette are obvious to even the casual observer of business. The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective MOAT around their economic castles.
· Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.
· Inactivity strikes us as intelligent behavior.
· We believe that according the name “investors” to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic.
· If my universe of business possibilities was limited, I would, first, try to assess the long-term economic characteristics of each business; second, assess the quality of the people in charge of running it; and third, try to buy into a few of the best operations at a sensible price. I certainly would not wish to own an equal part of every business in town.
· During October 1987 the stock market was on a manic rampage and massive seizure. We have “professional” investors, those who manage many billions, to thank for most of this turmoil. Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead. For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.
· Many commentators are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. This conclusion is dead wrong: Such markets are ideal for any investor---small or large—so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
· The new-issue market (IPO) is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of a public offering or in a negotiated transaction: It’s rare you’ll find x for 1/2x here. Indeed, in the case of common-stock offerings, selling shareholders are often motivated to unload only when they feel the market is overpaying.
· We favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek. We would rather be certain of a good result than hopeful of a great one.
· We have no insights into which participants in the tech field possess a truly durable competitive advantage. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. We stick to what we understand.
· Rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.
· Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you are clever and your neighbors get envious. But leverage is additive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade---and some relearned in 2008---any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.
· Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.
· To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these.-- Buffett
· In our view, though, investment students need only two well-taught course---How to Value a Business, and How to Think About Market Prices. --- Buffett
· “Value Investing,” typically connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics---a high ratio of price to book value, a high price-earning ratio, and a low dividend yield---are in no way inconsistent with a “value” purchase.
Similarly, business growth, per se, tells us little about value. It is true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth.-- Buffett
· It PAYS to be patient (3 to 5 years) and to OWN successful companies.
· Most of the money Peter Lynch makes is in the 3rd and 4th year he owns something.
· Stick to a steady and consistent performer for 3 to 5 years. Don’t move in and out of one company to another. That’s a sure way to lose money.
· Investing is most intelligent when it is most businesslike.
· Invest in companies or industries you already understand. That’s your edge.
· Invest within your “circle of competence”.
· Invest within your area of financial and intellectual understanding.
· Investment success is not a matter of how much you know but how realistically you define what you do NOT know.
· The most profitable business in the world is a bad investment if the price is too high.
· Investing is a volatile and dangerous game if you don’t do your homework.
· Do your homework by :-
(i) Studying the reports (Annual reports, balance sheet, Cash, P&L Account, Chairman’s comments, etc.)
(ii) Chatting with experts in the field (Anything NEW? What other competitive advantages?)
(iii) Going and seeing yourself (Visit the H/Q, the factory, the Mall)
· There is no fundamental difference between buying a business outright and buying shares in a business.
· The best time to buy share is when you have found a solid share at a good price.
· BARGAINS are normally found between October and December and when market collapses, drops, freefalls, declines.
· Wait for market declines to pick up good shares.
· Concentrate on return on equity not EPS.
· Market declines are as common as thunderstorms.
· In 70 years (1923- 1993) there are 40 declines:
13(1/3) of which, the declines are 33% or more.
27 (2/3) of which, the declines are 10% or more.
· There is no shame in losing money on a share. Everyone does it. What is shameful is to hold on to share, or, worse to buy more of it, when the fundamentals are deteriorating.
Selecting Shares The Zulu Principle Way
(by Jim Slater)
Do Study the Financial Reports
· Have a steady 15-25% Increase In EPS for past 4-5 years
· Earnings are the engines (EPS) that drive the prices
· Fear and greed are the fuels (PER) that ignite the market
· Most reliable indicator for the future is the brokers’ consensus estimate of future earnings
· Look for PEG of not more than 0.75 and preferably less than 0.66
· Sell if PEG> 1.2
· EGR >> PER
· Very few companies can maintain over 30% EGR for many years
Best bargains are 15-25% EGR
Steady, sustainable 20% EGR is beyond price
· Ensure strong Financial Position
Strong liquidity---companies that generate CASH
High cash flow---current assets: current liability>1.5: 1
High ROE--- net operating cash inflow> net operating profits
High pre-tax profit margin
Low borrowing---debt: equity ratio < 0.5
High borrowing---avoid companies that borrow heavily for capital expenditure
· Avoid companies that need to spend heavily on capital equipment as they have little dividend for shareholders
Do Look for strong competitive advantages
· Excellent brand names, patents, copyrights, strong market niche, monopoly
· Avoid over-crowded market (competitors)
Do Look for something NEW
· New management, new products, new events (bonus rights), new legislations, new acquisitions
· Have Optimistic Chairman’s Statement
The tone of the Chairman’s message is important
If dividend has been increasing regularly, be alert if suddenly it is simply maintained or there is a major decline in earning growth rate
Don’t Forget Management should have a significant shareholding
· Be positive when directors buy
· Be wary when directors sell major holding
· Forget to have more than nominal dividend yield
Don’t Forget to have reasonable asset position
· Prices not unreasonably higher than Net Tangible Asset
· Book value are often unreliable
Don’t Forget to buy growth shares and assets
· Avoid cyclical
· Judge correctly timing for turnabout and sell
Don’t Forget to have High relative strength of the shares
· Purchase price must be within 15% of the max prices during last 2 years
· Weaknesses in share prices should alert you to the possibility that something could be going wrong.
Don’t Forget to buy shares with small market capitalization
· Authorised Capital of not more than $300 million
PRICE. EARNINGS AND ROE
1) Benjamin Graham’s Method
a) P <2/3 Net Working Capital (assets--- all liabilities including long-term debt and preferred stock)
<2/3 Net Quick Assets [Capital--- all debts and counting as zero all other assets (factory buildings, office, machinery, goodwill and so forth)]
<2/3 Net Tangible Book Value (Sheet Assets - all debts and other obligations)
e.g. You buy hotel for 2/3 of the cash in the till and equivalents, including immediately saleable inventory minus current debt. You pay nothing for the hotel structure itself or the customer list.
b) Earning Yield > 2 x AAA bond rate
c) Dividend Yield > 2/3 AAA bond rate
d) c. PER < 0.4 highest PER 5 yrs
e) debt:equity ratio < 1
2) Warren Buffett’s Method
Value of a business = future net cash flow discounted by long-term USA bond rate.
3) 5 Ways to Increase Earnings:-
(a) Increasing Price----niche market, quality product or service
(b) Increasing Sale----more market shares
(c) Increasing successful duplication---expand into new market
(d) Reduce operating cost
(e) Reducing (culling) non-profitable operations or subsidiaries
(4) 5 Ways to Increase Return on Equity (ROE ):-
(a) Increase asset turnover (ratio between sales & assets)
(b) Increase operating margin
(c) Increase leverage
(d) Reduce taxes (pay lower taxes)
(e) Reduce interest rate (use cheaper leverage)
· Most US companies average 10 - 12% ROE and the ROE show no correlation to inflation.
· “I wouldn’t change a word of what I said.” He (Buffett) was speaking at a time when investors had grown used to average annual total returns of 12 percent on their holdings. He expected instead that 7 percent was a reasonable estimate as to what investors— before inflation— could earn annually in total returns over the seventeen years from 1999 to 2016 (the article explains why he selected that oddball number of years). And that was a gross figure, before the heavy transactional costs that investors bear— commissions, sales loads, and management fees, for example. After these costs, Buffett thought that a reasonable expectation for the return would be about 6 percent annually. (Tap Dancing to Work, p. 167).
ESP, PER and PEG
1. Operating earning = Net Profit after Tax (NPAT)
2. Earning per share (EPS) = NPAT
No. of shares
· Earnings (EPS) are the engine that drives the share prices, If the engine fails or falters (i.e. EPS fails), the share prices will come down.
· Nobody can predict with accuracy the future earning, but you can check HOW the Company plans to increase earnings.
·Basically, Company increases earning by :-
(1) Increasing price--- niche market, quality product or service
(2) Increasing sale---more market shares
(3) Increasing successful duplication---expand into new market
(4) Reducing operating cost
(5) Reducing (cutting) non-profitable operations or subsidiaries
3. Current Price/Earning Ratio (c. PER)= Current Price = c. Price
Current Earning c. Earning
· You must avoid buying share with a high PER
· Too many things can go wrong with shares, and if anything does, the fall in PER will be catastrophic.
· Buy share with a PER that is attractive in relation to the history for the Company, the average for the industry and the average for the market as a whole.
· What is a bargain in PER for one industry may not be a bargain in another industry.
· Avoid low PER in cyclical share. It usually means that the period of prosperity is at its end and people are selling off. It may be many years before the next cycle comes again.
4. Current Price (c. Price) = Current Earning x Current P/E Ratio
( c. EPS ) x (c. PER)
5. Current Earning per share = Current Price
6. Current Earning Growth Rate (%)=(c. EPS - last year EPS )x100%
last year EPS
= 60c (say) – 50c (say) x 100%
· You want to buy a share with a steady’ compound earning growth rate of 15 to 20% for the past 4 to 5 years i.e. c. EPS must be doubled that of the last 4 to 5 years EPS.
7. Future Earning Growth rate (%) f. EGR = best quesstimate
8. Future EPS = c. EPS+f. EGR
= c. EPS [ 1+ f. EGR (%)]
f. ESP = c. EPS[1 +20%]
=1.2 c. EPS
9. Future Price = f. EPS x f. PER
· Future Price gain is directly proportional to
(1) f. EPS
f. EPS is dependent on f. EGR
and (2) f. PER
The bigger the increase in the future PER, the larger is the price gain.
In fact, future PER is far more important than the future earning growth rate (%), when it comes to the future price gain (see examples)
10. Price Earning Growth factor (PEG) = Price/Earning Ratio
Earning growth rate(%)
11. c. PEG = c. P/E Ratio
· All things being equal a share with a PEG of one is still a bargain.
12. f. PEG = f. PER
· You are looking for shares with
(1) a future PEG multiple of not more than 0.75 and preferably less than 0.66 of the future earning growth rate.
(2) a past earning growth rate of 15% p.a. compound or more
(3) an increased in EPS over the last 4 to 5 years at a compound rate of 15% p.a. or more i.e. c. EPS at least double the EPS over the last 4-5 years.
13. Net tangible asset per share (NTA/share) = Shareholders Fund
No. of shares
14. Return on Equity (ROE) = NPAT x 100%
· Concentrated on the average of the past 4- 5 years ROE, not EPS.
% increase in Price = f. P – c .P x 100%
= ( f. ESP x f. PER) - (c. EPS x c. PER) x l00%
(c. EPS x c. PER)
Assume f. EG (%) increases by 10%
f. EPS = c. EPS +f. EG(%)]
= c. EPS(1+0.1)
= 1.1 c. EPS
Assume c. PER =10
f. PER = 10 same as current PER
Thus increase in Price = [ 1.1 c. EPS x 10) -(1.0 c. EPS x 10) x 100%
(1.0 c. EPS x 10)
(i.e. Future Price increase) = (11- 10) x 100%
Assume f. EG(%) increases by 20%
f. EPS = c. EPS [1 + f. EG (%)]
= c. EPS [1 + .20]
= 1.20 c. EPS
Assume c. PER = 10
f. PER = 10 same as c. PER
Thus % increase in Price = (1.20 c.EPSx10)-(10 c. EPS x10) x100%
1.0 c. EPS x 10
= 12-10 x100%
Assume f. EG (%) increases by 20%
f. EPS = 1.20 c. EPS
and Assume c. PER =10
f. PER =15 an increase by 50%
Thus % increase in Price=[(1.2 c. EPS x 15)-(1.0 c.EPS x 10)]x100%
[ 1.0c.EPS x10 ]
=18c.EPS-l0c.EPS x 100%
10 c. EPS
= 8 x 100%
Assume f. EG (%) increases by 20%
f. EPS = 1.20 c. EPS
Assume c. PER = 10
f. PER = 20 an increase by 100%
Thus % increase in Price=[(1.20 c. EPS x 20)-(1.0 c. EPS)]x100%
[ 1.0 c. EPS x10) ]
=[24 c. EPS- 10 c. EPS ] x100%
[ 10 c. EPS ]
=14 x 100%