The Intelligent Investor – 20 – “Margin of Safety” as the Central Concept of Investment

This is one of the most important concepts which we need to understand thoroughly for becoming a successful investor.

The margin of Safety concept is for getting saved in the future while unfavorable situations occur. If we have projected sales, PATM (%) for the next 2 years but also conservatively, we have made few haircuts on the projected sales, PATM (%) for making an investment decision for getting saved if any unfavorable situation occurs into the future. Or we can provide a valuation multiple in a conservative manner that protects us from future unfavorable events. This protection against the future unfavorable situation is known as the “Margin of Safety”. The major risk is not uncertainty but losing capital. We can make a good return while there is uncertainty. If we keep on playing the game without proper care for protection against future uncertainty then we always need to be depended on the luck.

Mr. Graham has mentioned that he looks for a greater margin of earning power compared with the bond rate. That means if the AAA bond rate is around 6% then we should buy a company with higher earning power then 6%. Now, the question comes that above 6% but what should be that rate- 7, 8, 9 ….? Such earning power rate should be depended on the quality of business, quality of financial, the stability of earning, growth of future earning, quality of management, future visibility of the business, cyclical nature among the business earnings, future return expectation by investing into the particular business, etc. If the business does not have a stable earning, quality of financial is average, cyclical nature of the business, etc. then we should make an investment at least around the twice of AAA bond rate, I.e. earning power at 12%. We should measure earning power on the PBT, CFO and FCF levels for better judgment.

We should focus on better chances of profit rather than chances for loss. If prices are low for the good assets then that provides us with an opportunity to make an investment with a margin of safety. If prices are too much higher than there will be no availability of any margin of safety.

Few principles are given by Mr. Graham-

We should not rely on the others’ opinions or optimism on the particular business rather we should focus on the data and arithmetic. Though the crowd does not agree with our view, our data and arithmetic support our view then we should stick with it. If we get over-optimistic towards our investment then we ourselves become a risk for us.

For not being ourselves as a risk for ourselves, there are few points which we need to focus –

The above questions work as a checklist for removing our emotions from the decision making and make a better decision. We do not know the future and sometimes our best analysis will be turnout as a worst so that we need to keep the margin of safety with it.

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 – 19 – Shareholders and Managements: Dividend Policy

When a question about the questionable management getting asked the shareholders then –

It is always a debatable situation for paying a high dividend or reinvesting profits into the business.

One of the finance company which paying out lower dividend but reinvesting to the business

One of the capital goods company which pays out a decent dividend

If the company does not require to make a reinvestment of profit and no further huge growth opportunity then the company should pay out a higher dividend. But if a company does not pay out a dividend or pay with a lower payout then market price can be seeming to be lower to the fair value.

Another point is when the financial position of the company is not favorable then the company should work on paying out debt and other obligations first rather pay a dividend.

One of the steel company of India

In theory, we have learned that equity shareholders are the owners of the company but in practice, such things do not go to happens. As a minority shareholder, we need to follow the recommendations given by the management. We cannot go against them.

There can be two types of problems, we found among the management. First, they are not able to run the business efficiently and second, they do not work in the favor of minority shareholders, they make decisions that help them & create their personal wealth. We need to thoroughly read annual reports, footnotes, corporate announcements, etc. for understanding the efficiency and shareholder-friendly behavior of the management.

For checking the efficiency of the company, we need to compare the company with its peers in terms of profitability, size, growth, competitive advantage, etc. If the company is doing better than peers consistently for a longer period of time, then we can say that management can able to run the company more efficiently.

For checking the shareholder friendliness of the management, we need to check compensation, stock ownership, related party transactions, etc.

Though We are owning a 100000, 1000 or 1 share of the company, if we do not read an annual report of the company and company has gone for a toss then we need to only blame ourselves.

The stock repurchase is considered a good strategy, the dividend comes with tax obligation but buyback is tax-free and also improves financial of the company. But in reality, the company issues ESOP to the executives as a performance bonus and that will end up with the dilution of the equity. Many times, buyback is done for counteracting such dilution. Also, stock buyback is done at the overvaluation or at the undervaluation is matters a lot.

SIMPLE IS BETTER – ISSUE -13 – BUYBACK

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 – 18 – A Comparison of Eight Pairs of Companies

We should take care when company deliver their promises but actually traded at more than their promises.  Companies that have to deliver a higher sale, earnings growth then they will be available at higher multiple. But we should distinguish between higher and reasonable multiples. Stocks which does not have underlying soundness then those will become speculative and riskier.

When sales growth keeps coming people ignore the underlying quality of business and financial. As the company grows, its growth becomes slower otherwise the company will eat up the entire world. As growth gets slower, multiple also gets lower. We need to understand that we cannot provide similar multiple to the same company at every phase of the company. Higher quality growth commands a higher multiple but as growth slows down, multiple for the same business gets lower down.

One of the air-cooler manufacturing company of India

We can see that as growth slowdown in the FY2018 and 2019 then P/E multiple of the company has fallen down rapidly.

Comparison of Real Estate VS Pharma VS FMCG

We can see that in the Jan-2008 Real estate companies (Just two companies) MCap was ~4x of 10 pharma companies and ~2x of 10 FMCG companies. Pharma and FMCG companies have posted growth and real estate companies are not able to grow at the same peace. In addition, real estate companies were traded at sky-high valuations which resulted in an average return of ~-91% whereas Pharma (*not taken from high mcap) and FMCG has posted average return of ~963% and 1109% respectively.

If we look at the fall in price too low of 2008 then also pharma and FMCG have outperformed real estate.

If we see the quality companies i.e. pharma and FMCG then those fall less than the entire market fall, Nifty fell by 50%+ in the year 2008.

In the Short term, any stocks win the popularity of the market but in the long-term earnings matters. If we see that fancy business has does not perform in the long term but boring business such as FMCG has outperformed in the long term.

If we look at the P/E multiple of DLF and Unitech then that was 36.69x and 82.22x in high of the year 2008 and that fall to 4.67x and 4.21x respectively. Whereas Lupin, Sun Pharma, HUL, ITC, and Nestle was traded at P/E of 13.54x, 17.91x, 26.23x, 29.34x, 26.90x and fall to 12.50x, 17.52x, 26.71x, 22.28x, 24.80x respectively.

Market panic provides us with an opportunity to enter into such business which helps us to get more returns. If we have bought the above-mentioned pharma and FMCG companies at a high of the year 2008 and then bought again at low of the year 2008 then-current average return of pharma and FMCG has been increased by ~347% and 137% respectively.

For the current scenario, if we see HUL MCap vs 10 Pharma companies then HUL has a 24% higher MCap from pharma 10 companies.

This analysis is given by many of the investors and fund managers but if we look at the return ratios then average RONW% & ROCE% of top 25 pharma companies is ~20% and average RONW% & ROCE% of top 10 pharma companies is ~16% whereas RONW% & ROCE% for the HUL is 80% and 90% respectively.

So, if we look at the growth and profitability of the top 10 pharma and HUL then does not has a wide difference but asset quality is far good for HUL compared to the top 10 pharma which must need to look. This comparison is not similar to real estate and pharma and FMCG whereas real estate has poor asset quality compared to the pharma and FMCG but here HUL has a better asset quality. If pharma has a huge earning growth compared to the HUL with 15-20% of return ratios then we can look into it. If we look at the ~73 listed FMCG then those companies do not have similar asset quality then they do not have a similar kind of valuation but those have, they command.

Closed watch also shows real-time sometimes in a day that does not mean, we consider that watch as a good watch.

If we compared sugar companies’ vs tea & coffee companies then it can be a good comparison where sugar companies are available more than double in MCap.

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 – 17 – Four Extremely Instructive Case Histories

Mr. Graham has mentioned a few points which need to be check for any of the companies in which we are planning to make an investment. And if the company having such points then should avoid it is a better choice.

• The company not paying income tax through earning profits. We must have doubts about the earning of the company if the company continuously not paying income tax. We need to check whether the company has any tax benefits or not. If the company has any tax benefits then we need to check where such benefits are going to expire and need to adjust tax benefits for our calculation of future estimation of profitability / per-share earnings.
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• Overpriced giant companies. Giant companies are those which have shown decent growth in the past and gaining market share. Thus, such companies have won the trust of the investors and available at a higher valuation. We need to understand that not always a great company can be a great investment. Also, we need to stay away if the company available at an extreme higher valuation. One of the current giant IT companies was traded on 200+ of P/Ex during the IT bubble and after that company has posted sales & profitability growth of 30%+ but the stock has given return ~7-8% CAGR during that period.
• Interest coverage is less than 5x. If the company cannot able to generate pre interest profit 5x higher than the interest amount then any unforeseen circumstances can affect the profitability of the company.
• The company involves frequent mergers and acquisitions. Frequent merger and acquisition turn a simple financial statement into a complex which becomes much difficult to understand. In addition, the company can hide many things through mergers and acquisitions which becomes difficult to identify.
• Merger and acquisition are huge in size compare with the size of the company and also, funded through huge debt. Such M&A can create trouble for the company if not played well. The majority of such M&A has failed badly. One of the steel company which has done an acquisition of the company which is huge in size by taking a huge debt.
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• Here, we can see that the company has faced a hugely difficult to get survived. Also, the company has to take a huge debt + equity issuance.
• Acquisition of the company at a higher valuation. When one company has acquired another company at higher valuation then it will consider as a capital misallocation and it will take time to cover the extra value which the company has paid. If the company has paid a huge premium + balance sheet also not stronger than it can be troublesome.
• Frequent merger and acquisitions. This will create trouble for an investor to understand financial statements. In addition, the company can hide many things under such frequent M&A and can boost up revenue and profitability in a fraudulent way.
• Deferred debt expense which is greater than entire shareholders fund
• Amortization of deferred debt expense
• The company has a debenture that is traded at a huge discount then also, the company buying warrant.
• Increasing debt in more peace compared with the revenue
• We need to deduct preferred stock payment, debenture payment from available cash & investment of the company to reach the conclusion regarding available cash & investment for the common stockholders.
• Checking a liquidity position of the company
• Expansion strategy, if expansion is huge enough that it has a higher probability to get fail, the profitability of the company can wipe out. And if such a huge expansion funded through external fund then can be the hero or zero kinds of situation arise.
• One of the chemical company of India has announced a huge expansion plan which is a hero or zero kinds of plan
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• Here, we can see that the company can able to grow its revenue and profitability after the huge Capex which has helped the company to get survived very well.
• The company owning huge preferred, warrants and convertibles then need to check such companies with more patience or should avoid it.
• Changes into the method of arriving at the pension
• Changes into the depreciation rates
• Stock trading at Extreme cheapness. When things available at cheaper valuation then we need to be cautious and ask to question & try to find out the reason for cheap valuation.
• Avoid hot stocks and hot fancy businesses
• An initial public offering of shares in a basically worthless company. IPOs of the company which are not good in the balance sheet and just coming up with an IPO due to fancy in a sector or in the market.
• Inspection from SEBI or other regulatory authorities. When we come across such news then we need to study carefully with that company.
• Few more things to avoid – MY LEARNING FROM MY MISTAKES

  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 – 16 – Convertible Issues and Warrants

As per Mr. Graham, convertibles are smaller into the risk compared with the common stock of the same company. We also know that preferred stockholders get first preference compared to the common stock for dividend/interest and also at liquidation.  Convertibles are more related to common stocks rather than debt instruments.

But always a question that when to sell convertibles? Should we opt for the conversion to common stock? Or keep on holding a bond and getting interested in it?

When the company is doing well, growing more than a cost of capital, generating higher return ratios, then it is advisable to hold convertible and let them getting convert to common stock.

If the company has an average performance, average return ratio, no clue for potential decent growth then it is advisable to hold convertible and keep getting interested in it.

Generally, warrant or stock option are not recorded under the common stock capitalization and also, EPS is shown without an impact of it. So that we need to add those warrant or the stock option to the outstanding equity shares and consider EPS. Company issues warrant when they require a capital, prepayment of bond / preferred stock, etc. But this is not a suitable way to raise capital. If a company wants to issue a common stock then they need to directly issue to shareholders on the prevailing market price rather issue a warrant on the below market price. This will result in more dilution of equity compared to the issue at a higher price.

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 – 15 – Stock Selection for the Enterprising Investor

Enterprising investors or aggressive investors are those who put more effort into stock selection and investment decisions. Graham-Newman Corporation was involved in the few investment classifications such as –

Arbitrage – opportunities where companies involve the reorganization, merger, demerger, etc.

Few businesses have a good quality but due to operating with the other gruesome businesses, good business does not get value. So that demerger of good business from the gruesome business will create value for the shareholders.

Details on post – SIMPLE IS BETTER – ISSUE -14 – DEMERGER

Liquidation – opportunity to earn profits where the company is gone through liquidation phase, sold out of assets and make cash payments to the stockholders. Many a time, company liquidate non-core assets for improving productivity and to reward shareholders.

One of the pharma companies has sold out their business to the MNC company and rewarded shareholders with a special dividend.

Related hedges – buying a convertible bonds/preference shares and selling of stocks into which they are going to convert. Such opportunities are rare and difficult for the Indian market due to the unavailability of wide derivatives stocks.

Net current assets or bargain issues – purchasing an issue which is available below net current assets value, not giving any value for the plants, land, machinery, etc. Here, wide diversification requires.

We should buy cyclical companies when the business cycle is depressed and due to depressed earnings valuation seems to be higher. I have explained on cyclical companies in detail in Warren Buffett’s letters series.

We can find out some of the undiscovered companies by using different types of criteria. Such a criterion helps us to filter out a few companies from the huge list. And then we need to put further due diligence, efforts for selecting or rejecting companies for an investment purpose from the available filtered list.

Enterprise investors can make an investment into the bargain issues and to the workout or special situations (I.e. demerger, merger, buyback, divestment, etc.) where they can reap an additional profit. Special situations have a lower probability of large loss so that we can earn lower losses with a satisfactory return.

We as an investor also need to do a practice for making an investment decision. We can make paper trade and decisions which help us to improve our decision making. As we know that cricketers, musicians, athletes, etc also getting engage in the practice before the actual performance. When we are learning to drive then we do not directly drive a car on the highway but we learn at peaceful roads so that we can avoid a big accident. Similarly, we need to perform with the investment field, rather make an initial huge investment, we need to put efforts to learn investment skills. This will help us to improve our decision making, philosophy, minimization of errors, etc.

We need to focus on the ROIC rather than focus on the EPS.

It shows us how efficiently a company is utilizing the fund to generate optimum returns. And provide us with good returns over a longer period.

We also need to check about the management who runs the business, whether they focus on the stock price or business, do financial statements are easy to understand or full of ambiguity? what company has promised and how-much they have delivered? does top management turnover higher or they stay for the long-term with the company?

We will find out many of the answers to the above questions from the annual report.

We also can learn and improve our approach by reading the approach of other investors such as Warren Buffett, Phil Fisher, Ben Graham, Charlie Munger, Howard Marks, Prof. Sanjay Bakshi, Neeraj Marathe Sir, etc.

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 – 14 – Stock Selection for the Defensive Investor

For stock selection and for investing for defensive investors, Mr. Graham has mentioned a few criteria –

• Adequate size of the enterprise

Mr. Graham has quoted that investment candidate companies should not be too small into the size. As per him, we should not invest in the company which does not have sales and assets less than $100 Mn (Rs.700 crore) and $50 Mn (Rs.350 crore) respectively.

• A Sufficiently Strong Financial Condition

We should check the long-term debt to working capital also. Such strength provides a margin of safety to defensive investors.

• Earning stability

Earning of the company does not get highly fluctuated during the past ten years. This indicates that a company has a stable business model. The stability of the business model provides safety to defensive investors.

• Dividend record

Uninterrupted dividend for at least the last 20 years. Further, we can check that whether company paying dividend through cash earning or through debt, which I have already explained in – The Intelligent Investor 11

• Earnings growth

Earning should be grown for the last ten year. We should decide the % of earnings growth, we seek from the business.

• Moderate price/earnings ratio

As per Mr. Graham P/E ratio should not be higher than 15x for the past three years of average earnings. Reverse P/E ratio is near to the AAA bond rate, which means 1/15 = 6.67%.

• The moderate ratio of price to assets

The price to book value should not be higher than 1.5x. and also, P/E * P/BV will not be higher than 22.5x (15x * 1.5x). it can be possible that P/E can be 20x and P/BV can be 1.12x or vice-versa.

We should not invest in the companies where earnings getting worst though those companies are available at the cheaper valuation. And if everyone thinks similar for an investment opportunity then advantage for a similar investment opportunity will be gone. Similar happens during the FY17 to FY18 to equities where everyone wants to invest in the equities and equities valuation reach at the higher level.

Mr. Graham has also mentioned that we should not put all our eggs into the one basket, diversification protect us, minimize the risk. But diversification should help when we have a stock of quality companies, also over-diversification does not help. If we own the worst quality companies and make diversification then also our winning odds will never be favorable.

These all parameters are important for initial screening, after that we need to make our due diligence before investing in a particular stock. We need to read at least five years of annual reports, if the institution holds more than 60% to particular stock means that it is highly discovered (>15% is much more for Indian companies), and need to put efforts before investing.

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 – 13 – A Comparison of Four Listed Companies

When we have decided to make an investment then we need to perform an analysis work so that we do not be stuck with the wrong investment avenues or at the wrong time. For making an analysis, we must need to focus on a few points.

Profitability – how the company performs? Return on invested capital, margins, growth in sales-profits, earning per book value, etc. If the profitability of the company gets hampered then we need to check whether it is permanent or temporary.

Stability – earning of the company decline in any of the years from the past ten years? Do the earnings of the company get fluctuations? Does a company involve in a seasonal or cyclical business?

Growth – companies with higher growth command for the high multiples and lower growth with low multiples. The growth of the company can help us to grow our wealth also. The growth provides an opportunity for the company to use capital appropriately.

Financial position – liquidity ratio, the position of a balance sheet, debt, preference share, etc. Tree does not grow in the sky. If financials are not strong then the business will not be surviving for a longer period. So that we need to put emphasis on the financial. How does a company utilizing assets? Company is capital intensive or asset-light? Working capital intensive or negative cash conversion cycle?

Also, we need to check what the company is doing with the capital generated. What is the capital allocation decisions of the management? Long dividend track record, increment into the dividend, buyback, buyback at higher than intrinsic value or lower than intrinsic value and if a company requires fund for growth then reinvest profits for growth rather pay dividend or buyback.

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 – 12 – Things to Consider About Per-Share Earnings

Many of the companies having smart enough management who know that analysts and the majority of investors focus on the bottom line so that they also emphasize the boosts earning at any means. Manipulating earnings for the few years can reward them a better way by offloading their stakes. Thus, we require to study earnings quality by putting a huge emphasis.

I have a different series under the “Simple is Better” category which covers tricks to identify earning manipulation.

Management of companies can be hungry for getting recognition which makes them involved in the playing with the earnings. We should not focus on the short-term earnings or one year earning for deciding for investment purpose otherwise we can be stuck into the trap. We need to focus on the footnotes for understanding properly for onetime earnings. Whether such earning will be going to recurring or one time? We also can perform an adjustment to the one time earning and need to check that still stock available at cheaper multiple or not. Does the company involve the frequent selling off assets for boosting profits? Does Company has change revenue recognition policy, change other accounting policy? Does the Company involve accounting shenanigans? When things available at dirt cheap then first need to check it thoroughly that why such cheapness is available with the stock. Cheapness is attractive always but the reason behind cheapness is an important factor.

One of the exchanges

The company got other income due to stake sell into the subsidiary company which has boost earning by ~3x and due to such one-time earning P/E multiple has fallen drastically. And, this fallen P/E multiple misguide investors and attract them to make a mistake.

We have to remove the effect of one time gain in the normal business and need to take an average of the 10 year or entire cycle for elements temporary and extreme profitability effects.

One of the automobile company has a reverse of the provision made during a slowdown time

If businesses into the cyclical nature then it is advisable to take an average of past seven to ten years or a business cycle earning average for nullifying the effects of ups and downs into the earnings due to changes into the cycle. If we focus on the earning at the best cycle then we can attract to buy and end up with the losses or has to wait till the next good time of the cycle. Reversely, when we focus on the worst cycle then we avoid the opportunity and we end up with the opportunity miss.

Example of the cyclical company regarding buying at top of the cycle which resulted in losses and the bottom of the cycle resulted in a profit

We are habituated to buy at the lower P/E and sell at the higher P/E but the same is not applicable in the cyclical industry. We have to buy company during the bad cycle which has depressed earnings that shows higher P/E and need to sell during the good cycle which has good earning that has depressed P/E. So, if we buy at the lower P/E then we end up with losses though P/E will be increased. Also, higher-earning is temporary and as the cycle turns out then earnings will disappear.

We can start reading an annual report from the backside so that some facts which the company wants to hide in the last section which comes first to us. Always read footnotes, focus more on learning about financial reporting.

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 – 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