Lektioner fra 20 investeringsbøger, del I: Jagten

Reflection

Lessons from 20 value investing books, part III: The hunt

November 5, 2017

This post is also available in: Dansk

Abstract

  • This blog post is the final in a series that attempts to distill the key take-aways from 20 value investing books. The third domain, which is covered in this post, concerns the hunt for bargains.
  • Everybody can identify a good asset, but the art of value investing is to spot good buys: strong businesses at attractive prices.
  • When engaging in security analysis, one should consider two domains: a quantitative exposition, and a qualitative analysis. In terms of the former, the analyst seeks to determine how the business has fared in the past in terms of revenues, earnings, returns on capital, capital structures, profit margins etc. The qualitative domain is more ‘fluffy’, as it seeks to determine how the future will unfold by e.g. considering industry and market dynamics as well as the business’ moat.
  • To find good buys, I set-up screens that incorporate business quality criteria (e.g. high ROE) and value criteria (e.g. low P/E, P/S and P/BV).

In part I of this posts series, you learned that value investors are patient and rational contrarians with an owner’s mindset. In part II, you were informed that value investing is a risk-averse strategy that seeks to identify undervalued assets – bargains – that offer margins of safety based on the Dhandho-mantra: “Heads, I win; tails, I don’t lose much.” In this third and final post we’ll zoom in on how some of these super-investors go about spotting bargains and analyzing them.

The perfect business is not necessarily a sound investment
Remember, it’s not about finding good assets, but good buys. The former are easy to identify. By clicking your way through a list of stocks you can quickly identify which have increasing revenues and earnings, achieve a high return on capital relative to competitors, strong gross and net margins etc. The art is to spot these businesses when they’re priced attractively. That’s the essence of a good buy.

Benjamin Graham argued that the analyst should consider two aspects when evaluating whether a business or opportunity is a good buy. In Security Analysis, he taught us that a stock analysis should include 1) a quantitative exposition of the business’ history and a snapshot of the present, and 2) a qualitative analysis. Based on this distinction, I’ll try to walk through the characteristics that have been highlighted in the 20 books I’ve read so far within each domain.

The quantitative exposition: What does history tell us?
Uncovering the quantitative domain is fairly easy. It’s a matter of typing the stock ticker into Google Finance, Yahoo Finance, Morningstar or the like. I prefer the latter, since it displays a 10 year history. Nevertheless, the literature teaches us that the following characteristics/trends could be of interest to the analyst who is on the look-out for a good business:

  • A consistent increase in revenues, earnings, EBIT(DA) and/or free cash flows.
  • A return on equity above 15% (or well above that of the competitors).
  • A consistent increase in book value.
  • A return on invested capital (ROIC) well-above the cost of capital (WACC).
  • A conservative/sound capital structure, e.g. debt/equity ratio below 0.5;
  • A positive working capital ratio (Graham recommends 1.2-1.5).
  • A consistent illustration that it can maintain gross and net margins above the industry average.

To many value investors, the quantitative exposition is a way to assess the stability in a business. At its core, this exercise is about evaluating whether the business’ earnings power is solid and sustainable through various market and industry conditions. In length, I prefer a 10-year historic average when I attempt to normalize earnings, revenues or FCF, as the analyst can assess such factors with greater confidence than i.e. a mere 3 or 5 year track record. As an effect, you may feel more comfortable with the predictions you’ll plot into your valuation models (i.e. a Discounted Cash Flow analysis).

The qualitative assessment: What can we conjecture about the future?
While the quantitative exposition mainly teaches us what has occurred, the qualitative analysis seeks to settle what will happen. Here, the analysts must conjecture, guess and estimate how the business’ future will unfold, i.e. can it sustain or increase its earnings power? From the 15 questions Phil Fisher presents in Common Stocks and Uncommon Profitsthese four are of greatest significance in my opinion:

  • Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
  • Does the company have a worthwhile profit margin?
  • What is the company doing to maintain or improve profit margins?
  • Does the company have a short-range or long-range outlook in regard to profits?

The quantitative exposition can be indicative in terms of answering these questions. Sure, businesses that has exhibited increasing revenues, stable margins and a long-term mentality in the past are more likely to do so moving forward than cyclically unstable businesses with shortsighted management teams. That’s common sense. However, the qualitative analysis should seek to uncover if the business is standing face-to-face with industrial challenges (new entrants, intensified competition, decreasing demand, increasing commodity prices etc.), whether it’s keeping a tight leash on costs, if there’s any expansion plans, if a share buyback program might be launched, or if there’s investments in facilities/capabilities in the offing that’ll impact free cash flows or similar. There’s a ton of other questions that might be relevant to address for a given businesses. A neat place to start when trying to answer such questions, is the latest annual report.

Another important aspect to assess is management’s ability to allocate capital efficiently (more about this topic in The Essays of Warren Buffett). Though capital allocation decisions are not captured perfectly in any one metric, many books argue that businesses that consistently achieve a high return on capital measured as either ROA, ROE, ROIC are more likely to display a history of good capital allocation decisions; particularly important is it that one’s return on capital is consistently higher than one’s cost of capital (WACC), cf. Find the Best Stocks for further information. The businesses that really give Warren goosebumps are those that have a cemented position that’ll allow them to generate earnings without having to allocate lots of capital into the operations. One example is Coca-Cola, since it’s invaluable and cemented brand enables it to earn high rates of return.

In length, an array of authors argue that stocks/businesses, which have exhibited industry-beating returns on capital, often possess a competitive edge, moat, of which there are four types:

  • Intangible assets such as brand value, patents and licenses. A strong brand enables the company to e.g. charge a higher price than the competitors. It further ensures the company’s pricing power, hence allowing it to raise prices alongside inflation. Patents hinders competitors to copy one’s products. Licenses are difficult to obtain, so once you possess one/more, it’s a lucrative advantage that one can capitalize on while the competitors play catch-up.
  • If the switching costs are high, it’s less likely that one’s customers will leave you for the benefit of the competitors. For instance, two B2B enterprises may be intertwined after years of collaborating, and switching vendor would require investments in IT systems, education, training etc.
  • When the number of customers/users of one’s service, e.g. a dating site, increases, so does the value of the business due to the network effect. Everyone has a Facebook-profile because everyone has a Facebook-profile, right?
  • Businesses that are able to achieve higher margins than the industry average possess a cost advantage, since they can undercut rivals’ prices and garner more capital to allocate in one of the aforementioned 6 ways.

Companies who are well protected by a moat often possess pricing power, too. It’s a powerful quality that allows the business to increase (a perhaps already high) their products’ prices, since one’s customers are willing to pay a premium for one’s goods. Have you ever considered that Coca-Cola’s liter price is twice as expensive as gasoline (at least if you’re living in Denmark)? Kurt Kara explains in The Rational Investor that monopolies and duopolies often possess a pricing power. Most importantly, you got to evaluate whether the moat is sustainable and durable. Ask yourself if the industry is stable or subject to quick transformation, and how the moat would be affected by such.

Furthermore, you should dive into the industry and the competitors, the management’s integrity and abilities as well as the simplicity and comprehensibility of the business. Surely, there are lots of other aspects to consider, but the highlighted should give you an at least basic idea of the inputs these authors argue should go into your analysis.

The quest for gold
As mentioned, identifying businesses with such characteristics is but one side of the coin. The other, and more difficult aspect, centers on acquiring these businesses when they’re offered at attractive prices. I do not, by any means(!), claim to have the proper way of spotting these. As you may know, I too am on a journey into the value investing universe. However, I can try to outline how I’ve went about spotting bargains so far.

I use Morningstar’s Premium Screener, which is part of my yearly subscription of around $200. I primarily try to spot businesses that adhere to the above quality criterions. To this end, I use an ROE of above 15% as well as a net margin of minimum 10% criterions. I then add ‘value criterions’ to ensure I don’t pay too much for a good business, i.e. P/E, P/S and P/BV. A typical screen looks something along these lines:

  • Price-to-sales (P/S): <= 1
  • Price-to-book (P/BV): <= 1,2
  • Price-to-earnings (P/E): <= 12
  • Return on equity (ROE): => 15%
  • Net Margin: => 10%

In addition, I sometimes experience with revenues and earnings growth, market cap spans, dividend rates and relative strength (read What Works on Wall Street). I may, of course, also choose to slacken my requirements, i.e. decrease the ROE to 12% or increase the P/E-ratio to 14 in order to unfold if any borderline cases should exist.

Fish where the fish are
In Why are we so clueless about the stock market?, Mariusz teaches us to ”fish where the fish are”. He informs the reader that running screens isn’t the only territory the value investor may explore. He recommends 52-week low lists as well as scrutinizing the media’s ‘hetz’-column, those companies that are getting battered in the papers. In The Dhandho Investor, Mohnish Pabrai gives his two cents on where to potentially find inspiration, i.e. www.gurufocus.com and www.valueinvestorsclub.com. In addition, you may benefit from reading my book summary of The Manual of Ideas in which 9 different approaches to spotting different bargain types are outlined.

Be conservative, and know your circle of competence
In the dying moments of this posts series, I wish to underscore Warren’s mantra once more: Be aware of your circle of competence, and stick within it. I’m not yet fully aware of mine, but I am quite certain of what is not within it. For instance, I don’t yet know how to read banks and insurance companies’ annual reports. Hence, I must pass up all of these opportunities. Furthermore, I have no special insights in terms of which biotech company will be able to e.g. get a certain type of drug on the market. I can’t predict that, so better stay clear of all such situations. In short, if I’m not able to confidently perform a valuation of a business, I keep my distance.

Finally, remember to be conservative in your expectations and valuations. Just because a business has experienced a few extraordinary years in terms of e.g. revenues and earnings growth, you shouldn’t extrapolate such results into perpetuity. Lower your expectations; it’s better to let oneself be positively surprised than betting the farm on a dream scenario.

These were the key lessons learned from the first 20 value investing books I’ve read. I hope this series of reflections have been helpful to you. Happy hunting!

This post is also available in: Dansk

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