Presentation on theme: "Constructing a Winning Portfolio"— Presentation transcript:
1 Constructing a Winning Portfolio Lessons in Stock Analysis from Master Investors
2 Some Key QuestionsOut of all the possible stocks in the world, how do you decide which ones merit a closer look?Stock “screening”What is your comparative advantage?Invest in what you know!What is your universe??Can’t just ask, would Warren Buffett invest in this stock; need to ask, would Warren Buffett invest in this stock if he were you??How will you know when you are wrong about a stock?How will you know when you are right about a stock?
3 Growth + Value 4 Legendary Investors: Benjamin Graham Philip Fisher The Father of Security AnalysisDeveloped the field of “value investing”Philip FisherStarted in 1928, still investing today“It’s quality that counts”Warren BuffettBerkshire HathawayInvesting from a “business perspective”Peter LynchFidelity Magellan (1977 – 1990)Invest in “understandable” stocks
4 Benjamin Graham: the Father of Security Analysis Lived from 1894 – 1976Founded Graham-Newman partnershipTaught at Columbia Business SchoolWrote:“Security Analysis,” with David Dodd“The Intelligent Investor”Defined the “intelligent investor” as one who viewed investing in a stock as buying a part ownership of a businessFocused on “value investing”
5 General Advice to Investors Be an investor, not a speculatorDon’t expect to profit from market movementsKnow the asking priceRake the market for bargainsNCAV rule is useful, but rules out most stocksOnly buy when there is a “margin of safety”What’s the stock worth?IV = E*(2R+8.5)*4.4 / YRegard corporate figures with suspicionDon’t stress outDon’t sweat the math
6 General Advice to Investors First rule of diversificationAsset allocation at least 25% bonds, at least 25% stocksIncrease bond allocation if the earnings yield on stocks is less than the yield on high-quality bondsSecond rule of diversificationTry to hold at least 30 different stocksWhen in doubt, stick to qualityDividends provide a clueDefend your shareholder rightsBe patientBe prepared (financially and mentally) for prolonged market downturnsThink for yourself!
7 Specific Advice to Investors: Ten Attributes of an Undervalued Stock An earnings yield (inverse of P/E) at least double the AAA bond yieldA P/E ratio no more than 40% of the highest average P/E ratio achieved by the stock over the previous 5 yearsA dividend yield at least 2/3 the AAA bond yieldA stock price no more than 2/3 the tangible book value per shareA stock price that no more than 2/3 the “net current asset value” or the net quick liquidation valueThese five attributes assess the amount of risk (in terms of margin of undervaluation) involved in buying a given stock
8 Specific Advice to Investors: 10 Attributes of an Undervalued Stock Total debt that is no more than tangible book value.A current ratio of at least 2.0Total debt no more than net quick liquidation value(6), (7), & (8) relate to financial soundnessEarnings that have doubled in the most recent 10 yearsNo more than two declines in earnings of 5% or more in the past 10 years(9) & (10) show a history of stable earningsVery few stocks make it through this screen, and many potentially valuable stocks are excluded!
9 It’s Quality that Counts: the Philip Fisher Approach Wrote “Common Stocks and Uncommon Profits”investing as a mix between science and artinvestment decisions often boil down to a judgment call about the relative importance of relevant qualitative factorswanted companies that could generate and sustain long-term growth
10 PhilosophyInvestment in “outstanding” companies that, over the years, can grow in sales and profits more than the industry as a whole.Key features of “outstanding” companies:strong management with a disciplined approach designed to achieve dramatic long-term growth in profitsproducts or services that have the potential for sizable sales long termother inherent qualities that would make it difficult for competitors and newcomers to share in that potential growth
11 Universe of StocksNo restrictions on universe of stocks to select from; OTC stocks shouldn’t be overlooked, but “outstanding” companies not necessarily young & smallCriterion for initial consideration:15 points, divided into 3 categories:Functional factorsExcellence in managementBusiness characteristics
12 Functional FactorsProducts or services w/ sufficient market potential for sizable increase in sales for several years; major sales growth, judged over series of yearssuperiority in production - lowest cost provider of goods or servicesstrong marketing organization - efficiency of sales, advertising, and distributionoutstanding R&D - amount expended relative to its size; effectiveness as indicated by ability to bring research ideas to marketeffective cost analysis and acctg. controls; choice of capital investments that bring highest returnfinancial strength or cash position - sufficient capital to exploit prospects w/o needing to sell additional equity
13 Excellence in Management Entrepreneurial attitude among management - keep innovating w/ new products or services to keep sales growingDevelopment of good in-house management & teamworkManagement depthGood labor and personnel relations; labor turnover relative to competitorsLong-range outlook by mgmt., even at the expense of short-term profitsGood investor relations & willingness to talk freely about problemsMgmt. of unquestionable integrity; salaries & perks in line w/ those of other managers
14 Business Characteristics Above average profitabilitycompare profit margins w/in industry and over several yearsolder & larger firms usually best in industryyounger firm can have narrower profit margins if spending (investing) a lot in research and/or marketingAbility to maintain good profit margins; good position relative to competition due to:skill in a particular line of businesspatent protection
15 Secondary FactorsOnce “outstanding” company is found, purchase stock when it is out of favor due to:market has temporarily misjudged true value of company, orgeneral market conditionsoutstanding companies can be purchased at fair value, but investors should expect a lower (though still respectable) return
16 Monitoring / When to Sell 3-year rule for judging results if stock is underperforming but no fundamental changes have occurredhold stock until there is a fundamental change in its nature or it has grown to a point where it will no longer be growing faster than the overall economydon’t sell for short-term reasonssell mistakes quickly once they are recognizeddon’t overdiversify - hold companies in a variety of industries having different characteristics
17 “The Warren Buffett Way” “An Unreasonable Man”Influenced by Benjamin Graham and Philip Fisher“The reasonable man adapts himself to the world. The unreasonable man persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.”– George Bernard ShawGeneral Philosophy of Warren BuffettInvest in stocks based on their intrinsic value, where value is measured by the ability to generate earnings and dividends over the years.Target successful businesses – those with expanding intrinsic values – and seek to buy at a price that makes economic sense, defined as earning an annual rate of return of at least 15% for at least 5 – 10 years.
18 “The Warren Buffett Way” Step One: Turn off the stock market.Mr. Market and the Lemmings – the market as manic-depressive“After we buy a stock, consequently we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100 percent position in See’s or H.H. Brown to validate our well being. Why, then, should we need a quote on our 7 percent interest in Coke?”
19 “The Warren Buffett Way” Step Two: Don’t worry about the economy.“If Fed chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, it wouldn’t change one thing I do.”Buy businesses that have the opportunity to profit regardless of the economy.
20 “The Warren Buffett Way” Step Three: Buy a business, not a stock.Four categories of tenets companies must satisfy to be considered as potential investments:Business tenetsManagement tenetsFinancial tenetsMarket tenetsWill be described in more detail later …
21 “The Warren Buffett Way” Step Four: Manage a portfolio of businesses.“Know-nothing” investors should own a large number of equities and space out their purchases over timeUse an index fund and dollar cost average purchases.Will enable investor to outperform a majority of investment professionals“Know-something” investors“if you are … able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense to you.”If the best stocks you own present the least financial risk and have the most favorable long-term prospects, why would you put money into your twentieth favorite choices rather than add to your top choices?
22 Back to Step Three: Buy a Business; Not a Stock Business Tenets:Is the business simple and understandable? How does it make money?Does the business have a consistent operating history? Do earnings exhibit a stable upward trend?Does the business have favorable long-term prospects? Is the business a “consumer monopoly” or a commodity-type business?
23 Monopoly vs. Commodity Consumer monopoly: Commodity-based business: Repeat business, plus one or more of following:Strong brand or other barrier (Nike, McDonald’s, Amgen (patent), rock quarries)Necessary gateway for mfrs. to reach customers (worldwide advertising agencies, newspapers)Provide necessary services (tax preparers, insurance)Commodity-based business:Low profit margins, low ROE, absence of brand loyalty, presence of multiple producers, existence of substantial excess capacity, erratic profits that depend on management’s ability to optimize the use of tangible assets
24 Buy a Business; Not a Stock Management Tenets:Is management rational? Do they invest the company’s cash profitably?Is management candid with its shareholders?Does management resist the institutional imperative?
25 Buy a Business; Not a Stock Financial Tenets:Focus on return on equity, not earnings per share.Calculate “owner earnings.”NI + (D + A) – (capital expenditures necessary to maintain economic position)Look for companies with high profit margins.Want company’s management to view earnings as belonging to the shareholders.For every dollar retained, make sure the company has created at least one dollar of market value.What is the value of the business?Can the business be purchased at a significant discount to its value?“Margin of safety” to protect against mistakesFocus of Benjamin Graham
26 Investing in a Business: the Warren Buffett Approach Advantage of stocks over bondsStocks have opportunity for growth in yields“Margin of safety” vs. “margin of protection”“Margin of protection” comes from investing in successful companiesGet good growth opportunities even if stock never moves all the way up to its intrinsic valueContribution to Warren Buffett’s thought from Philip Fisher
27 Universe of stocksNo limitation on stock size, but analysis requires some operating historyCriterion for initial consideration:Consumer monopoly, not “commodity-based” businessStrong managementBusiness that is easy to understand & analyzealso must have ability to adjust prices for inflation
28 Indications of capable management: Strong upward trend in earningsConservative financingConsistently high return on S/H’s equityHigh level of retained earningsLow level of spending needed to maintain current operationsProfitable use of retained earnings
29 Valuing the StockYou’ve found a promising company, now how much should you pay for it??Buffett uses several approaches, incl:Compare investment in bonds:relative value = EPS / LT T-bond yieldProject value forward using historical data:estimate growth rate in EPS using past 10 years’ worth of earnings datafuture EPS = current EPS * (1 + est. g)multiply by high & low P/E’s over past 10 years to get estimated future price range for stockQ: will this future price allow 15% return?
30 Monitoring / When to Sell Prefer investment in small no. of companies that investor can know & understand extensivelyDiversification not favoredhold for long termhold as long as company remains “excellent”consistently growingquality management operating for S/H’s benefitSell if:these circumstances change, oralternative investment offers a better return
31 “Invest in What You Know”: the Peter Lynch Approach Wrote “Beating the Street”Bottom-up approach, selection from among companies with which investor is familiar, then through fundamental analysis that emphasizes a thorough understanding of the company, its prospects, its competitive environment, and whether the stock can be purchased at a reasonable price
32 PhilosophyInvestment in companies in which there is a well-grounded expectation concerning the firm’s growth prospects and in which the stock can be bought at a reasonable priceA thorough understanding of the company and its competitive advantage is the only “edge” that investors have over other investors in finding reasonably valued stocksFind a “story” for the stock:slow growers, stalwarts, fast-growers, cyclicals, turnarounds, asset opportunities
33 Universe of Stocks All listed and OTC stocks, but ... Size DOES matter!Other than that, specific criteria depend on company’s story, but factors to examine include:earnings - stability & consistency w/ an upward trendP/E in lower range of historical averageP/E below industry average(P/E) < (g + D/P) / 2low levels of debt financing relative to equity financinghigh levels of net cash per shareif co. pays a dividend, look for low payout ratio but long records of regularly increasing dividendsesp. for cycicals, want inventory growth < sales growth
34 Other Favorable Characterisitics Boring name, product, or service; or company does something disagreeable or depressing; or rumors of something bad about the companyspin-offfast-growing company in a no-growth industryniche firm controlling a market segmentrepeat-purchase product that customers must keep buying even in bad timesnot a technology producer, but can take advantage of technological advanceslow % of shares held by institutions; little analyst coverageinsiders buying sharescompany buying back shares
35 Unfavorable Characteristics Hot stock in hot industryCompanies (particularly small firms) with big plans that are yet to be provenProfitable companies involved in diversifying acquisitions (“di-worse-ifications”)Companies in which one customer accounts for 25% - 50% of sales
36 Monitoring / When to Sell As with Fisher & Buffett,don’t diversify simply for the sake of diversification, esp. if it means less familiarity w/ firmfor diversification, invest in several categories of stocks, but invest in few enough firms that you can still fully research & understand each firmdon’t put all your eggs in one basket, but don’t use so many different baskets that you can’t watch them all!
37 Monitoring / When to Sell Review holdings every few months, rechecking the company’s “story” to see if anything has changed - sell if:the story has played out as expected oreither something in the story fails to unfold as expected or fundamentals deterioratePrice drops should be viewed as opportunities to buy more of a good prospect at cheaper pricesConsider “rotation” - selling played-out stocks with stocks w/ a similar story but better prospectsMaintain a long-term commitment to the stock market & focus on relative fundamental values
38 A sampling of other approaches: Growth (less emphasis on value per se)The Motley Fool –Rule Breaker / Rule MakerGeoffrey Moore –The Gorilla GameGeorge Gilder –Telecosm ParadigmQuantitativeRobert A. Haugen – The Inefficient Stock MarketTechnical AnalysisMartin J. Pring and John J. Murphy