Method of evaluating and selecting stocks

This is in response to a question by Jojo on how I evaluate and select businesses. Since last November where I picked up Value Investing and made my first stock purchase, my method of evaluation and selection has evolved from the classic Benjamin Graham concept to an approach which is an improved and extended concept that originated from Benjamin Graham’s tree of thoughts which is to buy a dollar for 40 cents.

The classic Graham method advocates purchasing businesses 1) for 60% of current net asset value or working capital, 2) uninterrupted dividend payout record for 10 years or more, 3) Price to book value ratio of not more than 1.5 and so on. As the years went by, the bargain which met Graham standard got lesser and lesser. By and large, at the time, he was living in the 1930s, the situation was totally different. You could get a business that is worth less than the sellout value or working capital, close shop, fire all the workers and take home the capital. In today's world, it is simply not possible or at least they didn't.

However, having said that, his basic notion is very much applicable today or timeless. He had this concept of value to a private owner - what an enterprise would sell for if it is available and in many cases, it is calculable. As the years moved on, the disciples of Graham got wiser as those obvious bargains disappeared and they changed the calibration of measuring a bargain. Graham would be horrified at certain calibration of value investing especially those that involve paying 2, 3 or 4 times book value which he would never even consider touching. But there are still many who stick to the classic Benjamin Graham route - not that it is no longer safe or good to practice, but it will not give an above average return - it is like the man with the hammer, in Charlie Munger’s words, everything looks like a nail.

So, people started to look for bargain in a different way. People kept changing their definition so that they could keep doing what they'd always done. And it worked pretty well. So in effect, the basic Graham intellectual system is a very good and timeless one.

The best notion he crafted was "Mr. Market." To Graham, it was a blessing to do business with a manic depressive who gave him a series of options all the time. On some day, he wants to buy from Graham his stake at a very high price. On some other day, he will offer to sell to Graham at a price which is very low. To buy or to sell is all up to Graham where he has a choice or to totally ignore Mr. Market. And this is one of the most useful construct one can have for his entire investment lifetime.

However, to stick with the pure Graham method today, it is very tough to get an outsize return because Graham would not consider many things which are essential to getting an outsize return. To be fair to Graham, he is more of an academic where he wanted to construct an investment framework for people from all walks including the layman. So his ideas have to be easily understood and practiced by the ordinary people. Thus, he would not consider bringing in any idea that the layman would otherwise not understand or will be accessible to and that is exactly how he preached and practiced it.

So what are the things he did not bring to the table to enhance the chances of getting a better return? For example, he would not talk to management which he believes most ordinary shareholders do not have access to and secondly, he would not consider buying any business which is priced a couple times or more of book value even if the business has a superb underlying business economic model. And the most important extension to the classic Graham intellectual system is to first and foremost consider buying better business at a fair price even if it is a few times book value. In all cases, the notion of value investing is to find mispriced bet and gain more than what you pay for, and this may not be just limited to discount to book value, free cash flow and the old-school way of value investing.

And one of the best insights to selecting businesses is mentioned by Charlie Munger, "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." So the trick is to buy into better businesses.

Starting as Grahamites is totally fine and will work out fine or at least average for the rest of your investment lifetime. But then, to get better returns, it is important to recognize that buying companies which are 2 or 3 times book value can be a hell of a bargain because of the momentum implicit in its position and sometimes combined with an unusual management present in an individual or some other system.

Plainly speaking, it is better to consider investing in better business, evaluate the moat of a business, you may want a simple business but not an easy one where anyone can take over its place easily, look for a great and honest management, buy into businesses you can understand (for me I avoid tech stocks as much as possible and any business that always require change to maintain its existence), stick to your circle of competency. It is also importance not to buy a business which has a great management but lousy business economics as most times, it is highly unlikely a business would turn over due to the brilliance of an individual if a moat is missing. Conversely, if you come across a situation where you have to bet between a brilliant manager or a brilliant business, bet on the business. Also, if you have to bet between a fair business available at a great price or a great business available at a fair price, bet on the latter.

Here, I shall illustrate of how far I have evolved to from a pure Grahamite to buying businesses at an improved method from the classic Graham way.

Grahamite stock - Kingboard and United Food.

1) Kingboard - Late last year, the stock was available at slightly below 26 cents per share. At that price, it was selling at slightly less than 6 of 2005 earnings. Discount to NAV of 44%. Current ratio of more than 2. Sadly then, all I looked at was through the back screen rather than the front windscreen. I could not tell where the business will be 5 years down the road. And even if they survive, I could not tell explicitly what their plan is and how they are going to grow their business.

2) United Food - This is a total Ben Graham stock. Early this year, the stock was selling at 24 cents or so. Some slight discount to Net working capital. A huge discount to NAV. No debts and so on. Sadly, the reason of looking into the future is not calculable. Today, the discount to NWC is much more, traded at 18.5 cents, luckily, I sold it at about 30 cents somewhere in Apr this year. But if you are to bet on this today, it is a totally mispriced stock and the returns could be pretty significant.

Such stocks are safe stocks because of sound financial standing but the problem is the business economics are not great. They are perhaps only fair or good at most. But such stocks you can be sure that you are very well protected because essentially you are paying 50 cents for a dollar. You need lots of patience in pure classic Grahamite method and a control over your temperament for being on the other side of the fence when the majority is against you. Well, value investing is just as exciting as watching grass grows.

Therefore, after reading more on both Warren Buffett and Charlie Munger, I changed the calibration by buying into better businesses. I like businesses like Walgreens, Wal-Mart, Lowes, Home Depot, Radian, USG, Coca Cola, Harley Davidson, McDonalds, Johnson & Johnson and many more. I bought USG, Walgreens and Radian. I want to buy Lowes and J&J if I have spare cash now. All the rest it is just a matter of waiting for the right time. In investing, always study a great business, keep it in mind, keep studying and wait for it.

Walgreen - I bought it at slightly above US$40 per share. At this price, it is the lowest for the past 52 weeks but that is beside the point and unimportant unless you are a total momentum or technical buyer. At US$40, it is priced at about 4 times book value, 23 times earnings. However, considering the business historically earns 19% to 20% on shareholder's equity, at this price, I am buying at a future valuation of 2.25 times book value, 13.55 times earnings into year 2010. And most important, I can both understand the business model which is very simple and how they plan to grow their business into the future by year 2010. The business they operate is retail of drugs. They operate round-the-clock drugstores in the States. In retail, the overall business model is to stock items that the consumers are seeking for in a timely fashion and conversely to sell these items while generating the most sale per square feet of retail space. At the end of fiscal 2006, Walgreens operate 5461 drugstores, they intend to grow up to 7000 stores by 2010. That is to say you can be pretty sure sales and profit will grow and thus, shareholders will ultimately by getting more profit and value per share. The next question is how confident Walgreens will be able to achieve 7000 stores? In 1994, there were 1966 stores, they had a plan then to grow to 3000 stores by year 2000. In year 2000, they operated 3181 stores. And the best thing here while growing is they do not need to dilute shareholders stake by selling any new shares to fund their expansion which is very common in many companies. So for each original shareholder in 1994, they had a share of profit of US$0.29 per share, in year 2000, they had a profit of $0.75 per share. In fiscal 06, it was $1.72. And the business is coupled with a great management where they focused on the business rather than on the share price. The CEO mentioned something to the effect that "if a business is well taken care of, the share price will take care of itself and the share price is one matrix where he has no control over." I think that is honest management and bam, you have both a great management and a great business which has more than 100 years of operations and counting.

As for the rest of the great businesses, it is too long to even put the reasons down here.

To summarize, to get better returns and also importantly so as not to worry about the daily quotes on the tickers, it is important to buy into better businesses because if you get a great business at a fair price today, you can essentially put it aside, can it up, sit on it and maybe some many years down the road and you look at the price and value, you will have a pleasant surprise. And also just as important, you will have missed a lot of unhappy and tensed experiences.