Notes from The Little Book on Value Investing

Personal notes from The Little Book of Value Investing

 

Christopher H. Browne and Roger Lowenstein

Two ways to determined intrinsic value

· Using statistics and financial ratios

· Appraisal method

o Making a company-specific estimate of what the stock would be worth if the company were sold to a knowledgeable buyer in an open auction

The two tenets of value investing – intrinsic value and margin of safety

Margin of safety

· Graham buys stocks at 2/3 or less of intrinsic value

· Avoid investing in companies with a lot of debt relative to net worth

· Have a broadly diversified portfolio – a minimum of ten

· Be a contrarian

How to find out intrinsic value? – Book value, cheap earnings and balance sheet analysis

Buy earnings on the cheap

· Look for low price/earnings ratio

· The lower the P/E the higher the earnings yield, which is EPS/ stock price

· Earnings before interest, tax, depreciation and amortization – EBITDA

Buy companies below book value per share

· Book value – what a company owns less what it owes

· Have a global approach – look for foreign stocks too

Investing globally

· Watch out for difference in accounting – it might lead to opportunities

· Invest in stable markets of developed economies and countries

Buy when insiders buy

· Management has intimate knowledge of the fortunes of a company

· No other motivation for insider buying other than to profit

· Insider buying of below book value stocks is even better

· When insiders sell, it might be for a myriad of reasons, hence it is not always bad

Watch for company buyback of stocks – companies feel they are undervalued and prospects are good

Watch the movement of major shareholders – look out for successful investors

Where to find info and do research

· Websites – Bloomberg, Yahoo! Finance, Zacks.com

· Publications – Wall Street Journal, The Financial Times, Barron’s

· Find who owns a stock and track their movement – hedge funds etc

· Read fund manager reports for ideas

· Look at prices paid in corporate mergers and acquisitions to find stocks that are selling at a significant discount to what they are actually worth to a knowledgeable buyer

o Most of the time mergers and takeovers occur at a price close to the real worth of a business

Identifying bad bargains – how to determine why a company’s shares are cheap and which ones have low chances of recovery

· Too much debt – Graham: “A company should own twice as much as it owes.”

· Missed earnings estimates set by professional analysts is not fatal and it tends to create opportunities for value investors

· Cyclical stocks might be a bargain but only if it is not overly leveraged since its earnings are cyclical

· Avoid companies with excessive pension liabilities and a contentious labour environment

· Avoid companies faced with strong competition and product obsolescence

· Steer clear of overly complicated financial reports and accounting fraud

· Buy companies in industries which business is easily understood and/or for which there is an ongoing need

· Look out for investment moats

· Practise healthy sceptisim

Company health

· Check the balance sheet

· Liquidity is important – current assets vs. current liabilities

· Current ratio as indication of company’s ability to pay short-term obligations – preferably 2:1 in last few years

· Long term assets – long term liabilities = shareholder’s equity or book value

· Debt to equity ratio

· Strong balance sheet is indicative of a company’s stamina and ability to withstand problems

Earning prospects

· Check the income sheet

· Sales/revenue vs. expenses (cost of production of goods sold)

· Gross profit = sales – expenses

· Gross profit margin = gross profit / sales

· Operating expenses = fixed expenses and all employees not involved in production

· Gross profits – operating expenses = operating profit, or earnings before interest and taxes

· Final earnings = operating profits – (interest expense + taxes + depreciation)

· Check the trend of the income statement over 5-10 years

o Increasing or decreasing? Cyclical?

· Check the shares outstanding

o Too many shares? Too much stock options? Or company buying back shares?

· Return on Capital – divide earnings in any given year by the beginning year’s capital, stockholder equity plus debt

o A high ROC means greater chance of financing growth with self-generated cash

· Net profit margin = earnings / total revenue

Identifying the best companies – questions to ask

· Ability to raise prices and sell more

· Can it increase its profits?

· Can it control or reduce expenses?

· Ability to sustain profitability

· Any one time expenses?

· Any unprofitable operations it can shed?

· How much can it grow?

· How growth is achieved?

· What does the company do with excess cash?

· How does it compare financially with other companies in the same industry?

· What do the insiders do?

· Does it plan to buy back stock?

· How much is it worth if sold?

Notes from John Train’s The Art of Investing

Excerpts from John Train’s The Craft of Investing

 

An Investment Credo

 

1. The basic purpose of investment is to buy a stream of earnings and dividends that will rise substantially faster than inflation: that is, to preserve capital in real terms and provide an income to live on.
2. Within this broad objective, active investment management seeks to buy undervalued securities that should rise faster than the market, and can then be sold in whole or in part to buy new undervalued securities.
3. We have a number of specific techniques that we follow when making an investment. Some of them are:
   1. Normally, we want to know more about a company whose stock we buy than almost anybody else outside of management.
   2. The stock should be misunderstood by the market at the time we buy it, for reasons that we also understand.
   3. The imputed rate of return, assuming that one could buy the whole company at the market capitalization implied by the price per share, should be much higher than either inflation or the nominal return on bonds.
   4. We only buy the stocks of outstanding companies that we would be willing to hold for a long time in the absence of any market… the way one buys a house. We do not buy unseasoned, mediocre or troubled companies that seem underpriced: that is a more profitable strategy if it works, but increases risk if things go wrong.
4. Here are some of the characteristics of an outstanding company:
   1. By nature it can float on the surface of inflation. This usually means that it dominates some particular area of a growing market, and it is able to pass on price increases to its customers.
   2. Management is superb, and dedicated to the shareholders’ interest, with substantial ownership position.
   3. It is not a natural target of government regulation, consumerism, or intense competition (e.g., Japanese).
   4. It has a high profit margin, and makes a high return on capital: in cash, not just in taxable accounting profits. In practice this usually mean that I has very low debt, and also that it is the low-cost producer in its industry.
   5. Typically, an outstanding company that is big enough so that we can feel confident we understand, and still small enough to have a lock on something with dynamic growth, will have sales in the middle to high hundreds of millions of dollars, and will not be significantly unionized.
   6. Often such a company will be a “productivity play”; that is, it enables other companies to make more money, rather than competing in the consumer market.
5. We do not employ margin. In a severe market decline, good stocks can be cut in half in a few months. If one is employing meaningful margin, one risks a wipeout, even though everything recovers in due course. That is even truer of short sales.
6. We maintain reasonable liquid reserves at all times, increasing them when we believe the market to be dangerous. Our cardinal objective is to avoid a major impairment of our clients’ assets.
7. We do not regard bonds as a desirable long-term investment, unless one reinvests most of the income. If one spends bond interest during a period of inflation, one is to some extent really consuming capital, since because of inflation the value of a bond in real terms often declines at a rate comparable to the after-tax interest received. And above all, during hyperinflation bonds can lose most of their value in real terms.
8. One is, on the contrary, increasing capital in real terms if, for example, one owns shares in businesses whose value is building at the rate of 15 percent a year before inflation (or, let us say, 10 percent after inflation) and one spends 5 percent of one’s capital a year, even though the actual dividend income is only 3 percent.

Information websites

Information Websites

(taken off Ken Fisher’s The Only Three Questions That Count)

 

Authority	Website	Data Includes:
Bloomberg	http://www.bloomberg.com	Global stock market news and quotes, calculators and other media
Bureau of Economic Analysis	http://www.bea.gov	GDP, current account balance, import/export
Bureau of Labour Statistics	http://www.bls.gov	CPI, unemployment, productivity, inflation
Centers for Disease Control and Prevention	http://www.cdc.gov	Statistics: births, deaths, health trends and statistics, demographics, etc.
Department of Commerce	http://www.commerce.gov	Trade conditions
Energy Information Administration	http://www.eia.doe.gov	Energy source statistics, historical data
Forbes Magazine	http://www.forbes.com	Business and market news, personal finance
International Monetary Fund	http://www.imf.org	International economic and financial statistics
Lexis Nexis	http://www.lexisnexis.com	Comprehensive search engine of news, public records and information sources
Morgan Stanley Capital International	http://www.mscibarra.com	MSCI indexes, data, characteristics, performance
National Bureau of Economic Research	http://www.nber.org	Business cycles (recession timing)
New York Stock Exchange	http://www.nyse.com	New York Stock Exchange
Organisation for Economic Co-operation and Development	http://www.oecd.org	International economic and trade statistics
Real Clear Politics	http://www.realclearpolitics.com	Essential political news, headlines, blogs, polls, etc.
Russel Index Service	http://www.russell.com	Russell index data, characteristics and valuations
Standard & Poor’s Index Service	http://www.standardandpoors.com	S&P indexes, data, characteristics, constituents
The Economist	http://www.economist.com	World financial and economic news, current events weekly
The Financial Times ( UK)	http://www.ft.com	International stock market, business and world news
Thomas/US Library of Congress	http://www.loc.gov	Legislative information
U.S. Department of Defense	http://www.defenselink.mil	Official news, reports
U.S. Federal Reserve	http://www.federalreserve.gov	Bank balance sheet, credit statistics, money stock, flow of funds
U.S. Government Official Web Portal	http://www.firstgov.gov	Links to all government branches, departments, areas
U.S. House of Representatives Office of the Clerk	Clerk.house.gov	Legislative branch details, history, election statistics
U.S. Office of Management and Budget	http://www.whitehouse.gov/omb	U.S. Budget
U.S. Treasury	http://www.ustreas.gov	Taxes, interest rates, social secutiry, medicare
Wall Street Journal (US)	http://www.wsj.com	International stock market, business, and world news
Wilshire Index Service	http://www.wilshire.com	Wilshire stock indexes, valuations
World Health Organisation	http://www.who.int	Global health & burden of disease statistics, mortality, news, alerts

 

Notes from Super Cash: The New Hedge Fund Capitalism

Ideas and notes taken off Super Cash: The New Hedge Fund Capitalism by James Altucher. Not all the ideas are reflected here, only those that I feel are relevant and of further interest. A fascinating book on the various unconventional techniques used by various hedge funds to earn returns.

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a constant reminder of risk and the chance of blow-up

The decision to have blackswans.wordpress.com as my blog address is a practical one: it forces me to be constantly reminded of the existence of risks and the odd event that might happen in the markets at any moment, represented by the metaphorical “black swan”. Having more than one black swan serves to intensify this sense of fear, hence the use of the plural in the blog address. Try imagining one market crash happening after another in rapid succession. Keeps me awake at night.

The Scottish philosopher David Hume first coined the idea of a “black swan” incident. Deeply critical and sceptical of the use of induction as a means of obtaining knowledge, he cited the example of how people used to believe only white swans existed because thats the colour of swans they see back home in Europe. However the appearance of a black swan refutes the entire claim. In his book “Fooled by Randomness”, Nicholas Nassim Taleb used the term “black swan incident” to refer to an event that has a very very low probability of occurring (in statistical terms, an “outlier”) and based his entire investing philosophy around this central idea of the unforeseen, super-rare event that occurs in the markets and taking advantage of such an event should it happen.

Needless to say I have been very much influenced by Taleb’s fantastically readable book on the role of probability in life and (especially) the markets. For quite a while, I have always been pretty much set on parking and dumping my entire savings into a “diversified” portfolio of exchange-traded funds because of the various books i have read over the course of the past year or two. They include A Random Walk Down Wall Street by Burton G. Malkiel, various books by John C. Bogle of Vanguard fame and many ad hoc personal investment books. Most advocate index funds as a “safe” and surefire means of prudently investing one’s savings.

The main push factor for the use of index funds as an investment vehicle is the central assumption that the stock market will rise over time. Many studies, like Jeremy Siegel’s Stocks for the Long Run, have shown how since inception, stock markets, especially American ones, have been on the rise, despite the various market crashes and unexpected events that occur. For every fall, the stock market rises twice. One dollar invested in the 1900s will grow to tens of thousands in the 1990s. That sort of thing. I used to subscribe to this viewpoint wholeheartedly, largely because of the lack of a viable alternative to active management and the seductive allure of the simple logic behind the case for index funds.

About 70% of fund managers fail to beat their benchmarks; while it is possible to choose a manager with a market beating strategy, the main question is an epistemological one: how do I know if a manager has superior skill? Not by reading a fund’s investment strategy statement, thats for sure. Most fund descriptions are by and large similar, usually split in the value or growth camps. Can I analyse the fund manager’s stock picks and decide if he has a viable strategy? Of course I can, but if i have the skill to do that, I might as well pick stocks myself. Past performance is no indication of future performance; surely the past 5 years’ performance cannot serve as a usable proxy for the performance in the next, say 30-40 years that you will be vested in the fund. Hence choosing a correct mutual fund is really hard, if not impossible for an average investor. Index funds seem like the best choice of investment vehicle for the lack of a better alternative.

Like Descartes’ monster in the brain which draws all into doubt, Taleb’s book sowed the seeds of doubt in my head. What if a black swan event happens? Won’t it erase all my gains from my investments? Buying an index fund means gaining full exposure to the black swan event. I am not taking assymetrical risk, as espoused by Ineichen in his book Assymetric Returns. I am exposing myself to a potential fatal collapse in the market. Of course, one can point to the historical prices chart and say that if I just stay in the market and tide over the storm, my index fund will recover in time and appreciate.

The main problem is, what happens if the black swan decides to appear right at the end of my investment holding period? Doesn’t that mean I lose a large part of my savings? What if the market crashes at an entirely inopportune time? Yes, one can try to time the market, but studies show that no one can do that well. Timing the market also defeats the purpose of indexing.

Hence my current policy towards my savings. I will actively manage my own investments in a bid to preserve and enhance my savings. It seems that there is no other way. Not that I mind though, because investing so far has been fun and a real intellectual joyride.

Notes from John Neff on Investing

Here are some notes, quotes and ideas from John Neff on Investing  by John Neff and S.L. Mintz.

John Neff was the legendary manager of Vanguard’s Windsor and Gemini Funds for 31 years. He beat the market 22 times while posting a 57-fold increase in an initial stake.

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