#1. INTRODUCTION
Dear Investor,
I am Dayanand Menashi, an individual investor like you. I
would like to Welcome you to my blog Safe Multiple. My Goal is to
empower you to become a Value Investor.
FIRST STEP : Learn the Investment Principles laid down in the Text Book "Security Analysis - By Ben Graham and David Dodd"
In the year 2007 I came to know about Warren Buffett when I
stumbled upon his biography at Barnes & Noble. I went home and researched
more about him and his company Berkshire Hathaway inc. Next few weeks I read
all his shareholder letters that were publicly available. I was little dismayed
that the letters prior to 1977 were not available, thus I reached out to a
financial data company and was able to purchase old Berkshire Hathaway Annual
reports from 1968 onwards. I was just awe stuck that Berkshire Hathaway inc’s
book value was a mere $36.20 million in
1968 and has since grown to $286.35 billion by 2016.
If you are looking for an Investment teacher then one
cannot find anyone greater than Buffett, because he eats his own cooking and
his long investment record proves that he knows what he is talking about.
Warren Buffett’s foundation of Investment acumen was laid
after he read the second edition of the
book “Security Analysis” authored by legends Ben Graham and David.L.Dodd. If
one wants to pursue Value Investing then this is the first book one needs to
read and understand the core Value Investment Principles.
Security Analysis text book is divided into 7 sections . In
total it contains 52 chapters and 851 pages. It can be a daunting task to
understand all the principles laid down in the book. The first time I read it,
it took me over 2 months to complete it . It was somewhat a frustrating
experience because the concepts laid down were very dry and examples related
to stocks that were active from 1911
thru 1940.
I had to read the book
few more times to get a handle of
the concepts that were explained in the book. That time I wish there was a
study guide with quiz questions to assess my knowledge on Security Analysis.
Thus I thought of creating a study aid that
also has Quiz questions . This will help you understand the concepts of
Security Analysis Faster.
Click here to access Security Analysis Study Guide. NOTE :
The above link will take you to Amazon.com
#2. BASIC THEORY OF INVESTING IN STOCKS
Before we delve further let us understand the basic
theory of investing in stocks. It can be summarized in simple words as follows:
If John Invests in the stock of Company-A, his
investment decision is based on his opinion about earning power of Company-A.
His opinion currently differs from that of the market’s opinion. But John
expects that in future market would agree to his opinion.
Following is an example that further explains the
above point.
EXAMPLE :
If a share of Microsoft is trading
at $75 / share, it implies market’s opinion about Microsoft’s
earning power as $75/share.
John feels Market is in-correct about
its opinion of Microsoft’s earning power. He feels that Microsoft’s earning
power is $100 / share. Thus he invests in shares of Microsoft, with the
assumption that sometime in future market would agree to his opinion and hence
then Microsoft’s shares would become more valuable and trade at $100 / share.
John can then sell his Microsoft shares
at $100 / share and make a profit of $100 - $75 = $25 / share.
#3. STOCK PRICE IN TERMS OF
EARNINGS MULTIPLE
A Stock price is a product of the underlying company’s
Diluted Earnings per share and it’s multiple.
What is Diluted Earnings per share? It is the Earnings per share, adjusted to
take into account the dilution of shares outstanding.
An Income Statement provides two values for Earnings per
share. They are as follows :
i)
Basic EPS = Net Income / Total number
of shares outstanding.
ii)
Diluted EPS = Net Income / {(Total number of shares outstanding) + (Shares that would be outstanding based on
the company’s commitments to issue them, like Stock options)}
iii)
Diluted EPS is always less than the
Basic EPS.
What is the significance of Multiple? Multiple is reflection
of the market’s opinion about a company’s growth prospects. For instance if we have 2 companies, Company-A and
Company-B. Each earn $1 / share. If Company A’s Stock is selling at $10 / share
and Company-B’s stock is selling at $15/share then it portrays that
the market is willing to pay higher price for Company-B than Company-A because
it thinks that Company-B’s Earnings will grow at a faster rate than that of
Company-A.
A company’s stock price keeps changing because market’s
perception of the company’s growth keeps changing based on the latest news and
Economic developments. This in turn changes the multiple and thus impacting the
stock price.
#4. SAFE VALUE OF A STOCK : 10 YEAR
AGGREGATE EPS THEORY
So what is Safe Value of a Stock?
If a Stock is selling at $20 / share and its aggregate diluted EPS for
the next 10 years is > $20 then the stock would grow at least at the risk
free rate for next 10 years. Thus in this instance we can say that the stock is
trading at its safe value of $20/ share.
NOTES :
1. Following
are scenarios that should not be counted towards aggregate EPS.
(i) Earnings
from discontinued operations.
(ii) Tax gains because of lower than usual tax
rate.
(iii) Any
other One-time gains.
2. The
above theory does not imply its corollary. In other words if the 10 year
aggregate EPS is not > $20 then the
stock might still have grown at the risk free rate or higher.
3. The
purpose of above theory is to calculate a Safe value of the stock.
EXAMPLE : If a company is currently earning $1 /
share. And we assume that its earnings would grow at 4%
per year for next 10 years. Then the 10
year aggregate earnings estimate is $12.00,
thus the Safe Value of the stock can be said as $12 / share with Safe
multiple as 12.00.
EPS growing at 4%
|
||
YEAR#
|
EPS
|
|
1
|
$1.00
|
A
|
2
|
$1.04
|
|
3
|
$1.08
|
|
4
|
$1.12
|
|
5
|
$1.17
|
|
6
|
$1.22
|
|
7
|
$1.27
|
|
8
|
$1.32
|
|
9
|
$1.37
|
|
10
|
$1.42
|
|
Safe Value (Totals
Year 1 thru 10)
|
$12.01
|
B
|
Safe Multiple (B/A)
|
12.01
|
|
#5. WHAT IS EARNING POWER?
Earning Power is the ability of an entity to generate future profits. Following is an example that explains the
concept of Earning Power.
Joe and Mark graduate from
high school. Joe does not pursue any higher studies. He is good with fixing cars and takes up a job at the local auto repair shop. His starting salary is $35,000 per year.Mark decides to go to college. He
spends next 6 years getting a Bachelors in Engineering and a MBA from Harvard.
After 6 years Joe has steadily increased his earnings from
$35,000 per year to $50,000 per year. He does not have any debt, instead has
managed to save $25,000.
Mark on the other hand has not had any job other than some
summer internships earning $10,000 per year. He has piled on $300,000 in debt
and has less than $2,000 in his bank account.
If one were to calculate the Earning power of Joe and Mark
based on their past records and their current financial strength, then one can
easily reach to a conclusion that Joe’s Earning power is more than that of
Mark.
But in reality Mark’s earning power is way more than that of
Joe, because as a Harvard MBA he would
be making a lot more than an average plumber, The point is that Mark’s earning
power does not reflect his past record, because he was yet to apply the
intangible asset of his college degrees. Thus one can conclude that a huge part
of calculation of earning power involves analysis of the Intangible assets that
an enterprise is building which are yet to bear fruit.
One should keep in mind that like Intangible assets, an
enterprise might have some intangible liabilities brewing that are yet to
surface and can impact its earning power.
#6. INVESTMENT vs SPECULATION
Let us
assume that each employee working in the job market is considered as a stock
whose value is the net earnings that employee is going to earn in his life.
It’s quite well known that the highest earners in the corporate world are the
CEOs of the blue chip companies. Most of them have a MBA degree from an Ivy
league college like Harvard or Stanford.
Even
though a fresh Ivy league MBA might just earn around $150,000 per year, one can
be tempted to value him as if he earns $10 million per year assuming that in
near future he would become CEO of a large blue-chip company.
If we
look carefully, a fresh MBA has just basic knowledge of management. Most of the
knowledge needed for the CEO’s job is obtained in the course of his work
experience. Thus, when one is betting on a fresh MBA graduate to become a CEO,
one is betting that he will obtain that knowledge in the course of his
experience and thus will become CEO.
In other words one is betting on something that is not present today. Hence this bet can be termed as speculation, because we are betting on something that's not present.
In other words one is betting on something that is not present today. Hence this bet can be termed as speculation, because we are betting on something that's not present.
Instead
of betting on fresh MBA graduates, let us assume a scenario where we bet on
workers with salary over $100,000 , but who right now are on a short term
disability and earning just $30,000. The market is valuing them as if they will
just continue earning $30,000 for the rest of their working career. Over here
if we are able to analyze the short term disability’s reason and feel assured
that they will return to work and earn their “present full potential” , this
bet can be termed as Investment. Because we are betting on something that’s
already present , which is the ability to earn $100,000. Its just that because
of a temporary situation the complete intrinsic value of the asset is not
evident.
If we buy the stock for this employee at a price equivalent to him earning $30,000 / year, it can be termed as Investment , because there is high probability that the employee will return to full time work and start earning $100,000. This gives us the margin of safety.
If we buy the stock for this employee at a price equivalent to him earning $30,000 / year, it can be termed as Investment , because there is high probability that the employee will return to full time work and start earning $100,000. This gives us the margin of safety.
Over here
the core competence of the value investor is his ability to forecast whether an
individual who is in short term disability will return to work or will go
towards long term disability.
#7. INSTITUTIONAL CHARECTERISTIC OF STOCK MARKET : -
HOW WE CAN BENEFIT
FROM IT?
Any
person who has worked in the Information Tech (IT) department of any large
enterprise might be familiar with the notorious “Project Estimation template” . This is basically a long checklist
that the Project manager asks his Tech lead to use it to to come-up with the total number of
development hours that will be needed for the project.
The
rationale for this process is that it gives the top management an input to
figure out the feasibility of the project. On an average the estimation process
does a decent job. The final cost of the project is always within 20% range.
But for certain projects, the estimate is way off.
Why is it
that this process does not work for certain project? Let us assume that one of
the main drivers of the final estimate is the number of lines of legacy code
that the developers need to analyze to arrive at their Integration solution.
Basically this is the solution that integrates the new system to the present
legacy system. The legacy code is designed in such a way that certain programs
have large data structures (called copybooks) embedded in them. Even though
this technically increases the total lines of code of the program , but the
developers spend very less time analyzing them because the core business logic
is very small. Thus whenever a project involves such modules, the estimate gets
bloated.
Let us
imagine that there are a set of Vendor managers who bid for the projects. One
of the Vendor manager is called “Value Vendor manager”. The “Value Vendor
manager” just bids at selective projects where he has enough information about
the loophole of the estimation process. In this case he knows the loophole to
do with lines of code. He undercuts his competitors by pricing the project at
10% less cost than what they bid for and hence wins the project. Other Vendor
managers think he is a big fool in making a money loosing deal. But in fact he
has played an almost risk less game. Following figures explain his perspective.
Estimation
as per template: 10,000 hrs.
Cost of
Developer time: $80 / hr.
Vendor
offer = 10,000 x $80 = $800,000 x 0.9 (10 % discount) = $720,000.
Actual
development hours : 6,000 hrs.
Actual
cost = 6,000 x $80 = $480,000.
Gross
profit = $720,000 - $480,000 = $240,000.p> Project overheads = 10% of Gross
margin = $24,000.
Net
profit from the project = $240,000 - $24,000 = $216,000
Net
margin = $216,000 / $720,000 = 30%.
Thus the
“Value Vendor manager’s” factor of safety was $216,000. As he was confident
that this cushion was good enough to avoid any loss, thus he could offer the
10% discount. On the flip side there might be some programs that seem somewhat
small, but involve large nested IF statements. These programs take a lot higher
time to analyze than what actually they are estimated for. The “Value Vendor
manager” would judiciously avoid any projects that involve such programs and
will let other vendors fight for the tiny profit that comes with large risk.
The above scenario gives a very simple example as to how one can benefit from a
process that is institutionalized.
Just like the IT
department, stock market is also institutionalized to its core. Overall the
process works for the market, but there are odd balls when its process fails
miserably. This is where Value investors jump in and benefit from those odd
balls.
Important thing to
remember is that these are “Odd balls”. In other words Value investing
candidates are very rare. If you analyze 10 stocks and find 8 of them worth
investing , then you can assume that you are not investing but speculating.
This is very important to understand, because it will set our expectations from
beginning that what we are hunting for is a very rare species, thus we are well
aware of the efforts and patience needed to discover them.
#8. WHAT IS GOAL OF AN ACTIVE
INVESTOR
Now we know some
basics about the factors that influence
Stock Price. Let us delve into another basic question as to – What is Goal of
an active investor?
There are two ways to invest in stocks, passive and active
way. One can invest in a passive way by investing in an index fund. The most
popular being the index funds that track S&P 500 index. The effort needed
for this is practically zero. One just needs to open an account with Vanguard (as they have the lowest management fees and
are most trustworthy) and invest in their S&P 500 index fund (Symbol :
VOO).
Another way to invest is to be an active investor where one
researches individual stocks and invests in undervalued stocks individually.
This entails a lot of effort and patience. If an investor chooses this path,
then his overall return should be higher than what is provided by S&P 500 index.
#9. S&P 500 INDEX COMPONENTS –
THE
BEST PLACE TO START LOOKING FOR STOCKS
There are over 4,000 actively traded stocks in USA. This can be overwhelming to any
individual investor. Thus the most efficient way to look for stocks is to start with the stocks that
are part of the S&P500 Index. These stocks have an edge over other stocks
because S&P 500 Index is the most actively traded Index. Thus once a company’s
stock becomes part of the index then it
is automatically bought by a whole bunch of index funds that track S&P 500
index and hence these stocks get a boost
for their demand as compared to stocks
that are not part of the index.
NOTE
: The above statement does not entail that one has to just restrict themselves
to S&P 500 index. If one has time to follow more than 500 stocks then they
can expand their horizon further to look for investment candidates.
#10. IMPACT OF RISK FREE RATE ON
STOCK PRICES
Investing in stocks carries certain amount of risk.
Investors in return demand a suitable return to carry that risk. If the return
is higher than the risk, investors make a profit. Vice-versa, if risk is higher
than the return then investors make a loss.
US Treasury Bonds are considered risk free, because they are
backed by the full faith of the USA Treasury. The return on a 10 year US
Treasury bond is considered risk free and is mentioned as the risk free rate.
Thus the expected rate of return on undertaking any risk would increase if the
risk free rate increases and vice versa.
This in turn has an effect on stock prices. If the risk free
rate increases, then the stock prices fall, because investors demand a higher
rate of return. Vice-versa, if the risk rate free rate decreases, then the
stock prices go up as investors demand a lower rate of return.
#11. BUFFETT’S MOST IMPORTANT
ADVICE TO INVESTORS
Although each and every shareholder letter of the Oracle of
Omaha is loathed with advice that would be valuable for generations to come.
But I feel the advice he gave in his 2000 shareholder’s letter is the most
valuable that all of us should adhere to. Especially when the market is at all
time high.
#12. HOW STOCK MARKETS WORK?
-
WHEN SHOULD AN INVESTOR BUY OR SELL A PARTICULAR STOCK?
Reference
- 1987
Berkshire Hathaway inc shareholder’s letter
This is
the first question that pops up to any person who is new to investment world.
The chances are more or less he will get it wrong the first time. Even Buffett
was no exception in this rule. When at the age of 11 he bought his first stock
of Cities services preferred for $38, he monitored the stock price every day.
The stock price initially went down but eventually started rising. Buffett sold
it at $40 later to realize that the stock soared to $200.
This is when he realized that timing the market was not an efficient long term investing system.Buffett later went on to study under Ben Graham and learnt that the stock quotes are delivered by a highly emotional person called “Mr. Market”. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains.
This is when he realized that timing the market was not an efficient long term investing system.Buffett later went on to study under Ben Graham and learnt that the stock quotes are delivered by a highly emotional person called “Mr. Market”. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his. Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains.
At other
times he is depressed and can see nothing but trouble ahead for both the
business and the world. On these occasions he will name a very low price, since
he is terrified that you will unload your interest on him. Mr. Market has
another endearing characteristic: He doesn't mind being ignored. If his
quotation is uninteresting to you today, he will be back with a new one
tomorrow. Transactions are strictly at your option. Under these conditions, the
more manic-depressive his behavior, the better for you. But, like Cinderella at
the ball, you must heed one warning or everything will turn into pumpkins and
mice:
Mr. Market is there to serve you, not
to guide you. It is his pocketbook, not his wisdom, that you will find useful.
If he shows up some day in a particularly foolish mood, you are free to either
ignore him or to take advantage of him, but it will be disastrous if you fall
under his influence. Indeed, if you aren't certain that you understand and can
value your business far better than Mr. Market, you don't belong in the game.
As they say in poker, "If you've been in the game 30 minutes and you don't
know who the patsy is, you're the patsy."
In the
short run, the market is a voting machine but in the long run it is a weighing
machine. By this Ben Graham meant that the day to day swings in a stock price
is mere reflection of people’s perception in the long term prospects of a business.
But the long term price movements of a stock is indeed reflective of the
underlying fundamentals of the business.
#13. HOW FANTASY BECOMES
REALISTIC IN STOCK MARKET?
One of the most common methods adopted by people to become
rich is by buying lottery tickets. It sounds great that one can buy a $1 ticket
and hope to get a return of $10mn. To extrapolate this theory, if a person buys
1000 such tickets every month then his chances should increase by 1000 times.
In real world if a person adopts this strategy, we will call him a “gambling
addict” and would try to avoid him.
Its because we know that even if a person buys 1000 lottery
tickets, the odds of losing are way more than winning. For some reason when it
comes to stock market this strategy is followed by majority of people. And
people don’t find anything wrong with it. …..How does this happen????
let us
say that Billy invests $1,000 to buy 1,000 lottery tickets of a newly formed
lottery company. They lure him with a deal, which states that if he does not
win the Jackpot then lottery company pays him back anywhere between $800 to
$1,200 in return.
In 3
months Billy has $6,000. His friends are praising his financial acumen because
they get the illusion that he has got a return of $5,000 on an investment of
$1,000 in 3 months and plus he still stands a chance to win the jackpot. In
this case the lottery management has created an illusion that it’s safe to buy
lottery tickets issued by their company.
Thus very
shortly all of Billy’s friends join because they suddenly feel that buying
lottery tickets worth $1,000 is not such a bad idea. In six months each of them
has reaped in on an average $4,000 gain. They are all partying. But the party
does not last for long. The lottery management has collected $80,000 and has
paid back $86,000, it is just about to break even.
The news of this lottery scheme is spread around
the town and all the folks are in it. In the 10th month the total collections
cross $100,000. But the returns start slimming down, new folks are not getting
that return the way they were getting before, but they are still positive,
hence the inflow continues. By the end of the year the total collections are
$450,000 and the lottery management has paid $322,000.
The
scheme comes to a screeching halt as the new investors start getting just
between $100 to $150 a month. And one fine day the scheme comes to an end. The
net collections of the lottery were $464,000 and the net payment was $355,000.
The late entries in the scheme have lost an average 80% to 90% of money, the
only folks who profited are the lottery management people, because they did not
buy any tickets.
Replace
the lottery management with the scrupulous Stocks brokers and we get the dark
side of Wall Street where the stock prices are just pumped up giving an
illusion of great investment , only to be seen later to crumble down. Time and
again it keeps happening because, the short term illusion puts blinders on a
common person’s logical thinking and very easily they are made to believe that
speculation is safe. One thing is very clear though, if you want to be in Stock
market for long time then the first challenge is to stop thinking like an
average individual who thinks speculation is safe.
#14. WHY AN INVESTOR SECOND
GUESSES HIS INVESTMENT DECISION?
If we ask 100 common investors as to what is their process
of selecting an Investment candidate, more than 90 would answer that they don’t
have any set process. Whenever they feel like investing they just browse some
web site or watch CNBC and just pluck an investment idea from there. The very
next day if they get a different opinion from some other analyst about their
investment, then they dump their stock So why does this happen???...to get
answer to this question , let us analyze a basic characteristic of human
psychology.
Let us assume that we are playing a game of estimating
commute time for a set of 200 commuters , each having a different route. The
details of the commute, traffic pattern and weather are available in a report.
But we don’t want to spend time going through it, so we just listen to some “so
called traffic experts” and deduce our answer. As the traffic experts change
their opinion so do we, it’s because we don’t have any of our own opinion.
Instead if we spend time understanding all the routes and
traffic pattern in detail then we can have a better judgment of ours. In this
case we won’t have any hesitation of going against the crowd because we know
that we have done our homework and can trust ourselves.
The same principle is applied to the Investment landscape.
The first step for any common investor is to build knowledge about the businesses
that comprise the Investment world. Once he has built that acumen then he will
be in a better position to stick to his judgment.
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