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Notes from The Little Book on Value Investing
April 23, 2007, 1:42 pm
Filed under: investments/finance/economics

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?

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