Morningstar StockInvestor: Seven Different Investing Perspectives

Recently, Paul Larson, an equities strategist with Morningstar, had described seven ways in which his investment strategy differs from the conventional wisdom and academia ("Seven Different Investing Perspectives"). If I were to make such a list myself, it would look identical to the one compiled by Paul Larson. Brief version of his "seven investing perspectives" is included below.

1. Focus on the next decade, not the next quarter.

Most Wall Street analysts who publish research for public consumption spend a lot of their energy focusing on near-term tax rates, weekly inventory trends, and so on, which really do not matter in the long term.

The army of analysts on Wall Street are then serving an exploding number of hedge funds, entities whose investors demand performance - and demand it now - given the exorbitant fees usually being paid. Many hedge funds cannot afford to think about the long term, because if they suffer even a little in the short term, they might not be around for the long term.

Luckily, those willing and able to take a long-term perspective can gain an edge in this short-term-focused world, and that's exactly what I and our analysts do here at Morningstar. We spend a lot of our time thinking about where a company is going to be many years from now, because this is what drives intrinsic value. We try to minimize the short-term noise to pick out the secular trends that will really matter.

2. Price volatility does not equal risk.

If you go to business school, you are likely to be taught that risk in the stock market can be defined as the historical volatility in a stock's price. Risk is usually thought of and measured in terms of beta, a statistical measure that represents a stock's past volatility relative to an index. Frankly, I just do not understand the relevance of beta when thinking about ways I might lose money. Not only is it backward-looking, but its connection to intrinsic business value is tenuous at best.

When thinking about a stock's risk rating, Morningstar analysts do not focus on the past stock price movements of a company. Rather, we focus on the fundamental business factors - competition, litigation, financial leverage, and so on - to try to figure out what sort of margin of safety to apply to a company before buying it.

3. Price volatility is a good thing.

Not only do I think stock price volatility is a silly way to measure risk, but I actually like volatility. When stock prices whip around, it creates more opportunities to buy things when they go on sale. Moreover, volatility can fling stocks well above their intrinsic values, creating selling opportunities.

I think two of the more famous Warren Buffett nuggets of wisdom apply here. (Though Buffett is as mainstream now as he has ever been, he is still seen as a heretic in many academic circles.) According to Buffett, one of the cornerstones of his strategy is, "Be fearful when others are greedy, and greedy when others are fearful." The other Buffett quote that backs up my favorable opinion of volatility is: "Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

4. Concentration has its benefits, overdiversity its downfalls.

It seems that whenever I hear financial advisors speak, they are always preaching the benefits of diversity. While I agree every portfolio should have some level of diversity to prevent any single mistake from causing financial doom, I do not think the downside of diversity gets enough attention. Specifically, the wider you spread your portfolio around, the less you will know about any single investment, and the greater the chance you will miss something that is wrong. Call it the risk of ignorance.

In other words, I agree that it is good advice to not put all your eggs in one basket, but do not forget about the risks of trying to carry too many baskets. Or, to use our "fat pitch" metaphor, don't swing at the marginally decent pitches, because then your swings at the truly fat pitches will be diluted.

5. Bottom-up is better than top-down.

There are two basic ways to look at stocks. The first way (and what we do here at Morningstar) is to look at an individual company - its competitive positioning, profitability, growth prospects, and so on - to come up with an intrinsic value estimate for the business. We then compare this fair value estimate with the current stock price to come up with our Morningstar Rating for stocks (the star rating).

The other way is to try to pick out macroeconomic trends and generate investment ideas from these trends. Some examples might include ideas regarding the aging population, interest-rate movements, global-warming regulations, changes in consumer-spending patterns, and so forth. Some investors might choose to overweight or underweight their portfolios in certain sectors based upon their views of some of these trends.

The problem I see is that there are often too many logical links between the ideas and the actual stock investments. Even if your idea is correct, you could still select the wrong stock for that idea. Another pitfall of looking top-down is forgetting the importance of valuation and paying too much for a stock.

I also do not try to "fill the box" when managing the [stock portfolio]. What I mean by this is deciding on some sort of asset allocation - either by sector or stock style - and then picking stocks to try to fit my target allocation. To me, this is putting the cart before the horse.

What I do instead is look at each stock on a case-by-case basis, and I then let the cards fall where they may with respect to the sectors and styles of my holdings. Only at the extremes might I get worried (such as having more than half a portfolio invested in a single narrow industry).

6. Increased portfolio activity does not create higher returns.

In the real world, the more activity you have in a given area, the greater the return in that area, in general. For example, the more you exercise, the more weight you lose. The more you play golf, the better your swing will get and the lower your handicap will go, and so on. But when trading stocks, the exact opposite is true. In general, the more you trade, the lower your returns will be.

There are the frictional costs of taxes, trading spreads, and commissions that will eat into your capital every time you trade. Of even greater importance in my mind is the amount of thought that goes into each trading decision. It seems that the greater the thought-per-transaction ratio, the better our results should be, all else equal. I spend hours upon hours considering each transaction in the Tortoise and Hare, but spend mere minutes interacting with our broker doing the mechanical transactions, worrying about nickels and dimes. I get the impression that too many investors have this ratio reversed.

7. Focus on value, not price.

It strikes me that many in the market know the price of everything and the value of nothing. I will admit that there are scores of companies for which I know what the stock price has done, but have no clue about the value of the underlying business. But before I invest in something, there is no way I would put a single penny in without having some idea what the underlying business is worth. Knowing price without knowing value means knowing nothing.

I recently was asked if I had in place any stop-loss orders for positions in the Tortoise and Hare. The answer is a resounding "no." Making decisions based on historical prices makes no sense to me. Moreover, assuming that the intrinsic value of a business is unchanged, when its stock price goes down, that is the time to get more excited and consider buying more, not time to cut bait.

Of course, the key phrase is "assuming the intrinsic value of a business is unchanged." We are continually questioning our theses and projections for the companies we cover, always digging deeper for pieces of confirming or contradictory evidence. These fundamental factors - not stock prices or ideas about future market sentiment - are what drive our fair value estimates.

Miscellaneous Stock Tips: Issue #1

1. As one fund manager has noted, there is a reason to not like companies with a very low tax rates: because it's a sign that IRS will eventually catch up with them or that the company is possibly manipulating the earnings. With an average corporate tax rate of 35%, companies with a tax rate of 15-20% seem suspicious.


2. Avoid homebuilding stocks as they are difficult to value: it is not always clear whether the gains come from the business growth or from the higher valuation of their land assets.


3. Bank stocks are still not a good buy since global credit boom is most likely in its last days and even good banks are likely to suffer or trade sideways. (Having said that, if you have a long-term investing outlook you can find a few financial giants that may rock your world, such as Bank of America (BAC) and Capital One Financial (COF), which I've recently reviewed).
   


4. Gold is considered as a hedge investment (or insurance) against an equity market slowdownsince it usually goes up when the stock market goes down.

Morningstar's Investing Strategy

I whole-heartedly agree with the investing strategies suggested by Morningstar and outlined below. This is definitely part of a value-investing approach, particularly as manifested by Warren Buffet's investing style.

This strategy fits in well with Morningstar's 20 Stock-Investing Tips.

1. Look for Wide-Moat Companies.

The fat-pitch approach is best described as buying above-average (wide-moat) companies at prices that provide a margin of safety to your fair value estimate.

Companies with wide economic moats reside in profitable industries and have long-term structural advantages versus competitors. These companies are fat pitches with predictable earnings, returns on capital higher than the cost of capital, and long-term staying power.

The beauty of a wide-moat company is that the odds are pretty high that the actual intrinsic value of the firm will increase over time, leading to higher shareholder value. In other words, time is on your side with these companies.

We recommend maintaining a watch list of wide-moat companies that you consistently monitor for any opportunities.

2. Always Have a Margin of Safety

Buy a stock only when it's selling at a decent margin of safety to your estimate of its fair value. Don't even think about the overall direction of the stock market, because that's impossible to predict with any consistency. By doing this, you'll need to exercise a lot of discipline and wrestle with the fear of missing out on a market rally. Patience is indeed a virtue when using this approach because oftentimes it may take many months, or longer, before a fat-pitch opportunity presents itself.

Think only about individual wide-moat companies; if you find one where the price is irrationally low relative to its long-term intrinsic value, consider buying it. If not, hold off for a fatter pitch.

Also, you must determine how much of a margin of safety you'll require before buying a stock. If the firm is not very risky, you could be content with a 15%-20% discount to its fair value. If the firm is riskier than average, you may demand a 30%-40% discount. Ultimately, it's your decision.

The beauty of fat-pitch investing is that it has two built-in factors that help offset the risk that your fair value estimate is wrong. First, by requiring a margin of safety, you've given yourself some "error cushion," just in case your estimate was too high. Second, by purchasing wide-moat companies, chances are high that the firm will increase in value over time. Thus, even if your estimates were way off, the firm--and its stock price--will likely appreciate in value, eventually catching up to your fair value estimate. In effect, by buying wide-moat companies, you have another margin of safety built into your investment.

3. Don't Be Afraid to Hold Cash

For instance, many professionals getting paid to invest other people's money feel they are actually required to stay fully invested even if there's a lack of fat-pitch opportunities. Thus, when the market drops, they often can't do anything but watch (or worse, sell out near the bottom).

So if the market isn't throwing you fat pitches, just hold on to your cash and wait until it does, because fat-pitch investments are much more likely to provide strong absolute returns over time.

4. Don't Be Afraid to Hold Relatively Few Stocks

Remember, it takes great patience to be a fat-pitch investor, but when opportunities present themselves (nice fat pitches right down the middle), you should buy boldly (swing away).

We caution you, however, that it's risky to hold a concentrated portfolio (few positions) unless you do three things:
1. Buy only wide-moat companies, which will increase in intrinsic value over time.
2. Buy them only at a significant discount to fair value (a margin of safety).
3. Have a time horizon of at least three years on each pick you make. It may take this long (or longer) for the market to recognize the value of a company.

5. Don't Trade Very Often

Think of it this way: Investing is nothing more than a game of probabilities. No matter how diligent you are, your fair value estimate for a stock will never be exactly right. It's really just an estimate of what a stock is worth under the most likely scenario for future earnings growth and profitability. Thus, there's always less than a 100% probability that you'll be right about a stock pick. Given that the odds are below 100%, there's little point in trading from one stock to another frequently; your odds of being "right" on the new pick are probably only a little higher than the odds of being wrong on the current pick.

Add to this the costs of trading--including taxes, bid-ask spreads, and commissions--and the odds of generating higher returns by trading frequently are worse than simply buying great stocks at good prices and holding them for three years or more.

Additional resources:

• Morningstar's 20 Stock-Investing Tips
  

• Morningstar's Investing Classrom (Free)
  

Morningstar's 20 Stock-Investing Tips

Morningstar has compiled a list of 20 stock-investing tips that they suggest for individual investors. In a way, it's a summary of the value-investing philosophy they follow and I find it to be a handy list to keep around when I need a reminder of what a sound investing process should be based upon.

So, without further ado, here is the list:

1. Keep It Simple.
Keeping it simple in investing is not stupid. Seventeenth-century philosopher Blaise Pascal once said, "All man's miseries derive from not being able to sit quietly in a room alone." This aptly describes the investing process.

Those who trade too often, focus on irrelevant data points, or try to predict the unpredictable are likely to encounter some unpleasant surprises when investing. By keeping it simple - focusing on companies with economic moats, requiring a margin of safety when buying, and investing with a long-term horizon - you can greatly enhance your odds of success.

2. Have the Proper Expectations.
Are you getting into stocks with the expectation that quick riches soon await? Hate to be a wet blanket, but unless you are extremely lucky, you will not double your money in the next year investing in stocks. Such returns generally cannot be achieved unless you take on a great deal of risk by, for instance, buying extensively on margin or taking a flier on a chancy security. At this point, you have crossed the line from investing into speculating.

Though stocks have historically been the highest-return asset class, this still means returns in the 10%-12% range. These returns have also come with a great deal of volatility. If you don't have the proper expectations for the returns and volatility you will experience when investing in stocks, irrational behavior - taking on exorbitant risk in get-rich-quick strategies, trading too much, swearing off stocks forever because of a short-term loss - may ensue.

3. Be Prepared to Hold for a Long Time.
In the short term, stocks tend to be volatile, bouncing around every which way on the back of Mr. Market's knee-jerk reactions to news as it hits. Trying to predict the market's short-term movements is not only impossible, it's maddening. It is helpful to remember what Benjamin Graham said: In the short run, the market is like a voting machine - tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine - assessing the substance of a company.

Yet all too many investors are still focused on the popularity contests that happen every day, and then grow frustrated as the stocks of their companies--which may have sound and growing businesses - do not move. Be patient, and keep your focus on a company's fundamental performance. In time, the market will recognize and properly value the cash flows that your businesses produce.

4. Tune Out the Noise.
There are many media outlets competing for investors' attention, and most of them center on presenting and justifying daily price movements of various markets. This means lots of prices - tock prices, oil prices, money prices, frozen orange juice concentrate prices - accompanied by lots of guesses about why prices changed. Unfortunately, the price changes rarely represent any real change in value. Rather, they merely represent volatility, which is inherent to any open market. Tuning out this noise will not only give you more time, it will help you focus on what's important to your investing success - the performance of the companies you own.

Likewise, just as you won't become a better baseball player by just staring at statistical sheets, your investing skills will not improve by only looking at stock prices or charts. Athletes improve by practicing and hitting the gym; investors improve by getting to know more about their companies and the world around them.

5. Behave Like an Owner.
We'll say it again - stocks are not merely things to be traded, they represent ownership interests in companies. If you are buying businesses, it makes sense to act like a business owner. This means reading and analyzing financial statements on a regular basis, weighing the competitive strengths of businesses, making predictions about future trends, as well as having conviction and not acting impulsively.

6. Buy Low, Sell High.
If you let stock prices alone guide your buy and sell decisions, you are letting the tail wag the dog. It's frightening how many people will buy stocks just because they've recently risen, and those same people will sell when stocks have recently performed poorly. Wakeup call: When stocks have fallen, they are low, and that is generally the time to buy! Similarly, when they have skyrocketed, they are high, and that is generally the time to sell! Don't let fear (when stocks have fallen) or greed (when stocks have risen) take over your decision making.

7. Watch Where You Anchor.
Unfortunately, many people anchor on the price they paid for a stock, and gauge their own performance (and that of their companies) relative to this number.

Remember, stocks are priced and eventually weighed on the estimated value of future cash flows businesses will produce. Focus on this. If you focus on what you paid for a stock, you are focused on an irrelevant data point from the past. Be careful where you place your anchors.

8. Remember that Economics Usually Trumps Management Competence.
You can be a great race-car driver, but if your car only has half the horsepower as the rest of the field, you are not going to win. Likewise, the best skipper in the world will not be able to effectively guide a ship across the ocean if the hull has a hole and the rudder is broken.

Also keep in mind that management can (for better or for worse) change quickly, while the economics of a business are usually much more static. Given the choice between a wide-moat, cash-cow business with mediocre management and a no-moat, terrible-return businesses with bright management, take the former.

9. Be Careful of Snakes.
Though the economics of a business is key, the stewards of a company's capital are still important. Even wide-moat businesses can be poor investments if snakes are in control. If you find a company that has management practices or compensation that makes your stomach turn, watch out.

When weighing management, it is helpful to remember the parable of the snake. Late one winter evening, a man came across a snake on the path. The snake asked, "Will you please help me, sir? I am cold, hungry and will surely die if left alone." The man replied, "But you are a snake, and you will surely bite me!" The snake replied, "Please, I am desperate, and I promise not to bite you."

So the man thought about it, and decided to take the snake home. The man warmed the snake up by the fire and prepared some food for the snake. After they enjoyed a meal together, the snake suddenly bit the man. The man asked, "Why did you bite me? I saved your life and showed you much generosity!" The snake simply replied, "You knew I was a snake when you picked me up."

10. Bear in Mind that Past Trends Often Continue.
One of the most often heard disclaimers in the financial world is, "Past performance is no guarantee of future results." While this is indeed true, past performance is still a pretty darn good indicator of how people will perform again in the future. This applies not just to investment managers, but company managers as well. Great managers often find new business opportunities in unexpected places. If a company has a strong record of entering and profitably expanding new lines of business, make sure to consider this when valuing the firm. Don't be afraid to stick with winning managers.

11. Prepare for the Situation to Proceed Faster than You Think.
Most deteriorating businesses will do so faster than you anticipate. Be very wary of value traps, or companies that look cheap but are generating little or no economic value. On the other hand, strong businesses with solid competitive advantages will often exceed your expectations. Have a very wide margin of safety with a troubled business, but do not be afraid to have a much smaller margin of safety for a wonderful business with a shareholder-friendly management team.

12. Expect Surprises to Repeat.
The first big positive surprise from a company is unlikely to be the last. Ditto the first big negative surprise. Remember the "cockroach theory." Namely, the first cockroach you see is probably not the only one around; there are likely scores more that you can't see.

13. Don't Be Stubborn.
David St. Hubbins memorably said in the movie This is Spinal Tap, "It's such a fine line between stupid and clever." In investing, the line between being patient and being stubborn is even finer, unfortunately.

Patience comes from watching companies rather than stock prices, and letting your investment theses play out. If a stock you recently bought has fallen, but nothing has changed with the company, patience will likely pay off. However, if you find yourself constantly discounting bad news or downplaying the importance of deteriorating financials, you might be crossing that fine line into stubborn territory. Being stubborn in investing can be expensive.

Always ask yourself, "What is this business worth now? If I didn't already own it, would I buy it today?" Honestly and correctly answering these questions will not only help you be patient when patience is needed, but it will also greatly help you with your selling decisions.

14. Listen to Your Gut.
Any valuation model you may create for a company is only as good as the assumptions about the future that are put into it. If the output of a model does not make sense, then it's worthwhile to double-check your projections and calculations. Use DCF valuation models (or any other valuation models) as guides, not oracles.

15. Know Your Friends, and Your Enemies.
What's the short interest in a stock you are interested in? What mutual funds own the company, and what is the record of those fund managers? Does company management have "skin in the game" via a meaningful ownership stake? Have company insiders been selling or buying? At the margin, these are valuable pieces of collateral evidence for your investment thesis on a company.

16. Recognize the Signs of a Top.
Whether it is tulip bulbs in 17th century Holland, gold in 1849, or Beanie Babies and Internet stocks in the 1990s, any time a crowd has unanimously agreed that a certain investment is a "can't lose" opportunity, you are probably best off to avoid that investment. The tide is likely to soon turn. Also, when you see people making investments that they have no business making (think bellboys giving tips on bonds, auto mechanics day-trading stocks in their shops, or successful doctors giving up medicine to "flip" real estate), that's also a sign to search for the exits.

17. Look for Quality.
If you focus your attention on companies that have wide economic moats, you will find firms that are virtually certain to have higher earnings five or 10 years from now. You want to make sure that you focus your attention on companies that increase the intrinsic value of their shares over time. These afford you the luxury of being patient and holding for a long time. Otherwise, you are just playing a game of chicken with the stock market.

18. Don't Buy Without Value.
The difference between a great company and a great investment is the price you pay. There were many fantastic businesses around in 2000, but very few of them were attractively priced at the time. Finding great companies is only half the equation in picking stocks; figuring out an appropriate price to pay is just as important to your investment success.

19. Always Have a Margin of Safety.
Unless you unlock the secret to time-travel, you will never escape the inherent unpredictability of the future. This is why it is key to always have a margin of safety built in to any stock purchase you may make--you will be partially protected if your projections about the future don't exactly pan out the way you expected.

Having a margin of safety is a recurring theme among several great investors. This is no accident; margin of safety really is that important.

20. Think Independently.
Another common characteristic you will find in the next section is that great investors are willing to go against the grain. You should find zero comfort in relying on the advice of others and putting your money where everyone else is investing. Quite simply, it pays to go against the crowd, because the crowd is often wrong.

Also remember that successful investing is more about having the proper temperament than it is about having exceptional intelligence. If you can keep your head while everyone else is losing theirs, you will be well ahead of the game - able to buy at the bottom, and sell at the top.

Evaluating Company's Management: Do They Have Shareholders' Best Interest at Heart

When you invest into a company, one thing you want to be fairly certain about is the quality of management. If the hired guns are only interested in the perks their position provides and don't have enough incentives to run the company to the best of their abilities, then it will not be the company where your investment as a shareholder will earn the greatest return.

Here are a few criteria that shareholders can judge management on as described in the recent Morningstar video report:

• Candidness about their mistakes: Management that tries to downplay or hide problems already in the open is likely to be sweeping more problems under the rug that investors will never hear about.


• Modest office space: As a shareholder, you're more interested in building a more sustainable business than in building lavish office buildings to house executives.


• Pay coincides with performance: If management gets paid handsomely no matter the outcome, what incentive do they have to go out on the limb and try to squeeze every dollar of profits possible?


• Lack of company-funded perks: Morningstar analyst makes a great point in stating that when an executive already makes a multi-million fortune every year, that person should be able to afford his/her own second home, security, or a car with a chauffeur. If executives are extensively taking advantage of luxurious perks provided by the company, they may easily lose focus of what should be the most important part of their job: earning shareholders the greatest return possible on their investment.


• Team work: CEO shouldn't hog credit for all the great things that the company has achieved and should give credit where it's due. Otherwise, other talented members of the executive team might get alienated and leave for a competitor where their achievements will be recognized.

Without a doubt, there are many more criteria to evaluate executive management on, but these five points are crucial and probably the easiest to use and consider during evaluation. For more information on this topic, please feel free to explore articles I've linked to below.

Additional resources:

• Morningstar's video report: Management Warning Signs
• Investopedia: Evaluating A Company's Management
• The Motley Fool: How to Evaluate Management

What exactly is "options backdating"?

This whole deal with "options backdating" scandals keeps popping up every now and then, while explanation for it isn't always included in such articles. So, every time I read a story on this topic, I need to stop and try to remember what exactly this thing means and why it's important. Hopefully this post will be the breaking point and I will understand/remember it once and for all after we're done here.

So, what does it mean? Lets start from the beginning. Companies grant options to employees to align their interests with the interests of the shareholders - the better the company performs, the higher the stock price, and everybody's happy. So, if the shares today are at $10, employees are granted an option to buy a certain number of shares for that price, $10, after a certain period of time when options vest (usually several years). This way employees have an incentive to perform their best to make sure that their company keeps growing and hope that the stock will grow too. If the stock stays at $10, employees will have nothing to gain by exercising their options.

So, some companies, in an effort to make sure that employees will gain the most from the options grant, backdate the options to the date when stock was lower. This way employees will have a guaranteed gain at the time of the grant. If the stock is trading today at $10/share, the company may put last year's date on the grant when the stock was trading for $8/share and employee will have a virtually guaranteed 20% gain from the get-go (unless, of course, the company's stock price crashes and burns before they get to exercise their options).

Even though it might not seem like such a big deal, so what if employees will gain more from the options grant than they would otherwise? Well, here are a few important points made by people covering this topic.

"...the system of awarding options has gone from an incentive program to an entitlement. Companies that can't or don't offer rich options are at a disadvantage to those that do. Executives - with the complicity of their accountants, lawyers, compensation consultants and boards of directors - game the system to ensure not that employees are working for the shareholders, but rather that employees will make extra money in all but the gravest of circumstances. Options were considered so sacrosanct that Silicon Valley bigwigs fought tooth and nail to avoid having them accounted for as a compensation expense."

- Fortune

"A company that grants “in the money” options as compensation had to disclose the practice in SEC filings and in their financial reports as an expense. By back-dating the options the company could avoid disclosing to their shareholders the full amount it was paying its executives. Moreover, the company that grants such options and the executives that receives them must pay more in taxes. So the back-dating scam is, in reality, a tax scam and a compensation cover-up.

"Companies that back-dated compensatory options submitted to the dual temptations of cheating their taxes and lying to their shareholders. It is a sorry, sorry spectacle. Executives, making multiple millions in compensation, strove to pick up the last nickel by stepping over the line of legality. And they were aided by accountants and lawyers who were necessarily involved, creating the documents that sanitized the required reports of the practice."

- Dale Oesterle, Professor of Law

"For several years, Micrel allowed its employees to choose the lowest price for the stock within 30 days of receiving the options. After these stock option terms came to the attention of the IRS in 2002, it worked out a secret deal with Micrel that would allow Micrel to escape $51 million in taxes and required the IRS to keep quiet about the option terms. Remy Welling, a senior auditor at the IRS, was asked to sign the deal in late 2002. Instead, she decided to risk criminal prosecution by blowing the whistle."

- Erik Lie, University of Iowa

Additional resources:

• Fortune article ("Why options backdating is a big deal"): click here
  
• Business Law Prof Blog (Dale Oesterle, Professor of Law): click here
  
• Erik Lie, University of Iowa: click here
  

Moats: How to Find One

Following a brief description of the economic moats in the previous post, here is how to determine whether the company has a moat or not:

• Strong free cash flow (operating cash flow minus capital expenditures)
• for ex., free cash flow greater than 5% of sales is a good start
• More profitable than competitiors
• for ex., net margins consistently exceeding 15%
• High efficiency
• for ex., companies with higher asset turnover (total sales/average assets) than competition are more efficient
• Consistently higher Return On Equity (ROE) and Return On Assets (ROA)
• for ex., ROE greater than 15% and ROA greater than 10%, if delivered on a regular basis are good indicators of a company with an economic moat

Additional notes about ROE and ROA:

• ROEs (net income/average equity) can be boosted by extensive leverage since the more debt there is the less equity there is relatively speaking (remember: assets=liabilities (or debt) + equity)
• since more debt means paying out more interest, it's better to avoid companies who boost ROE through overleveraging the company


• ROA (asset turnover x net profit) can be boosted through either the efficient use of company's assets or by having higher margins of on the products it sells

Schedule DEF14a: A Wealth of Information About Management

Schedule DEF14a, or annual proxy filing, contains a significant amount of information about management. It provides information about the firm's compensation structure and numbers for management and the board of directors, so you can judge for yourself how well the management's and directors' interests are aligned with those of investors'. The proxy also contains biographies and background information about c-level executives and directors.

It's probably a good idea to familiarize yourself with the most recent proxy filing for a company that you're interested in. After all, you'd better know who is running the business you're investing into.

Moats... What are they?

You maybe thinking medieval defenses now. Well, you're not that far off - moats are defenses, but rather economic defenses. The term "economic moat" refers to the competitive advantage a company might have in the market. The more sustainable and long-lasting the moat is the "wider" it's considered to be. Analysts usually classify companies as having a moat that is "wide", "narrow", or "none."

Competitive advantages that can be considered moats vary widely between industries. Some examples of economic moats are: patents (Pfizer); copyrighted materials and intellectual property (Microsoft); economies of scale unmatched in the industry (Wal-Mart); high-cost of switching to a competitor (think 2-year AT&T wireless contract with free calls to all your friends who are on the same network); powerful brand (Coca-Cola).

It is through wide moats, or sustainable competitive advantages, that companies are able to outperform the overall market and post great return over long periods of time.

Price/Book Ratio

Price/Book (P/B) ratio shows a relationship between the stock market value of the company and the book value. Book value of a company is its net worth (or net equity), it's what a company would fetch if it was liquidated today.

Book Value Per Share = Total Shareholders Equity / Shares Outstanding

P/B = Stock Price / Book Value Per Share = Market Capitalization / Total Shareholder Equity

P/B ratio is very important when evaluating companies, but like any other ratio it must be approached carefully and keep in perspective other factors such as: industry average P/B, ROE of the company, etc. Lowest P/B ratios can be expected in capital-intensive industries such as utilities and retail, while higher P/B ratios will be found at companies that have significant intangible assets that book value doesn't take into account such as pharmaceuticals, biotech, technological and consumer products companies. Also, if a company consistently earns a high ROE (Return on Equity = Net Income / Total Equity), it can commend a higher P/B ratio.

About PEG Ratio

The PEG ratio can help you determine whether a stock's P/E is too high and will give you an idea of how much investors are paying for a company's growth. A stock's PEG ratio is its forward P/E divided by its expected earnings growth over the next five years as predicted by a consensus of Wall Street estimates. For example, if a company has a forward P/E of 30 with annual earnings estimated to grow 15% per year on average, its PEG ratio is 2.0. The higher the PEG ratio, the more relatively expensive a stock is.

PEG = Forward P/E Ratio / 5-Year EPS Growth Rate

Of course, the PEG ratio should be used with caution. PEG relies on two different estimates - next year's earnings and five-year earnings growth - which makes twice as susceptible to the possibility of overly optimistic or pessimistic analysts. If anything, I would rather make my own rough estimates about the earnings instead of relying on the "consensus" estimates by Wall Street analysts. Those "consensus" estimates are often wrong as the analysts often look at same thing and think the same way. Consider this, if the analysts were always right there would be barely any volatility on the stock market, especially when yearly and quarterly earnings are announced. I am not saying I am smarter or more knowledgeable than they are, but since they are not all that reliable either, I might as well trust myself.

Three Kinds of Profits

Everytime I see some sort of a "profit" mentioned, I need to think for a second exactly what that particular "profit" means. So, hopefully once I'll actually type them out I will be able to keep them straight (yeah, I know, wishful thinking).

So, here we go, I will list them in the ascending order (first one is going to be the largest):

• Gross Profit: calculated as Revenues - Cost of Sales (or Cost of Goods Sold). It basically shows how much money is left over to pay for operating expenses after a sale is made.


• Operating Profit: calculated as Revenues - Cost of Sales - SG&A expenses (Selling, General, and Administrative). This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations.


• Net Profit (Net Income): generally represents the company's profit after all expenses, including financial expenses, have been paid. This number is often called the "bottom line" and is generally the figure people refer to when they use the word "profit" or "earnings."

There are also related financial ratios, which are the three profit margins:
Gross Margin = Gross Profits / Revenues
Operating Margin = Operating Profits / Revenues
Net Margin = Net Profits / Revenues

Earnings Per Share (EPS): Why bother?

In most business publications and investment educational materials "earnings per share" (EPS) is regarded to as a key metric in evaluating a company's profitability and one of the key ratios in evaluating a stock. Personally, I don't understand why. Not at all. Earnings per share are expressed in dollar figures, $1 per share, $2 per share, etc., but how is that supposed to assist you on evaluating a stock when it doesn't really provide you with any kind of a perspective in evaluating a company's profitability? Even though $2 per share in earnings might seem better than $1 per share, whether it really is better or not will also depend on the share price. $1 per share in earnings for Company A would actually end up being better if the share price is $20 than $2 per share earnings of a $50 share of Company B. What I am saying is that dollar figures that EPS provides don't provide the big picture or an objective basis to evaluate companies on. If anything, EPS expressed in percentage terms would make more sense - let's say 10% earnings per share. This way you could see that a company improved earnings per share from 9% to 10%, or company A is performing better than Company B which has earnings per share at only 5%. On the other hand if EPS increased from $1 to $1.15, that may not necessarily be great since the stock price could have skyrocketed during that period, so your earnings per share percentage-wise would have plummeted, or the company could have just bought back a significant amount of outstanding common stock and there would be less shares to divide earnings upon.

All I'm saying is that EPS doesn't seem to be an objective measure and in my opinion should be used in percentage not dollar figures. The result of this switch would actually make it a reverse P/E, or an earnings yield. For ex., a company with a P/E of 20 would have a yield of 5% (100/20) .

Determining Fair Value (per Morningstar)

I'm a big fan of Morningstar as it adheres to the value-investing approach (or as I like to call it, "The Warren Buffett Way"). Of course, it's not without faults and I wouldn't base my investing decisions purely on their star rating of stocks (the less risky and the more undervalued the deem a stock to be, the higher the rating they give to a particular stock). I don't believe that if you just pick their 5-star rated stocks you will gain superior returns, you still have to do your own research even among their top-rated picks. As they themselves say:

In the end, our fair value estimates are more of a guide than automatic buy or sell prices. As long as you have a good idea of what a stock is worth, you'll be in a better position to determine whether it's a bargain or is overvalued.

But their long-term oriented core values and in-depth analysis of 1900+ stocks are definitely valuable. So, here is how Morningstar evaluates equities (as quoted from their web site):

This philosophy of fundamental research is the foundation for our valuation model. We believe that:

• How much capital a company invests and what it earns on that capital drive shareholder value.
• Free cash flow--not reported earnings--is what counts.
• As Warren Buffett has said, “Growth is always a component in the calculation of value--sometimes a positive, often a negative.” If a company can’t earn its cost of capital, growth destroys value instead of creating it.
• Competitive advantages disappear over time.
• It’s dangerous to assume that the future will be better than the past.

These core beliefs guide our stock analysts as they estimate future cash flow, using their in-depth knowledge of each company and its competitive position within its industry. Our analysts forecast revenue growth, profit margins, and capital investment (and all of the numbers that go into them) for each firm they cover.

Their forecasts for each company populate our discounted cash flow model, which calculates the present value of the company’s future discretionary cash flow based on its cost of capital, as determined by our analysts.

Value Investing: To Each His Own?

As soon as you hear the words "value investing," the names Warren Buffett and Ben Graham come to mind. Yes, those are basically the forefathers of value investing, Ben Graham taught Warren Buffett, and Mr. Buffett has been the flagbearer ever since.

So, you'd think that value investing is a fairly universal concept and that everyone understands it in the same way. Wrong. That's what I thought too, but apparently to each his own. All the great value investors have their own techniques, methods, and valuation models for companies. The only common theme among them is that they don't invest into stocks, rather, they invest into companies and think of themselves more as business owners and less as stock speculators. They all buy good companies for cheap, but they all have different ways of determining which ones are "good" companies and what "cheap" is exactly.

There is a good article on Morningstar (Take-Home Lessons on Value Investing) highlighting some of those differences and a common ground among value investors. The takeaway lesson, in my opinion, is that don't take any advice at face value, even from Mr. Buffett: research companies you consider investing into and don't invest until you're absolutely comfortable with the decision to invest in it, because if you're not, you should simply move on and find the company (and stock) that you're comfortable with. As Warren Buffett himself has said on numerous occasions: Rule #1 in investing is "Don't lose money!". So, take your time, learn as much as you can, do read the advice and listen to investors with a great track record, but don't let anyone dictate you what to do, its YOUR money!

Looking into FactSet (FDS) - a great company, but inflated P/E?

I've ventured to analyze this company and go through their most recent 10-K filing (which is basically their annual statement). I have to warn you, this is not the most comprehensive or coherent analysis of a stock or company that you'll ever read, just some of my thoughts on the subject as I'm learning more.

Here is a very brief description of what the company does:

"FactSet® offers instant access to accurate financial data and analytics to thousands of investment professionals around the world. Our company combines hundreds of databases from industry-leading suppliers and clients' own proprietary data into a single, powerful information system, making FactSet a one-stop source for financial information."

10-K for 2006 Fiscal Year

- Revenue went up 24% from the previous year while cost increased by 32% and net income increased by only 15%. In the previous year changes between income statements items were much more consistent. The only thing that I could attribute this to is acquisition activity during this period.

- I’ve found that going through this filing is very time-consuming and much of the data is repeated a number of times throughout the document.

- All the financial information listed here can be found dissected and sprinkled with a variety of valuation/financial ratios on many financial web sites such Yahoo! Finance to mention one.

- It is rather tiring to look through these statements unless there is something specific that you want to find out about the company: what they do, the risks the take, how they obtain their revenue and where, who their competitors are, and how they explain various line items on the balance sheet or income statements.

- Although I’m most definitely not an expert by any means, but I have found nothing alarming, unusual, or strange in their financial statements. Everything seemed to be very in order and straightforward, which only further cemented my interest in this company.

What I am uneasy about is the fact that analysts are predicting a significantly lower P/E ratio for the stock, which means that the company would have to significantly increase its earnings just to stay at the same price level. What that means to me is that as a stockholder, you will make no money for at least a year if the P/E will go down.

But then again, maybe there is something that I’m missing with all these forecasts and estimates by analysts, I’ll show you what I’m talking about. I took this information from Yahoo! Finance (http://finance.yahoo.com/q/ks?s=FDS). Current P/E is 30 and forward P/E a year from now they expect to be at 24.5. Average estimate for earnings per share for next year is $2.44. Doesn’t that mean if both, the forward EPS and the forward P/E are correct then we should expect the price to be around $60/share ($2.44 x 24.5)? Well, apparently not. These same analysts have a mean price target of $69/share. Now, if the P/E does go down to 24.5, then earnings must increase from $2.04 to $2.82 to get share prices to the $69 price target those analysts expect. Only a 38% jump in earnings at a company that has generated growth in earnings between 15% and 25% in the past 5 years.

What am I missing?

Stock Indexes

DJIA

The DJIA is a measure of the relative price of 30 widely held stocks traded on the New York Stock Exchange. The value of the DJIA is determined by dividing the sum of the per share prices of the 30 stocks in the index by an adjusted denominator that accommodates for splits and changes in stock composition. Therefore the index values represent equal weighted calculations.

Though it is called an average, it is actually a price-weighted index, which means the gains and losses of the highest priced stocks are counted more heavily than gains and losses of lower priced stocks.

The best known US index of stocks. A price-weighted average of 30 actively traded, well-established companies' shares. The Dow, as it is called, is a barometer of how shares of the largest US companies are performing. There are hundreds of investment indexes around the world for stocks, bonds, currencies and commodities. Even though the Dow is composed of only 30 stocks, its performance has tracked that of the broader market indexes, such as the S&P 500, remarkably closely over long periods.

Nasdaq Composite

An index that covers the price movements of stocks traded on the NASDAQ stock market.

Russell 2000

An equity index comprising 2000 mid-capitalization US listed stocks.

Everything is Interconnected

In order to be a successful investor in the stock market, mutual funds, and Forex, you really have to understand the relationships between such things as gold, inflation, overall economic situation in the world, in the country you live in, and what affects each one of them. It's really overwhelming, but if you take one step at a time and actually start using your brain cells, you will gain understanding of what is going on in the world (and why) and how you can profit or at least protect your investment from various economic events happening throughout the globe. Make no mistake about it, an economic crisis in Chile or Korea can set off a chain of events affecting your own checking account. It's not enough to read business magazines and take in the information that they give you, you have to think about factors that affect economic situation around the world, look for them yourself and stay up-to-date on what's going on around you and in the global financial markets.