Safe Multiple

Security Analysis Notes and Interview Questions

2017-10-29T18:34:00.000-04:00

Security Analysis: The Classic 1940 Edition text book that one can get from Amazon 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.

Thus I thought of creating a study aid called Security Analysis - Study Aid, Notes and Quiz Questions that would have Interview/ Quiz questions which in turn would help the reader assess how much he/she has understood from the book.After studying all the 52 chapters I have come up with 232 quiz questions that cover all the major topics.

Click here to view the list of all 232 Security Analysis Interview questions questions.

How to analyze an annual report?

2017-10-21T22:36:00.000-04:00

Buffett's main source of information for valuing any stock is available to all of us FREE of cost. It is the Annual report of publicly traded companies.

Analyzing an annual report can be a very tedious task. The process of analyzing an annual report can be simplified if you have a ready checklist. This blog post gives a checklist of 25 items. As you go through the report you can keep filling the checklist. Thus by the end , you will have answers to all the checklist points that are applicable to the business.Based on the answers from the checklist , you can list down the factors affecting the earnings and in turn develop the earnings model.Which in turn can help you value the business.

1. How does the business make money – This is basically a 60,000 feet view of the business and should be explained in a short paragraph (not more than 5 lines).

2. Overview of basic Financials for past 10 years : Cash flow , Income statements , balance sheet and stockholder’s equity encompass the basic financials of every company. One needs to have a basic overview as to how these have progressed over last 10 years. For many new companies the data might not be available for last 10 years. In this case whatever historical data is available needs to be considered.

3. Segment Information : Most Companies have more than 1 reportable business segment. Many a times their results are not co-related. Hence one should try to analyze each segment separately .

4. What are the Factors that are currently impacting the business ?: One can find this information in the Management Discussion and Analysis section of the annual report.

5. Growth model , Capital expenditures and acquisitions.

6. The MOAT : What is the MOAT that the business has that gives it an edge over its competitors.

7. Getting to know the Golden “C” triangle :

(i) Customers: Profile of the customers – individual, institutional, govt.

(ii) Cost structure: Fixed costs vs varying costs.

(iii) Competitors: What’s the market share of the company’s product with respect to its competitors?

8. The selling process – How does the company sell its products? Directly to its customers or through some third party.

9. Pricing power: Does the company have pricing power. In other words can it increase the unit price of its products without impacting its volumes.

10. R&D expense details.

11.How much leveraged is the business.

12. What’s the impact of govt regulations in the business and what’s the risk involved here.

13. Is the business dependent on any government grants or subsidies?

14. Is it a Commodity business? If yes then what’s the volatility in the commodity prices.

15. Are there any long term contracts involved while selling the product ?

16. CASH cycle of the business.

17. What’s the risk involved with any quality issues? Auto industry is one of the great examples of this point where there are many recalls because of which large expenses are involved.

18. How easily are the products replaceable by other types of products? Newspaper industry is a great example of this point where the need of the product itself is shrinking and is being replaced by e-commerce.

19. What’s the spread of business between international and USA operations and the impact of foreign currency on earnings?

20. Is the workforce of the company Unionized? If yes then what’s been the impact to the business.

21. Is the business dependent on any proprietary technology?

22. How is the Tax structure of the company?

23. Does the balance sheet have large amounts of Goodwill and intangible assets.

24. Details of any legal issues company is facing.

25. Pension obligations.

26. Management stability – How often has the senior leadership and the board structure changed for the company in the past five years.

27. Intricacies of the Financial statements and foot notes – Here one needs to jot down any intricate concepts used in the Financial statements and foot notes that are hard to understand. These especially relate to Accounting methods followed by the company.

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Functions of Security Analysis

2017-10-21T22:06:00.001-04:00

Security Analysis can be broadly classified into three functions. Descriptive function, Selective function and Critical function. Following is a brief explanation of each.

Reference – SECURITY ANALYSIS by Ben Graham (Chapter-1, Page-18)

1. Descriptive function: This type of analysis pertains to detailed description of a set of businesses in similar field. Its objective is to organize information to aid a high level comparative analysis amongst the companies belonging to that set. This gives the big picture about the businesses.

2. Selective function: As the name suggests, the main goal of this function is to drill down in a business to evaluate it in order to make a decision whether to invest in it or not. One achieves this objective by evaluating the intrinsic value of the business. It’s very important to understand that intrinsic value is never a definite value, it a rough range of values deduced by analyzing the past results of a business and the current economic value of its assets and liabilities.

Very often we observe that financial statement users blindly extrapolate the past results of the business to get its future.

But SECURITY ANALYSIS clearly states that the future can only be a fair representative of past if the economic environment and growth factors of future are comparable to past.

EXAMPLE#1: “John’s pool supplies” , a privately owned pool supplies business has had a stellar growth for last five years. It’s only focused on supplying to small motels. The business has doubled last five years because John’s pool supplies’ market share has doubled from 25% to 50%. If one were to estimate the growth of the company by simply looking at its numbers, one can fairly say that the company can double its earnings in next five years. But in reality, the business has reached a cliff in its growth cycle which is evident from the fact that it has already captured 50% of the market share.

In order to double its earnings it has to literally capture 100% of the market, which does not seem practical. Hence the business has to start venturing in the residential market where the business factors are different and the company has to adapt to the specific market requirements. Hence one can conclude that the company’s chances to double its earnings are slim, unless and until the company quickly adapts to the new market.

Thus if we make the assumption that the company would indeed capture 100% of the market , then in true essence we have squeezed in the nectar of “speculation”, which might seem tasty at the beginning, but will have the impact of the bee sting at the end.

Intrinsic value as represented by Earning power : Very often the intrinsic value of a business is defined via its earning power. One can form a rough basis of the earning power by looking at past results, but as seen in the above example , this theory might not be right all the time. Conversely a business might have a valuable asset, but it might be overshadowed by the burder of an un-profitable subsidiary. Once the subsidiary is spun-off then the earning power of the valuable asset is unlocked and the business’ intrinsic value is way more than its past results.

Role of intrinsic value in the analysis process : Warren Buffett’s two investment rules are : 1. Don’t lose money , 2. Don’t forget rule#1. This points us to a very important concept as to what is the role of intrinsic value in the analysis process? To answer this question let us look at the following example.

EXAMPLE#2 : “Grey rock railways” is a major Rail company. The average earnings for past 5 years have been four times its interest payments. From a value investor’s point of view, it does not suggest that the earnings for next 5 years will be four times the interest payment, instead it points out the fact that the earnings have to drop almost 75% to endanger the interest payments on the company’s bonds.

Hence the intrinsic value is more seen as a cushion, rather than something to profit from. Value of analysis diminishes as the future gets more divergent to past: Let us say that one is certain that a major portion of a business will engage in completely different activities in next five years as compared to past five years. Thus it will be very safe to conclude that the analysis will not be of much help in evaluating the business because the future will be very divergent compared to past.

3. Critical function: This function involves in a critical judgment of management. It looks at its aggressiveness in using accounting rules to beef up its earnings, its record in using shareholder’s capital and its major acquisition decisions.

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Buffett's First Million

2017-10-21T21:50:00.001-04:00

Being a Value Investor is like running a marathon. One needs to have great endurance , patience and also lots of inspiration. There is no one more inspiring for a Value Investor than Warren Buffett. This post highlights how he made his first million. Hope his story inspires you.

References –
1. Buffett- The Making of an American Capitalist - By Roger Lowenstein
2. Warren Buffett’s letters to his partners.

Development of Buffett’s intrinsic value

Buffett’s core competence is his ability to grasp enormous amounts of information in very short time. This has helped him to build a mental image of the intrinsic values all the businesses that he follows. Thus when the market values these businesses at a discount, he naturally buys them. Warren’s father owned a securities business called Buffett-Falk. At an age when most children are busy chasing butterflies, Warren would be intrigued with the stock symbols of the S&P 500 guide and the numbers associated with them. His childhood friend Bob Russell would read out the names of cities and Buffett would spit out their populations. It seemed he never forgot any figure once he saw it. But more than everything he had an immense desire to become wealthy. As a kid Warren would go to the local racecourse Ak-Sar-Ben (Nebraska spelt in reverse order) and scout the dusty floors for stubs where once in a while he would get a winning ticket that was thrown out erroneously.

Warren was cautious beyond his years. When he learnt to walk , it was with his knees bent as if ensuring that he wouldn’t fall.When Warren was six, his family went for a vacation to Lake Okoboji in Northern Iowa. Warren would buy a six pack coke for 25 cents and would sell them for five cents each, pocketing 20% return in one day. When Warren was seven he was hospitalized, he took a piece of paper and wrote a number with many zeroes and showed it to Nurse, stating that the number represented his future net worth. Such was his confidence!!! As a 10 year old Warren accompanied his dad to Wall Street. This is where he got the first glimpse of the Engine that propels the Capitalistic world. At the age of 11 he made his first stock investment. He bought 3 shares of Cities Services preferred for $38/share. The stock went down to $27 but soon recovered to $40. This is when he sold it, just to see the stock climb to $200. Thus he learnt his first investment lesson of not being impatient.

Warren’s passion for probability pulled him to Ak-Sar-Ben Racetrack where he and his friend Russell developed a tipping system for horse players. They called it “Stable boy selections”. They tried selling copies of their system, but the authorities just shut them down as the boys did not possess proper license. At age of 13 Warren moved with his family to Washington as his father was elected to Congress. Warren took up a Newspaper route delivering Washington Post. He was meticulous to track his earnings and file a tax return. Warren’s grades were mediocre and he even once ran from his home. He was a rebellious kid. But his business passion was growing; he soon had five newspaper routes delivering 500 newspapers every day. An excerpt of this young business acumen is visible in his marketing strategy for selling magazines to his newspaper customers. Some of Warren’s customers left their magazines outside and Warren could tell by tearing off the address label when their subscriptions were ending. That is when Warren approached them with new subscriptions. The newspaper business soon blossomed; Warren was making $175 / month (equivalent to $2,625 in 2014). At the age of 14 he had accumulated $1,200 that he invested in forty acres of Nebraska Farmland.

Warren and his friend Danly bought a pinball machine, the machine always needed some maintenance and Danly was great at it. Warren noticed Danly’s skills and thought of leveraging it with his business idea. He planned on renting out the machine to a local Barber shop. The deal was that the Barber shop would get the share of the Pinball’s earnings. The business was super success. They soon had seven such machines in different Barber shops. Warren and his friend Danly were making $50 / week. By the time Warren was in his senior year of High school, he had decided on a career in Investing. He would scour through the business page, gleaning at Stock prices. The word of his expertise spread in his school and people were convinced that he knew what he was talking about. Warren graduated from high school in 1947 finishing 16th out of total 347 students. The High School yearbook stated “Likes Math……a future stockbroker”.

Chiseling of the great Investment mind

By 1950 Warren had accumulated $9,800 from his various little businesses. This is when he stumbled upon Graham’s book “Intelligent Investor”. Graham’s principles struck him straightway. Warren knew that if he wanted to make it big in the Investment world then he needed a mentor, a person who would shower him with the Investment acumen, which would give him that vital extra edge over other investors. They say things happen for a reason, In Warren’s case it was definitely true. He first applied at Harvard and was rejected because the Harvard folks did not find him as a perfect match. Warren then applied at Columbia where Graham was the dean of Securities profession. Warren got the nod from the school and he was heading to New York. Not realizing that his experience there would change his life forever.

Graham’s class of 1950 had 20 students; Warren was the youngest amongst them. Graham’s style of teaching involved asking questions to his pupils. Even before Graham had finished his question Warren would raise his hand. Graham wouldn’t say yes or no to the answer, instead would drill down to get the reasoning behind Warren’s answers. Warren passionately followed up with a logical explanation for his answer. The great thing about Graham was that he did not toil on past case studies; instead lectured on stocks those were active. One of Warren’s class mates Marshall Weinberg would later comment that through Graham’s lectures he came to know about cheap stocks like Youngstown sheet & tube, Real Silk Hosiery. He bought these stocks and later profited through them. These stock tips itself paid for his degree.

Buffett wanted to know about everything that Graham was associated with. He soon found out that Graham was Chairman of GEICO. On a Saturday morning Buffett boarded a train to its headquarters in Washington. Buffett banged the door of the office until a janitor opened for him. He wanted to know if there was anyone in office he could talk to. Janitor took him to 6th floor where Lorimer Davidson was working. Davvy as he was called by his friends was thrilled to hear complex business questions from a young MBA student. He was impressed with Buffett’s thirst for knowledge and spent four hours going over some intricate topics on Insurance business. Buffett graduated with A+, the only student to have received that honor from Graham in his 22 years of teaching career. Buffett was eager to put his new found Investment knowledge to work. He offered to work for Graham-Newman for FREE. But surprisingly was turned down. Buffett was saddened to hear this, but did not give up his determination. Though he was disheartened to know the reason behind the refusal, it was because Jews were not welcomed in Wall Street firms thus Graham wanted to reserve the spot for a Jew.

Buffett headed back to Omaha and joined his father’s investment firm Buffett & Falk. In April 1952 he married Susie and they rented a three room apartment for $65/ month rent. Buffett’s job at his father’s firm was to research investment ideas and sell to his customers. They saw him as a young in-experienced analyst and did not take his investment ideas seriously. Buffett’s best investment that time was the public speaking class at Dale Carnegie. This gave him confidence to speak in public. He made best use of it by teaching a night class on “Investment principles” at University of Omaha. His students were mostly established professionals like doctors who were twice his age. But they immediately were connected to these investment principles that were scooped out of Graham’s playbook. Buffett’s stars again took a turn; he got an offer from Graham-Newman to work for the firm. Graham had dropped the religious barrier. Graham-Newman was operating a mutual fund that bought stocks based on some very rigid principles. One of Graham’s favorites was to look for stocks that were trading at one third less than their working capital. Because of these rigid rules, a lot of Buffett’s investment ideas were rejected by the fund. One such idea was Home protective insurance. Buffett bought it at $15/share and saw it rise to $70/share. His confidence was growing day by day. Graham retired in 1956; his Investment firm had racked 17% annual returns (1936-1956). In the meantime Buffett had laid the solid foundation for his future endeavor. He had successfully tested his investment system by validating its theory; his net worth had grown from $9,800 to $140,000 (equivalent to $2.3mn in 2017)

Buffett Partnerships

May-1-1956: Warren Buffett, a green 26 year old money manager begins his journey to one of the most spectacular and most followed upon business journeys of American Capitalism. He puts in $100 (Yeah, no zeroes missing, just $100) to form an Investment partnership. His seven initial investment partners were his sister Doris and her husband, Aunt Alice, Doc Thompson, his ex-roommate Chuck Peterson and his mother and Dan Monen his lawyer. Together the seven partners put in $105,000. Very soon few more investors joined in and Buffett was running three small partnerships.

PARTNERSHIP’S INVESTMENT STRATEGY (Reference – letters to Buffett Partnership members 01/18/1963) Buffett allocated the assets of partnership into following kinds of investments.
Undervalued Securities : These he referred to as “generals” , because he had no control over the corporate policies of these companies and no time table as to when the undervaluation would correct itself. By 1962 this had slowly become the largest category of investment and he made more money here than in either of other categories. He allocated 5 % to 10% of total assets in each of five or six generals , with smaller positions in another ten or fifteen. It’s important to note that Buffett did not buy them because he saw any immediate catalyst and had no idea when the prices would appreciate. While investing in this group , he also sometimes followed the strategy of “coattail riding” where he felt that dominating stockholder group had plans for the conversion of unprofitable or under-utilized assets to a better use. In other words he planned his moves with the motive of leveraging on other activist investor's actions. Following are some very interesting words that outline this strategy.

“Many times generals represent a form of “coattail riding” where we feel dominating stockholder group has plans for the conversion of unprofitable or under-utilized assets to a better use. We have done that ourselves in Sanborn and Dempster, but everything else equal, we would rather let others do the work. Obviously, not only do the values have to be ample in a case like this, but we also have to be careful whose coat we are holding.”

Workouts These are securities whose financial results depend upon some corporate action like mergers , acquisitions , spin-offs etc. Buffett could predict their time table , within reasonable error limits. An example of this group was sell-outs by oil producers to major integrated oil companies. This category produced stable earnings and whose performance was not related to Dow, hence they seemed to look good when Dow did not do well and vice-versa. This was the second largest category of the investment where Buffett would spread his assets into 5 to 10 of these companies. He was not afraid in borrowing money for investing in these assets because he could somewhat predict the stable earnings. In 1962 the partnership paid $75,000 in interest for a total debt of $1.5 million. These investments generated 10% to 20% return. Buffett was disciplined enough as to not borrow more than 25% of total partnership’s assets.

Investments where the Partnership influenced the company’s operations These were investments where the Buffett partnership was the single largest shareholder and could influence the corporate actions. In short term if the prices declined then it worked in the partnership’s advantage as they could increase their holdings at a discount. These investments did not show much gains year over year , but finally yielded large gains when some major corporate action was taken. Following are some notable large investments belonging to this category.

Commonwealth Trust co of Union city (Reference – letters to Buffett Partnership members 02/11/1959) The intrinsic value was $125 / share and Buffett bought it for $50 / share (becoming second largest shareholder of the company) However for good reasons, it paid no cash dividends at all despite earning $10 / share, which was largely responsible for a depressed price of about $50 / share. Commonwealth was 25.5% owned by a larger bank (Commonwealth had assets of about $50 million – about half the size of First National or U.S National in Omaha), which had desired a merger for many years. Such a merger was prevented for personal reasons, but there was evidence that this situation would not continue indefinitely.

The trust had a winning combination of :
1. Very Strong defensive characteristics.
2. Good solid value building up at a satisfactory pace.
3. Evidence to the effect that eventually this value would be unlocked although it might be one year or 10 years.

Over a period of a year or so, Buffett was successful in obtaining about 12% of the bank at a price averaging about $51/share. Obviously it was definitely to his advantage to have the stock remain dormant in price. His block of stock increased in value as its size grew, particularly after his partnership became the second largest stockholder with sufficient voting power to warrant consultation on any merger proposal. Commonwealth only had about 300 stockholders and probably averaged 2 trades /month. By late 1958 Buffett’s partnership had become the single largest shareholder of the company. He was able to sell his entire block for $80 / share , even though the market price was 20% lower. Thus in around 1 year Buffett made 60% return on this stock.

Sanborn Map (Reference – letters to Buffett Partnership members 01/30/61): This was engaged in the publication and continuous revision of extremely difficult maps of all cities in the United States. The map showed minute street details like fire hydrants and composition of roof etc which was used by Underwriters of Insurance companies. The bulk of Sanborn’s customers were 30 Insurance companies. For 75 years the business operated in a very monopolistic way with steady profits with very little in sales expense. But by 1950 the company’s business became to deter because a competitive method of underwriting called “Carding” was introduced. The “after tax profit” fell from $500,000 per year to around $100,000 per year. During early 1930s the company began to accumulate an investment portfolio which blossomed to $2.5 million by 1950s. But market was not giving much weightage to it. In 1938 Dow Jones was at 100-120 range and Sanborn sold at $110 / share. In 1958 Dow Jones was 550 and Sanborn had declined to $45 / share. Yet during the same time the value of Sanborn’s portfolio had increased from $20/share to $65/share. Buffett was smart enough to recognize this and bought large chunk of shares from some disgruntled investors. Once he became the largest shareholder, he pursued the management to separate the map business and the investment portfolio and thus unlocking the hidden value of the investment portfolio.

Dempster mill (Reference – letters to Buffett Partnership members 01/18/63): By 1962 Berkshire had bought 73% of Dempster mill manufacturing company. The company was engaged in manufacturing farm implements like water systems, water well supplies and jobbed plumbing lines. On an average Buffett paid $28 / share. The company’s adjusted book value was $35 / share. Initially Buffett tried to work with the management to more efficiently use the capital by planning to reduce the overhead, but these efforts did not bear any considerable result. A friend of Buffett recommended Harry Bottle, a ruthless corporate manager. On Apr-17-1962 Buffett met him and presented a deal which provided for rewards based on objectives, on Apr-23 he was in charge at Beatrice. Harry was like a magician who surpassed all of Buffett’s targets. Harry was instrumental in freeing a lot of capital that was tied to non-performing assets. This helped the company’s capital position and helped it to secure $1.25 million. The company’s overall valuation was $51 / share (This included $16 / share tied to manufacturing).

BUFFETT'S FIRST MILLION By Jan-1 1963, the partnership’s net assets was $9,405,400. Buffett and his wife Susie together had a share of $1,377,400. Thus Buffett joined the millionaire’s club.

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Buffett's Words of Wisdom

2017-10-21T21:25:00.001-04:00

If you GOOGLE Buffett's investment advice you will get scores of links, ironically none of those results actually link to Buffett’s shareholder's letters - the source of all the investment advice, which to me is as pure as the water of Gangotri (Origin of River Ganges).Thus I thought of creating this post that lists down his words of wisdom and provides the reference Shareholder's letter where we can find more information about the topic.

1. How stock markets work and how we can benefit from it – 1987.

2. What kind of companies does Buffett prefer to invest? – 1987.

3. What an investor should know and his basic goal towards investing. – 1996.

4. How to value an asset Using the philosophy “Bird in the hand is worth two in the bush”. 2000.

5. What’s difference between Investment and speculation? 2000.

6. Growth and value investing are same. 2000.

7. How Buffett and Munger view themselves while analyzing stocks? – 1987.

8. SATIRICAL – Why investment professionals behave as they do? – 1985.

9. Even a great management cannot save a business with poor economics. 1985.

10. How Buffett measures Long term results? - 1979.

11. The value of a brand – case study of See’s candies – 1983.

12. Economics of mergers and acquisitions. 1981.

13. Economic Goodwill vs Accounting Goodwill – 1983.

14. How an Insurance company can have lots of cash and still be broke – 1984.

15. Buffett’s views on dividend policy – 1984.

16. Cash flow is important , but don’t forget capital expenditures. - 1986.

17. Difference between Book value and intrinsic value – 1987.

18. Case studies of arbitrage opportunities : Rockwood / Arcata- 1988.

19. Smart companies become aggressive when others are weak. How Berkshire profited in 1989 when Hurricane Hugo and California earthquake hit. 1989.

20. Bond investing – 1989

21. What’s the trait of a good insurance company – 1990.

22. Lesson on Banking business. 1990.

23. Difference between franchise and a Business – 1991.

24. Lesson on derivatives – 2002 / 2007.

25. A business should stay simple – Mid American’s zinc fiasco – 2004.

26. How super catastrophic premiums are recorded – 1992.

27. How Float can be an asset for an Insurance company – 1997.

28. Don’t just rely on accounting numbers- Look at the economic value Example of Scot Fetzer – 1986.

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Basics of Value Investing

2017-10-21T18:24:00.005-04:00

#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.

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.

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.

Reference – Year 2000 Berkshire Hathaway inc shareholder’s letter (pages 13 and 14)

#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.

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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