Summary from (Source)
Chapter 1 : : Buy stocks on sale. The basic concept of Value Investing is “Buying a business for far less than it is worth”. Value investing is not a set of hard and fast rules. When prices drop, people buy more of the things they want and need, except in the stock market. Everyone seems to think that they should buy stocks that are rising and sell those that are falling. Reasons: Herd mentality. It’s ok for me to lose money as long as long as others are also losing. Investors feel disillusioned when the stocks they own or markets decline significantly. This prevents them from buying stocks when they go down.They get scared. The time to buy stocks is when they are ON SALE and not when they are high priced because everyone wants to own them. Growth investing:There is nothing wrong with owning great businesses that can grow at fast rates. The fault lies in the price that investors pay. Just like it makes sense to buy cars and jeans on sale, it makes sense to buy stocks on sale too. Stocks on sale will give you more value in return for your dollars.
Chapter 2: What’s a business worth? Two principles of value investing: What is a business worth(intrinsic value) Don’t lose money (margin of Safety) Intrinsic value enables investors to determine if a particular stock is a bargain and also if a stock they own is overvalued. When overvalued stocks are revalued by the market,there is permanent capital loss. Two approaches to intrinsic value. Financial ratios are indicators of value. 2nd is the appraisal method. Stock prices often trade for far more or far less than intrinsic value. Most investors move from extreme pessimism to jubilant optimism. These emotions drive stock prices to extreme overvaluation and under-valuation. Rational value investors sit back and wait for the market to offer stocks for less than they are worth and to buy the same stocks back for more than their worth.
Chapter 3: Don’t lose money. As a company increases it net worth or intrinsic value overtime, the value of the shares will increase. If the price of the stock rises from less than intrinsic value to intrinsic value over time, you have a win/win.When you pay full price for a stock ( intrinsic value), future gains may be limited to company’s internal growth rate and dividends Graham wanted to buy stocks selling at two-third (66%) or less of their intrinsic value. If correct,the stock could rise 50% and still not be overvalued (99% of IV). If the market hit a rough patch, he knew what he owned was worth more than what he paid for it. Avoid investing in companies that have a lot of debt relative to their net worth. Such companies are far riskier investments than companies with excess cash. Also, such companies cede a measure of control to their lenders. Diversification provides a margin of safety and insurance against downturn in a few stocks/industries. Have a broadly diversified portfolio of stocks across industries. Hold a minimum 10 stocks in a portfolio. Lets you be contrarian. Lastly, if stocks are cheap buy them. Ignore the noise around you and take advantage. Reverse is true also. If stocks valuations are reaching or exceeding intrinsic value and there is no margin of safety, one must sell. Buy in bad times and sell in good times.
Chapter 4: Buy earnings on Cheap. (The lower the price, the higher the return) – Buying Low P/E has worked over the years in all countries all industries. – Earnings yield= inverse of P/E – Use it to compare to other investments. – Consider inflation effects on purchasing power – Trailing P/E (rear view mirror) v/s Forward P/E (often optimistic projections) – Graham looked for cos with stable record of earnings,predictable. – Buying cheap on past earnings for such stable cos is good. -Discussion on Cash flow and FCF and its merits. – Chris also looks at low P/E in terms of their worth to a potential acquirer. – EBITDA and how LBOs use EBITDA. Measure of debt serviceability. – Low P/E works in good and bad markets- Wait longer in bear markets to see returns. Best part of Low P/E approach is that it forces you to buy stocks when cheap and while fear is high. – Best opportunities are preceded by much pain and not great times. – Low P/E stock are low expectation companies (as opposed to high p/e stocks). – When low p/e company reports bad news, effect is minimal as its priced in. Good news resultsin a pop. (opposite in high p/e)
Chapter 5: Low P/B stocks. When: Poor earnings, Poor Industry conditions. Buy below book value (BV) per share. Examples: insurance, banks. Use global search approach to uncover stocks below BV. Sometimes stocks sell below cash balances.Buying stocks that sell cheaply when compared to asset values works.
Chapter 6: Global search for value Global economy; high correlation in world markets; global diversification is tough. Real reason is to increase the number of potential value ideas. At times of Regional economic problems, values can be found.Examples: Asian collapse in 98, Germany reunion in 80s. (My inference: Looks like crisis in Europe would present good buying in companies that are strong,profitable, stable earnings and good balance sheet.) Rising interest rates are enemy of the markets. Sell offs happen. Value deals can be found. (This would happen sometime in the future when rates go up).
Chapter 7: Value in friendly countries– International investing is easier with standardized international accounting (IFRS) Example of Roche which setup Contingent liabilities reserves in profitable years. Then, after reserve was reversed, they would add it directly to book value and not have to report as income. (Swiss laws allowed this). Example of Lindt and Sprungli. 10x p/e. Swiss market down due to higher inflation, CEO had divorced. Traded at 3.5x EBITDA. Similar companies bought for 20x earnings. Countries author avoids such as Argentina, Venezuela, Russian crisis example, Mexico, Bolivia, Asian financial crisis. Now, China. Government control and policies, appropriation means thatmargin of safety is lacking. Author prefers looking at developed economies.
Chapter 8: Buy when insiders buy – Insider buying can help find companies whose fortunes could turn for the better. – Insiders could sell for various reasons and is not as useful. – there is only one logical reason to buy – they think stock price is going up. – Insider buying of stocks selling at low P/E or below asset value is even better. – Corp buybacks are another good sign. – Look for presence of Activist investors. – Insider buying and activist investors can act as catalyst for stock appreciation.
Chapter 9: Falling prices can be a double edged sword Markets fall time and again because of political or economic announcements. Similarly, individual stocks and sectors often fall on weaker than expected earnings or unforeseen events. This is the time to be buying, but investors panic and go to cash. Risk is more often in the price you pay than the stock itself Prices of solid companies with strong balance sheets and earnings usually recover. If the fundamentals are found, prices always have and will always recover. Today’s worst stocks become tomorrow’s best stocks and the darlings of the day turn into tomorrow’s spinsters. Don’t try to catch an overpriced, cheaply made falling knife.Example of S&L crisis (very similar to current financial crisis), Big banks such as Bank of America and Chase Manhattan Bank fell to prices at or below their book value and had P/E ratios in single digits. Wells Fargo was hit hard due to high exposure to California real estate market (sound familiar ??).Investors who did their homework and investing in banks during this time earned enormous returns over the decade that followed as the industry went through amerger boom. In 1992, health care reform proposal caused stocks of leading drug companies such as Johnson and Johnson to decline sharply. JNJ traded at 12xP/E. Amex after 9/11 sold at 12x P/E Bargains are found in new low lists.
Chapter 10: Seek value the modern way Describes Grahams Net-nets method.Net Current Assets = Current Assets (cash + inventory + receivables) – Total Liabilities NCAV = Net current assets / Shares outstanding If stock is trading at 2/3rd of NCAV or less, Graham bought it. Talks about how modern day screeners make finding value easy. Lists of new lows WSJ, Barron’s, IBD are good starting points in search for value. He cautions that such lists or screened results are just a starting point and not the destination. He expects the investor to examine the firms to make sure they are good and cheap. Another approach is to look at what other value investors have in their portfolios via their quarterly letters and from Morningstar. Look at what who else owns a particular stock. Look at prices paid in mergers and acquisitions to find stocks that are selling at a significant discount to what they are worth to a knowledgeable buyer. Look at other companies in the same industry and compare P/E, P/S and P/B. When an acquisition happens, you can take the purchase price to calculate the P/S, P/E,P/EBIT/, EV / EBITDA etc and keep them for future reference.
Chapter 11: When a bargain is NOT a bargain? This Chapter deals with companies to avoid. Many companies are cheap for a reason. They have fundamental problems.We have to determine why a company’s shares are cheap and which ones have little chance of recovery. Why do stocks become cheap 1) Company has taken on too much debt. – Future is unknown. If you have too much debt, smaller chance of surviving an economic downturn. Graham’s simple method: Company should own twice as much as it owes. Avoid others. 2) Company falls short of analysts’earnings estimates. – May create a value opportunity. However, if trends continue price likely to fall. 3) Cyclical stocks (automobiles, large appliances, steel and construction) Avoid overly leveraged companies. 4) Labor contract issues. (Big Three Auto, Airlines) – Unfunded pensions that are large.Companies may not be able to pay. Avoid such companies. 5) Increased competition- If facing strong competition from a more efficient competitor with lowercosts, then move on to the next candidate. 6) Obsolescence (Blockbuster) -Avoid companies that are subject to technological obsolescence. 7) Corporate or accounting fraud. – No way to uncover before it becomes public – stay away from companies whose financial reports are overly complicated. Best companies are those that can be easily understood. And if they have a moat, it is even better. Moat can be in the form of patents, brand name, or Size. (Walmart)Moats do not last forever, but allow a company to make profits for many years.Chris likes businesses he understands and for which there is ongoing need Examples: Banking, Food, and Beverage, Consumer staples like detergents,toothpaste, pens, and pencils. People tend to use the same products over and over again. Skepticism is needed when considering candidates.
Chapter 12: Balance sheet checkup– Start with the balance sheet. – Liquidity – Avoid too much debt. – Current ratio = current assets / current liabilities. Ability to pay short term obligations. Rule of thumb is 2. Could vary by business. Compare this to other companies in the industry. Also look at it over several years.Declining ratio may indicate liquidity problem. – Working capital. – Quick Ratio – Inventory level and growth with respect to sales over several years. -Check long term liabilities versus assets over years. – Computer shareholder equity or book value. Subtract intangibles (patents, trademarks) – Debt to Equity ratio – Take both ST and LT debt./ shareholder equity. Compare this number toother companies in the industry – The less debt means greater margin of safety.- Evaluate levels and also the trends across years. – If BV is a lot of intangible assets like goodwill or excess inventory in relation to sales, it may not be quite the bargain on a P/B basis. – Sometimes BV is understated.Land or stock investments may be carried at cost. This has been true over the years in foreign stocks in particular. Winning means not losing. Strong balance sheet shows ability to survive when the going gets tough.
Chapter 13: Income statement checkup
– Explanation of the key terms and line items of an income statement.
– Compare revenues across the years to see growth.
– See revenues from different divisions to spot problems or spot strength in core business.
– See COGS as a % of sales.
– Steady gross profit means steady business and the better it is.
– SGA, the lower this number as % of sales the better.
– EBIT or operating profit is used by the author in valuation ( also Magic Formula )
– Look closely at one time charges. Back out one time charges as earnings may be grossly inflated due to one time gains or conversely earnings may look depleted due to one time charges.
– Calculate both EPS and Diluted EPS. If the difference is vast, then the stock is not as undervalued as originally thought.
– Use EBIT to determine EPS and Diluted EPS as it’s an accurate measure of corporate earning power.
– Most revealing aspect of Income statement is the trend over 5 or 10 years.
– Revenues rising?
– Expenses in line with revenues?
– Consistency of profits
– Cyclical earnings
– Growing profits
– Lot of one time charges?
– Shares outstanding: Are they growing,flat or falling?
– Return on capital and trends.Minimum is stability. Growing is even better. Declining ROC consistently is bad. Poor management
– Net profit margin. Falling margin could indicate bloated overhead, careless management or high competition. He likes to see consistent profit margins at least.
If you cannot understand the income statement of a company, just walk away from it.
Chapter 14: Thorough examination of an investment candidate (IMPORTANT)
Assume you have looked at book value;earnings are cheap, balance sheet analysis already.
- Does company have pricing power? What is the outlook for prices?
- Can the company sell more? Outlook for units?
- Can company increase profits on existing sales? Outlook for Gross profit margin as % of sales.
- Can the company control expenses? Outlook for SGA as a % of sales
- If company raises sales, how much of it will fall to the bottom line
- Can the company be as profitable as it used to be or at least as profitable as competitors?
- Does the company have one-time expenses that will not have to be paid in the future?
- Does the company have unprofitable operations that can be shut?
- Is the company comfortable with Wall Street earnings estimates?
- How much can the company grow over the next five years? How will growth be achieved?
- What will the company do with the excess cash generated by the business? Dividends? New stores/ factories? Acquisitions/ Buy back of shares?
- What does the company expect its competitors to do?
- How does the company compare financially with other companies in the same business?
- What would the company be worth if it were sold?
- Does the company plan to buy back stock? (Is the company following up on its announced buy back?)
- What are the insiders doing?
Chapter 15: International accounting
– Companies in US have two sets of books, one for IRS and one for investors
– In Europe, only one set of books.
– Example of Lindt. P/E on surface was 10 which was attractive by itself for a major consumer brand. Looking at depreciation and comparing to others, Lindt had high depreciation as % of sales. Double of industry. After adjusting this, the P/E was 7.5.
– Usually such rules meant lower earnings were reported and lower asset values (as compared to US rules).
– ADRs make it easy to invest in international companies.
Chapter 16: Currency issues, hedging
– When you invest in foreign stocks,another aspect to consider is the currency. Currency could fluctuate against your local currency. You could choose to hedge the currency so that your return is dependent on the underlying investment.
– Example: If you buy 1000 pounds worth of a company stock, you could SELL a currency forward contract for 1000 pounds.
– Another idea is to not hedge for currency. Over long periods, currency effects are neutral.
– What does not work is switching from hedged to unhedged approach depending on your guess of the currency movements.
Chapter 17: Market timing does notwork. Avoid it.
= 80-90% of the stock returns comefrom 2-7% of the time.
Chapter 18: Stocks versus Bonds.Avoid Bonds if you have a long term horizon.
In Jeremy Siegels’ book Stocks for the Long Run, he shows that stocks as measured by an index beat bonds and cash in every 30 year rolling period from 1871 to 1992. In 10 year rolling periods, stocks beat bonds 80% of the time.
– Keep 3 years of spending in short term bonds/ cash. You will then not have to sell stocks when they are at their lowest.
Chapter 19: How do you pick a money manager?
1) Does the manager have an investment approach and can explain it to you or any layperson in plain English. Has he applied it consistently over time?
2) How is his Track record? Min 5years, Prefer 10 years.
3) Whose record is it? Is it the manager who is presenting or his predecessor?
4) Do they eat their own cooking?
5) Does he own the investment management firm?
Chapter 20: Why do people not follow value investing principles?
– Temperament: Read Behavioral finance.
– Herd instinct. People feel confident when investing with the crowd.
– Reputational and career risk of being a contrarian.
– Periods of underperformance when following value investing.
– Courage is needed to buy out of favor companies. These are boring investments often.
– People seek instant gratification.
– Value investors are like farmers.They plant seeds and wait for the crops to grow.
– Overconfidence is another flaw of investors.
– The investment world equates activity with intelligence.
– Good long term performance results from beating the market in bad times.
– Caution should not be seasonal.
– Maintaining a steady state of mind in good and bad times is the key to successful long term investing.
– Indexes can be victims of bubbles. SP500 in 1999 was 30% tech.
– Lot of pressures against valueinvestors.
Chapter 21: Stick to your guns
– Value investing requires more effort than brains and a lot of patience.
– Growth and value are joined at the hip. Difference is a question of price.
– Track acquisitions. P/BV, EV/EBIT. Use this to screen companies that are selling in the stock market at as ignificant discount to what an LBO group may pay. This is called the”appraisal method”. 3rd approach along with P/E and P/B.
– Buying stocks for less than they are worth and selling them as they approach their true worth is at the heart of value investing.
– Buy below intrinsic value with a margin of safety, exercise patience.
– Patience is the hardest part of using the value approach.
