To achieve a target annual return of 15%- 25% on our investments.
The key to building a successful portfolio is to:
- Identify very good businesses
- Buy them at a good price (huge discount)
- Wait for the market to realize its true value or over-value it
What is a VERY GOOD business? It is one that:
- Has exceptionally good long-term economics
- Has a durable competitive advantage (economic moat) that protects it from any competition.
- We can predict with strong confidence that over the long term, earnings, shareholder value & prices will grow.
- Can recover and prosper in the event of any major recession or bad news.
9 STEPS TO VALUE INVESTING
The first 7 criteria are used to determine if the stock you are investing in is a GREAT BUSINESS that will grow in value over time.
The 8th and 9th criteria are used to determine if the price is right and if it is the BEST TIME to buy the stock.
IS IT A VERY GOOD BUSINESS?
History of Consistently Increasing Sales, Earnings and Cash Flow
* Note that earnings, net income and profits are used interchangeably, while Sales & Revenue are used interchangeably
The first indication of a good business is one that has at least a 5-10 year history of CONSISTENTLY INCREASING SALES, EARNINGS, & CASH FLOW, especially during tough times.
If a company’s past earnings show consistency, then future earnings will be more predictable to forecast with confidence.
While earnings can be creatively manipulated by accountants, cash flow & sales cannot be manipulated.
SALES REVENUE & CASH FLOW FROM OPERATIONS should also increase at same rate as EARNINGS.
Sustainable Competitive Advantage
For the company to continue to increase earnings growth, it must possess a sustainable competitive advantage (wide economic moat) that protects it from any potential competition.
INVEST in Companies:
- Consumer Monopoly
- Sells a product where the company is free to raise prices without affecting the demand
- Very strong sustainable competitive advantage
- High profit margins
- Consistent increasing profits
- Predictable future growth of share equity and prices
- Stores or distributors have to carry the product or lose money. People or businesses have a strong desire for the product or service
DO NOT INVEST in Companies:
- Commodity type of product/service
- Sells a product where price is the most important factor in buying decision
- Lots of competition selling same product or service
- low profit margins
- erratic profits
- little future growth in share equity and price
- Lowest cost producer always win
Future Growth Drivers
Although the company has a strong track record of consistent revenue and earnings growth, are there any strong goals and strategies that management has announced that will continue to drive growth into the future? Are there any new market opportunities that will allow the company to keep selling more products and services?
- Development of new product lines
- Upcoming product innovations
- New application of patents
- Expansion in capacity
- Opening new markets
- Building more outlets
- Huge untapped market potential
The next criterion is that the company should have a conservative debt policy. The rule of thumb is that long-term debt should be less than 3 X Current Net Earnings (After Tax)
Long Term Debt < 3X Current Net Earnings (After Tax)
Note: While having conservative debt is useful for generating growth while keeping ROE high, too much debt can lead to bankruptcy during a prolonged recession or calamity.
Return of Equity (ROE) & Return on Assets (ROA) Must be Consistent & High. ROE > 12-15% & ROA > 7%
A company that shows a high & consistent ROE indicates that:
- The company has a sustainable competitive advantage.
- Your investment in the form of shareholder’s equity will grow at a high annual rate of compounding that will lead to a high share price in the future.
Generally, a company that has ROE of 5-10 years:
ROE > 15% => Great Investment
ROE > 12% => Good investment
ROE = 12% => Fair investment (most global business average this)
ROE < 12% => Unattractive investment
Danger: Some price competitive companies show high ROE as they purposely shrink their equity base through large dividend payouts or share repurchasing. To solve this problem, Return on Assets (ROA) should be consistent and > 6-7% as well.
Low Capital Expenditure (CAPEX) Required to Maintain Current Operations
There is no use in a company generating high earnings if a substantial amount goes to replacing plant & equipment in order to maintain current operations and competitive advantage. This is normally so for PRICE COMPETITIVE businesses and businesses involved in MANUFACTURING.
Why? Because the earnings cannot be paid out as dividends, be retained to be re-invested in growth projects or to re-purchase shares.
From understanding the business model, you should only invest in companies that:
- Does not require high capital expenditure to maintain efficiency or replace plant and machinery
- Does not require extensive research to maintain competitive advantage
- Produces a product that hardly goes obsolete
Management is Holding/Buying the Stock
The next factor to look at is whether the company’s own directors are holding, buying or selling their own shares.
If you find that KEY APPOINTMENT HOLDERS like the CEO, CFO or chairman are selling a LARGE proportion of their own stock, then it may not be as good an investment as it seems.
The Company is Undervalued: Stock Price Is Below Intrinsic Value
You should only buy a stock if its CURRENT SHARE PRICE is SIGNIFICANTLY BELOW its INTRINSIC VALUE.
When you buy a stock that is UNDERVALUED, it gives you a high margin of safety.
For example, if a company’s stock is worth Php 50 (i.e. Intrinsic Value) and it is selling for Php 25 (i.e. Current Share Price), it will definitely be a great buy.
Why is a Great Business Undervalued?
Great Businesses become undervalued from time to time because the market is irrationally driven by fear and greed in the short-term.
Stock markets tend to over-react to bad news in the short-term, sending the stock’s price way below its true value.
A value investor who knows the true value of the stock will take advantage of this and buy while the company is on sale and sell when the investor optimism returns.
The Bad News Must Be Temporary
Always check that the bad news that causes the stock price to decline is a temporary reason and DOES NOT affect the company’s long term growth prospects.
Common reasons for short-term undervaluation are:
- The stock’s sector (e.g. Heath Care) goes out of rotation
- The overall stock market is declining due to recessionary fears
- The company misses its quarterly earnings estimates
- Product or patent failure
- Accounting or management scandal
How to Calculate a Company’s Intrinsic Value?
The Value of a Stock is Equal to the Present Value of All Its Future Cash Flows
To be even more conservative, calculate the Intrinsic Value of a stock to be the sum of all its future cash flow for the next 10 years only!
In certain cases, where it is more tedious to calculate and project CASH FLOW, use EARNINGS PER SHARE as a proxy instead.
Using the Intrinsic Value Calculator (Cash Flow)
Key in the Following Values:
- Name of Stock
- Stock Symbol
- Operating Cash Flow (Current)
: If you are using COL Financial, go to Quotes → Stock → Valuations → Cash Flow
♣ Cash Flow Growth Rate can be computed using a calculator
: Use EPS Growth Rate as a Proxy
: If you are using COL Financial, go to Quotes → Stock → Valuations → Earnings per share
♣ No. Of Shares Outstanding
: If you are using COL Financial, go to Quotes → Stock → Valuations → Total Outstanding shares
♣ Current Year Discount Rate: Use the latest treasury bond rate:
Stock Breaks Out of Consolidation Or On An Uptrend and must be above the 20 or 50-Day moving Average
This final criterion will help you time your investment just before the stock makes its upward move.
You would want to know if the stock price is on a DOWNTREND, on an UPTREND or in a CONSOLIDATION pattern (moving sideways).
Always go with the current and avoid going against the current of investor psychology as much as possible. Once a trend is established whether it’s moving up or down a stock is more likely to stay in that trend than to reverse.
Stock Price On An Uptrend
The Best Time to Buy Would be When The Stock Price Dips On An Uptrend
Stock Price In A Consolidation Pattern
The Best Time To Buy Is When The Stock Breaks Out Of the Consolidation Pattern on High Volume
Stock Price on a Downtrend
Avoid Buying Stocks When It Is Still On A Downtrend! Keep It On Your Watch-list Until It Bottoms Out.
Also, ensure that the stock price is ABOVE THE 20-DAY AND/OR 50-DAY MOVING AVERAGE. When the stock price cuts ABOVE the 20-day and/or 50-day moving average, it signals that the stock will rise even higher.
The 20-Day Moving Average cutting ABOVE the 50-Day MA is also a signal to buy.
What Do You Do Once You Buy?
Regularly monitor the progress of your stock portfolio by checking:
2) Quarterly Review
3) Real Time
Seven Reasons To Sell A Value Stock
You Should Sell A Value Stock For Profit Only When:
- The stock price drops 20% below your purchase price. A 20% drop is very unlikely if you buy a very good company that is undervalued.
- You found you made a mistake when evaluating the company, as it does not meet one of the 9 investment criteria.
- During your regular evaluation, you notice a negative change in one of the 9 investing criteria, and it does not seem temporary (e.g. fall in profit margin, earnings per share, ROE etc.
- Management takes action that is not in shareholder’s best interests or dilutes their stakes significantly.
- You identify a much better investment (higher growth prospects, better price) that will give you a much higher annual rate of return.
- When the economy is approaching a bubble and the stock’s price is way overvalued.
- The Stock price reverses into a downtrend
Other than these seven reasons, allow the value of your stock to compound over the medium to long term. The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value.
Note: This is an excerpt from http://wealthacademyinvestor.com/