The Intelligent Investor – 11 – Security Analysis for the Lay Investor: General Approach

A security analyst has to deal with the past, the present and the future of any security issues. The analyst works on the understanding of businesses, financial strength, strong & weak points, possible risk, future earning power under the various scenario, etc. after all works, he decides whether to invest in the given security or not. We do not always rely on past performance, but for selecting the growth stocks, we need to value a future earning power and growth rate. Additionally, we should not forget the past performance given by the businesses for making a mathematical calculation of valuations. When we forecast for the longer future horizon then it will become the involvement of more errors.

Bond analysis

We need to focus on the safety, quality of the bond issue. And our prime criterion should be several times interest charges have been covered by the earnings currently. Cover on the average earnings of previous years and cover on the poorest earning year. As preferred stock dividend is not tax-deductible so that we need to check cover on PBT to interest charges + 2x of preferred dividend.

With the above points, we need to check the size of the company, (debt + preference stock)/equity ratio and property value. Now, if bonds passed through the stringent test and survived into the past performance then it has a higher probability to survive into the future. If the bond does not meet such criterion then it must be avoided though it offers a 2-3x yield compared to the risk-free rate.

Common stock analysis

Valuation of common stock needs to perform for deciding whether a common stock is attractive to purchase or not.

This means estimating future earnings and then multiplying it with the multiples. Multiple decided as the 1/expected earning yield. For example – if I expected to get 6% earning yield then my multiple would be 1/6% so multiple will be 16.67x. Different people provide different multiples and estimate different earnings which tends to a different price target for them. Why one company available at 10x of earning and other at 20x of earning? Do we pay rightly or paying overdue to a rosy picture? These all questions getting answered by the following factors –

Long term prospects – we cannot able to know that what will be going to happens in the longer future but then also, we try to estimate for the far future. This estimation creates a different multiple for the same stock. Also, need to check that whether the company is a serial acquirer or they make an investment to own company? If serial acquirer then what is the track record of previous acquisitions? Whether the company able to generate enough cash from operating a business or has to rely on other people’s money? Whether diversified customer base or rely on one single customer?

Does the company spend money on research & development, developing new products though they have a successful product? (R&D as a % of sales) and also how much company is spending on selling and marketing? (Selling & marketing, distribution spending as a % of sales)

One of the Pharma company of India

A company having R&D and Selling spending combined account for ~16.73% of sales. Such spending improves the longevity of earnings. Sales and profit of the company have grown by CAGR of 17% and 26% respectively during FY12-19.

Management – we know that management plays an important role in the development of the business. And many a time, given weight to the management leads to overvaluation or undervaluation to the stock. If any business is continuously successful for a longer period then it will be considered as having good management. Does management has fulfilled promised made by them? How they behave while meet failure – they admit failure or pass responsibility to the economy, uncertainty, weak demand, etc.? Look at their behavior during the best period. Does senior management involve the frequent buying and selling of shares? Does management involve to direct the market speculation through announcement? Does the financial statement of the company is transparent?

All the above points provide a study of qualitative aspects of the management part. If we focus on the above points then we can avoid the management who is not shareholder-friendly.

Financial strength and capital structure – one company has an excess of cash on the balance sheet and another one has a bank loan + preference shares + bonds then we should consider the first one good compared to the second one though both have the same revenue, EPS, etc. Good business does not frequently require huge cash to run a business and they generate a good sum of money.

I am not quoting any example over here; I have already explained the same in Warren Buffett’s 2007 letter article. And many businesses pass and fail from the above parameters.

Dividend – consistent dividend payment is one of the criteria for judging the quality of the company. Defensive investors will focus on the consistency of the dividend payments. We also have to check that the company paying dividends out of free cash flow or from borrowings.

One of the steel manufacturing company

There are few companies which are into the expansion phase then also paying out dividend by taking a debt and equity dilution rather retain cash for expansion. In such cases, we should not focus on the dividend. Also, if the company can grow with generating a good return ratio then we should prefer to retain cash for expansion purposes rather than the distribution of dividends.

One of the retail company

The company has good growth and over some time, the company has started generating a decent return ratio. Here, the company does not require to distribute dividends and retain cash for expansion of the business which the company is doing with zero dividend payout.

If the company does not have a growth opportunity and does not require to bring external funding to run a business then it is preferable to distribute earning as a dividend.

Dividend policy – how much company is distributing profit as a dividend, higher the dividend distribution higher the valuation the company gets. Here, we need to see that whether dividend serves the purpose of shareholders or retaining profits for future expansion serves the purpose. The company should buy back the shares when it available cheap, not when it traded at high/overpriced.

The capitalization rate for growth stocks

Value = Current Earnings * (8.5 + 2 * Expected annual growth rate)

*Expected annual growth rate would be considered as growth for upcoming seven to ten years

Industry Analysis

For making an analysis of any security, we need to check the industry growth, position of the particular company within industry, how industry will grow and earn profits, what was the past of the industry, what is present state and what will be the future state of the industry, what will be the new product and process.

For calculating the value of the company, we need to check how the company has performed into the past and what are the factors which can change the future performance of the company. Calculate valuation on the past performance and list down the factors which make changes to the valuation based on past performance. Also, mention points that can change the future performance of the company.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

The Intelligent Investor – 10 – The Investor and His Advisers

Many of the immature investors seek advice from the investment advisers to improves their returns on investment.

Immature investors have to be knowledgeable and experienced to pass an independent judgment for any of the investment opportunities communicated by others. Investors need to analyze the services provided to him by the consultant or advisers are of benefits to them or him, whether they are involved to generate commission/brokerage or true advice, etc. Intelligent investors look at the recommendation provided by reputed firms but they decide by themselves. So that we can have safety rather be sorry for the decision. It is always a question that should we manage our portfolio independently or should we seek for the help of others? It depends on to them how we have performed during the market cycle, better than the market or not, whether we can easily meet our financial goal or does we require to take help.

Before trusting any of the advisers, we need to make our due diligence and check whether any complaints, fine, a penalty against him or not. Before selecting an adviser, we need to ask a few questions –

Answers of the above questions provide us clarity of selecting or rejecting an adviser. It is difficult to find a genuine adviser so that we also need to do due diligence from our side. I have experienced that no investment strategy outperforms in every period so that we should analyze the performance of the adviser over a market cycle, does adviser changing his process frequently? does he behave rationally with his investment or get emotionally trapped by market moods? We need to analyze all such aspects. And the most important aspect is to have an investment process and investment philosophy. If the adviser does not have it then we do not have to be in help of him.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

The Intelligent Investor – 9 – Investing in Investment Funds

For selecting whether to make an investment to the investment fund or not, we need to think for the answers of few questions such as getting better than average return (performance fund?), if not, then avoid fund which can give us a worse than average return and lastly, can we make choices between different types of funds or not.

General people who open a trading account, most probably engage in the speculations but such behavior is not common for the mutual fund investors. People also tend to select a fund that is growing fast.

Many times, due to the support of luck, few of the fund managers or investors stay in the right direction at the right time and they earn good returns but when such tide goes out, we can see the real skill of the particular manager or investor. It is also highest into the possibility that winning fund does not always remain winner due to –

If a fund has a good touch of the fund manager then every other fund house demands the same manager and they hunt to the manager at a higher pay scale also.

When a particular fund provides a good return then it will attract the investors. Due to the higher flow of the investors, managers have to put additional money into the stocks which he already owns. Such strategies lower down the returns. Sometimes, we can play a few risky strategies with small funds but the same is not suitable for the huge size fund.

As the fund grows bigger, the fund manager gets higher fees on it. So that reluctant to lose the higher fees and they started playing the game which everyone else is playing. If we see that top holding of the different funds then it will be more or less similar to each other. So, for protecting their higher fees, they do not focus on their ability to generate a superior return. They believe in getting wrong conventionally rather than unconventionally.

If we see then the majority of the funds having a similar stock as a top holding.

On the other view for good return from the fund when –

A fund manager is the biggest investor of the fund then his motive and motive of other investors will be the same and they work for generating a decent return.

Expenses of the fund are lower than definitely, the fund provides better performance.

Few fund managers do not focus on what others are buying but they focus on what looks good to them. They do not follow the herd and such strategies provide them decent return. Also, they do not get involved to do advertisements.

When a fund manager feels that they will not able to generate a good return if the fund becomes huge then they close the door for the new investors which restricts the fund to get huge by the additional flow of new investors.

We should also focus on the few points which can help while the exit from the investment of the fund such as an unexpected change in the strategy, increase in the expenses, sudden huge volatility to the returns, etc.

Few funds mentioned such a warning to the fund. I found PPFAS long term equity fund which has mentioned warning and to whom this fund is suitable and to whom it’s not.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig

The Intelligent Investor – 8 – The Investor and Market Fluctuations

When we have invested in the bonds then that will get little fluctuation to the market price. But when we have invested in the common stocks then it will have a wider fluctuation to the market price. So that we need to be ready financially and psychologically for upcoming fluctuation into our common stock investment. It is easy to advise for not doing a speculate but hard to follow it. Fluctuation and behavior of the market attract us to make a speculative decision. So, if we want to make a speculative decision then keep aside some amount of money as considering that we are going to lose it through speculation.

We need to take a benefit from the swing of the market pendulum rather than getting trapped into it. And we can take a benefit by way of timing to the market or through pricing.

We cannot predict the direction of the market consistently and if we start predicting a direction then we end up as a speculator, not as an investor. People want to buy during the bear market where everyone else is selling and sell during the bull market where everyone else is buying. But people are tending to do the reverse, the majority of the people buy at high / during a bull market and sell at low / during a bear market.

Similar has happened during the year 2017, people have seen a bull market from the year 2014 to 2017 and they started believing that this will never be going to end and stock prices keep on going higher and higher.

1^st, 2^nd and 3^rd point has been explained to the previous articles of the same series.

One of the optical and data networking products company

IPO of the company came at Rs.257 so that MCap was ~Rs.2367cr which was at the EV/EBITDA of 14.09x in FY17 and stock price rose to ~Rs.437 in FY18 which was at EV/EBITDA of ~26.33x. The company has incurred losses in a few years and came to profit since FY2016.

One of the publication company

The IPO of the company came at P/E of 33x and EV/EBITDA of 16.59x.

Day-to-day or month-on-month fluctuation to the market does not make investors richer or poorer. But what will happen for a longer period that will impact the wealth of investors. We need to keep distance ourselves from the crowd rather than go with the crowd. Also, we need to focus on emotional stability over an investment journey which helps us a lot. The normal investor gets trapped with greed as the market starts advances, but at the same time, intelligent investors booked a position of overpriced issues and parked those funds to bond, he will re-balance his portfolio.

Owning a common stock means we are a part-owner of the business, but due to the advancement of the stock market operation, investor’s mind gets diverted and they are getting more engaged towards the stock prices. They forget that stock price fluctuation should not be focused but they have to focus on the value of the businesses, quality of the businesses and progress of the businesses. Stock prices bring distance between business and us. If a person is making an investment for a longer period, but getting fluctuated as stock prices get fluctuate then he does not know for the emotionally stable and matured investors. Matured and intelligent investors do not focus on the price quotation every second but they focus on the underlying business. As businesses show successes it becomes popular among the people and it will command more premium, its mood swings with the market, etc.

We need to focus on earning the power of the business with the asset value of the business. But we should avoid paying higher to the assets as well as to the earning, otherwise, we need to be stay affected through the market fluctuation.

One of the telecom company

(Source – Thoughts on Thoughts blog)

The company looks very cheap based on the financial metrics and assets base, but if someone who does not have paid attention to the business of the company and earning the power of the business then—

One of the gelatin company

The company has some uncertainty and raw material problems but having a stable business. The company was traded at ~Rs.66 cr of MCap with having investment + cash on the balance sheet was worth of ~Rs.70+ cr so that entire business was available at free due to uncertainty. The company has delivered a decent return with also deliver Rs.10/per share as a dividend.

Few critics of value-based investing tell that such an approach does not work with the listed companies due to the ample amount of liquidity available. Such liquidity and stock market platform provide a daily opportunity to the participants to make changes to their holdings.

Many a time, Mr. Market ready to pay overpriced for the business and sometimes, He is ignoring too few of the businesses. We need to stay away to getting trapped from the Mr. Market mood swings. Mr. Market also behaves like a human being because prices of it and the behavior of it direct through human involvement as a market participant. We need to control our emotions based on our experience and belief over a while. We should stop overpaying attention to the market.

If we are doing a business then daily price fluctuations will not be going to disturb us and we do not make a change to our holdings. Price fluctuations only provide an opportunity to buy a business at a favorable price and sell when Mr. Market shows a higher price of the business.

The main distinction between speculators and investors is their attitude towards the market. A speculator is willing to make profits by way of market fluctuations whereas investors are willing to hold security at a suitable price and market fluctuations do not important for them. Market prices are just for our conviction so that taking benefits of it or to ignore it depends on us.

Stocks or a bond, the Market price will remain to fluctuate over a longer-term period. Good company with good management gets recognition into the good market price and bad management will get bad market price recognition.

Mr. Graham has explained the liquidity concepts which is suitable for the current scenario. The fund manager purchases few stocks for the portfolio, then the market starts moving upwards which attracts the investors to put more money. Now, due to the additional fund inflow, the fund manager has to buy a similar stock to the additional fund which brings stock prices to the dangerous level. Now, as the market falls, investors ask for the withdrawal of the fund and fund manager has sold out stocks to make the payment which leads to further fall to the stock prices. So here, they buy at high and sell at a low price. Our brain makes a pattern that similar has happened during the last time so it might be going to happens now also. And many times, our brain creates a pattern when there is not the availability of any pattern.

What we should need to do for the better than average return –

Our behavior is most important to get an above-average return. By controlling ourselves, we can stop ourselves from becoming our enemy. When we have made any prediction and that proven right then we become addicted to own predictions.

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation. 

Read for more detail: The Intelligent Investor by Benjamin Graham, Jason Zweig