Wednesday, March 28, 2007

How to be a shrewd investor?

“Nowadays, people know the price of everything and the value of nothing.” – Oscar Wilde, The Picture of Dorian Gray.

Oscar wasn’t even an investor or participant in the stock market. He wasn’t even living the age of stock market. He was a playwright who died in 1900. Nonetheless, his famous quote illustrates the difference between price and value.

All of us are able to distinguish the difference when we behave as consumers. For instance, we wouldn’t pay $10,000 for a vehicle’s CEO with 7 years to go when a new 10-year CEO is going for $12,000. In fact, we’d be downright suspicious of any car salesman trying to pull that one over on us.

As consumers, we want to get the most for our hard-earned money, and we don’t want to overpay for the products we buy. However, we don’t always think the same way when picking stocks.

Then again, valuing a stock is slightly more difficult than looking up a car’s fair value. Maybe that’s why novice investors can turn to false indicators of value – that is the share price on the ticker – and interpret it as value, due to convenience or otherwise.

The thing is, share price alone tells us very little, in fact nothing, about the actual value of a stock. For instance, Singapore Food which trades at $0.86 per share could be a much better value than Capital Land which trades at $7.80 a stub.

To value a stock properly, we need to look at the company’s financial statements – particularly the cash flow statement. If you are either too lazy and do not bother to learn how to interpret the basics of a financial statements, it is highly suggested you do not invest – not even a single cent. Warren Buffett said: “If you bring nothing to the party, you shouldn’t expect to bring any thing home.”

Why the cash flow statement? Cash flow shows us how well the company manages its cash – If its cash is generated through normal operation, loans or otherwise. And cash, after all, is what we eventually want in return from our investments. As Scott Glasser, co-manager of the Legg Mason Partners Appreciation fund, puts it: “Shareholders don’t get earnings. They get cash.”
Moreover, companies with positive earnings could be burning through their cash, which could be a sign of inefficiency. Some businesses could have posted positive earnings over the past 12 months but have not actually produced any free cash flow.

In some other cases, which could be false, the earnings are a fraud – like how Enron did. Before Enron got busted, they were posting earnings of more than a billion. However, they were perpetually negative in free cash flow.

Ideally, you’d like to see a company generating enough free cash flow to either reinvest in the business, repurchase outstanding stocks, or return to shareholders in the form of dividends. Long-term winners such as Procter & Gamble and Johnson & Johnson for instance, have consistently generated enough cash to pay dividends every year since the 19th century.
Once we know how much extra cash a company is generating, we can estimate how much cash it will down the road. Using the discounted cash flow model, we can then decide how much those future cash flows are worth in today’s dollars. If the sum of those values is higher than the stock’s current price, the stock might be undervalued and worth buying.

This is one of the methods that many value investors use to select stocks for their portfolio. And many of them have had a lot of success with it.

Looking at stocks in terms of value and not simply price is a simple way to help improve your returns in the long-term. It’s worked for guys like Buffett, Templeton, Graham, Schloss, Browne and many more. By integrating their framework into your framework, it can work for you too.


musicwhiz said...

Another insightful article, thanks ! I learnt to recognize the value in businesses rather than the price about 1.5 years ago, and have since not looked back. Since then, I have sold off all my lousy businesses for a small loss, and retained the good, growing ones. The profits have been growing, and I can see the visibility in earnings and FCF (as you mentioned) about 2-3 years down the road. Thus, I can sleep soundly every night.

To add to your article, sometimes intrinsic value can be very hard to estimate. Future cash flows are about as hard to predict as future earnings, thus I use an all-round value investing approach to review a potential company. Besides using metrics such as FCF, ROE, PER and EPS, I also use qualitative measures such as Management strategy, integrity, transparency, competitive advantage, industry review etc. This is to broaden my understanding of the company and see if it has the ability to grow in future years.

So far, the companies I own have shown the ability to scale up earnings, but not at the expense of cash. Thus, their share prices have correspondingly increased too. I have learnt that patience is the key and Mr. Market cannot under-value the company forever.

Keep your articles coming ! Great reading !

Anonymous said...

hi there again...
Totally agree with the value investing method. In fact this is how I predict the intrinsic price. But sometimes estimating the percentage growth is not easy as Musicwhiz has said...

JNJ is a company that has good value now at the price it is trading today : )


Berkshire said...

Hi Musicwhiz,

That was exactly how I started value investing. Initially, I can only appreciate the old-fashioned way of value investing, that is to buy cheap stocks with a huge discount to NAV. Then I realized it is a lousy way to invest. Not that it doesn't gives me a good return, on the contrary, it gives me a much better return than what I am currently practicing which is to buy into great business at a great price. To put it into perspective, I gain about 40% return from both Kingboard and Stamford Land, which are of course the old fashioned way of value investing. But what beats this old-fashioned through invesing in great businesses at a great price is I am able to sleep soundly every night without caring about the direction in which the stock price goes. In fact, currently, I am under water for JNJ which I purchase at about $65 but it don't bother me a bit because I will probably hold it forever unless the valuable goes way over the line.

I gotta agree with you the qualitative side like management, the business model, its competitive moat and so on should lies above what the numbers and figures say. That is what a complete value investor should embrace.

Berkshire said...

Hi Musicwhz,

I noticed you mentioned intrinsic value in your comments and I am unsure if you are qualifying IV to be the same as FCF. So I'd better clarify my thoughts on IV and FCF.

IV is not the same as FCF. FCF value will always be higher than IV. Never the other way around. In IV, it is actually a comparison between a stock you are interested in and an alternative, preferably risk-free. So IV will be the residue value after factoring in the earnings you could have otherwise earned in a risk-free investment. I have wrote an article earlier on this and I am not sure if it gives a clear understanding sufficiently.

I look forward to hearing from you if you think otherwise to what my thoughts are.


Nina Athena said...

Thank you for sharing such valuable information and knowledge. It is very useful and informative. It would be great to see more updates from you soon.

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