Thursday, August 28, 2014

Book Review #12: How to pick stocks like Warren Buffet: Author: Timothy Vick

Key Concepts: Power of Compounding, Buy and Hold Strategy, ERR, Risk Premium, Book Value, Discounted Earnings Method, Takeover Arbitrage

One of the pleasures of my current project of reviewing the finance books is the opportunity to read some great books. Reminiscences of a stock operator written by LeFavre was one such book. This book 'How to pick stocks like Warren Buffet' written by Timothy Vick is another. Both the books are lucid and significantly simplifies the complexities of finance an investing. In addition, both the books are filled with pearls of wisdom that makes the reader a better person.

This book is divided into five parts. Part 1 covers the firs two chapters and discusses the timelines of Buffet's transition to a multi-billionaire. Part 2, covering the next 6 chapters discusses Buffet's use of mathematical concepts to add value to his investments. Part 3, covering chapters 9 through 15, discusses the core theme of the book, which is how one can analyze stocks like Buffet. The focus of part 4, covering the next three chapters 16 to 18 discusses the importance of avoiding losses when it comes to managing the investments. The last part, part 5, covers Buffet's idea of forming good investing habits. 

Warren Buffet is special. He is the only multi-billionaire in the world who has made his entire fortune solely through investing in stock market. Having completed his Post Graduation in Economics from Colombia University (where he studied under Benjamin Graham) in 1951, he worked as a stock salesman for his father till 1954. From '54 to '56 he worked under Graham. After leaving Graham in 1956, Buffet started Buffet Partnership whose goal was to invest other people's money in the stock market. Having started with Assets under management of about 100000 in 1957, the partnership ended with AUM of 104,429,431 out of which Buffet's share was 25% or 25 Million Dollars!

Second phase of Buffet's investing career started around 1970. Following Graham's concepts, Buffet started purchasing companies which were trading significantly lower than their intrinsic value and which generated good cash flows. One such Company that Buffet picked up was Berkshire Hathaway (BH), which was a Textile Company. Buffet converted it into his holding company and used it to invest in other companies either through buyout or through investing in shares of the companies. This way Buffet was able to focus single-mindedly on increasing the book value of BH which has increased at a compounded rate of 20% per annum.

It is worth noting that while Buffet started off as a Value Investor, towards the latter periods he started following the concepts of Philip Fisher.

The hallmark of any book on finance and investment would be the dollops of practical wisdom oozing out of its pages. While chapter 3 of this book purportedly deals with compounding, it is littered in every page with pearls of wisdom that made me say 'wow, that's me'. First the math. Buffet is a great fan of the power of compounding. The chapter dramatically illustrates the power of compounding by asking the question if Spain would have been better off today had they not spend 30000 dollars financing Columbus trip to find India. If that 30000 were compounded at 4% annually, that would have become 8 Trillion dollars by 1999, which was the total GDP of USA !.

Coming to the wisdom part of the chapter, it discusses the common mistakes made by retail investors in their strategy and execution. The strategic mistakes include low return expectations, excessive diversification, investing without doing the required analysis and finally failure to monitor the portfolio at regular intervals. Execution mistakes include selling a winner early and keeping a loser for a long time.

Successful investing is simple. Identify a good company with long-term growth prospects. Find out if the price that you are paying is in line with the expected growth and that you are not overpaying. And monitor regularly. Company's share price and growth compound in tandem. When price exceeds growth, it is time to sell and when growth exceeds price, it is time to buy. This shows the significance of PEG ratio for an investor.

How do you know if the market is overheated? When total market cap exceeds GDP of a country, we know that it is time to sell. Two factors that have an impact on stock performance are interest rates and corporate after-tax profit growth. These are related. Normally when interest rates are high, the profit growth rate is low.

It is said that profit in stock market is made when you buy and not when you sell. The three rules to follow when buying stock are, one, buy at low cost, two, maintain a concentrated portfolio rather than spreading oneself too thin and three, be mindful of the brokerage commission. One should also be aware of the opportunity cost of every penny that they spend. For example, 1000 rupees spend in a restaurant today is worth 2594 in 10 years at 10% interest, is worth 4045 at 15% interest and is worth 6192 at 20% interest. So if one has the opportunity to compound your money at 20% interest one is better off skipping the expensive dinner and investing the same amount.

Other than the opportunity cost of spending, there is an opportunity cost of investing. For example, if your investment returns 8% while Nifty returns 20%, you are paying a high opportunity cost of investing.

In the book Reminiscences of a Stock Market Operator, the protagonist, Larry Livermore, exhorts the investors to 'Sit Tight', meaning that when one invests into a trend one should curb the instinct to trade frequently. Buffet also follows the same strategy. Buffet 'Sits Tight' both before buying a stock and after buying the stock. Before buying a stock, Buffet is comfortable sitting on cash and waiting for the selected stock to reach the target price. Once he buys a stock, he holds it for the long term waiting for the benefits of compounding to accrue. One advantage of waiting for the right price is that it will give investor an opportunity to spend time studying the company, the industry and the business model. This in turn will make her a better investor.

Chapter 9 through 16 discusses the various mathematical models that Buffet uses to evaluate business. Chapter 9 starts off by listing various approaches to business valuation including Replacement Cost Method, Historical Cost Method, X times Revenue Method, Book Value method, and the traditional Discounted Earnings Approach.

The last approach (Discounted earnings) consist of four steps.
  1. Extrapolate the current earnings over a predefined number of years (normally 10 years) based on the historical (preferably) / projected growth rate
  2. Discount each year's earnings by your expected rate of return
  3. Add the terminal value of the company discounted to the current period
  4. Reduce the debt / share. The resulting value is the Discounted Value of the company.
One thought on the Expected Rate of Return (ERR). This will consist of a Risk Free Rate (10 year treasury bond rate) plus a risk premium which increases with the earnings fluctuation (higher the fluctuation higher the risk premium) and the size of the company (smaller the company, higher the risk premium)

Since Buffet only focus on big companies with steady earnings growth, his risk premium is close to zero.

For cyclical companies, where earnings growth fluctuates, Buffet users Historical Average Growth in earnings to extrapolate the earnings growth. Benjamin Graham recommends use of 16 PE to evaluate a cyclical business.

Buffet follows a different approach called 'Bond Parity Approach' to value the companies. This approach consists of two steps.

1. Current EPS (TTM) / Treasury Bond Rate will give you the Bond Parity Price.
2. Add growth premium to factor in the earnings growth.

Consider Waterbase for example. Current EPS is 4.5. Assuming the Treasury bond rate as 8.5%, the bond parity price is 4.5 / 0.085= 53. Currently this stock is trading at 55. This company is also paying 10% dividend (Rs.1 per share), which means that we are getting a Dividend yield of 1.8% and an average earnings growth of about 10% absolutely free. (Pl. do your research before investing in this Company)

Chapter 10 discusses Book Value. Buffet gives a lot of importance to Book Value as a valuation method. Companies can increase Book Value by expanding their profits, generating high returns on assets and acquiring companies that add economic values. Other ways in which companies can add book value are:
  1. Issuing more shares
  2. Acquiring other companies that are not related to their core business (unrelated diversification)
  3. Keeping their money in savings bank account
Investors should be vary of companies resorting to these approaches to increase Book Value

We have so far discussed Earnings Growth as a valuation method. Why are we now talking of Book Value? 

Earnings can be manipulated by
  1. Using restructuring charges
  2. Asset sales
  3. Write offs
  4. Employee lay offs
  5. Asset 'Impairment' Charges
All the above methods will increase the Future Earnings without corresponding increase in Book Value. The lesson that we learn from the above is that if earnings rise without corresponding increase in Book Value, it could mean that company has resorted to accounting charges (also called Provisions) to cover their operational problems. 

Chapter 11 covers Return on Equity (ROE). Companies that can generate high ROE need to be coveted because they are relatively rare. They should be purchased when they trade at attractive valuations relative to earnings growth and ROE. For a company to maintain a constant ROE, its earnings have to grow in excess of ROE.

Following points have to be considered when analyzing ROE
  1. ROE without debt is better than ROE with debt
  2. ROE differ across industries
  3. Share buyback can increase ROE
  4. ROE follow business cycle
  5. ROE can be inflated by one time charges
Finally, given the linkage between ROE and Earnings growth, one can use ROE to predict the earnings growth.

Buffet follows '15 percent rule' (Chapter 12) for buying companies. He believes that buying good companies at reasonable prices is the only way to create long-term wealth. The operative phrase is 'Reasonable Price'. Buffet's expected return from a stock is 15% compounded annually over his holding period. 

We can do that Math for Waterbase.

Current Price = 55
Price at the end of 10 years compounded at 15% rate = 55 *1.15^10 = 223
Current EPS = 4.5
EPS at the end of 10 years growing at 10% per annum = 4.5*1.1^10=11.67
Price at the end of 10 Years using current PE of about 12 = 11.67*12 = 140
Dividends received at 10% = 10
Total value at the end of 10 years = 150.

As you can see, with the given assumptions, the price is going to be only 150 while expected price is 223. Based on this, Waterbase is not a buy. If you want to buy Waterbase, you can either review if your assumptions are too conservative (10% earnings growth or 12 PE at the 10th year) or you have to wait for the price to fall to 37.

Inflation is an insidious tax that can significantly lower the return on investment. There is a clear correlation between inflation, stock prices and bond yields. When inflation rises:
  1. Interest rates tend to rise
  2. This lowers bond prices and increases bond yields
  3. Increasing interest rates also lowers the stock prices and increases the earnings yield 
The key point is that stocks are bonds with less predictable coupons. Earnings yield is defined as
 Earnings / Purchase Price. It is better to buy stocks with good potential for earnings growth at a very low price. As the earnings grow, the earnings yield will grow in tandem.

Six rules for comparing stocks to bonds.

  1. Main goal is to find companies whose returns can beat inflation
  2. Next goal is to beat the risk-free return on government bonds
  3. Compare the coupons of the stocks and bonds
  4. Try to buy stocks whose current earnings yield is near or above long-term bond
  5. If the current earnings yield is less than bond yield, the earnings should grow quickly soon so that the earnings yield overtakes bond yield
  6. Buying growth stock at the cheapest price is the best way to beat bond yields by a wide margin.
As Guy Thomas points out in his book 'Invest and Grow Rich', investing is a negatively scored activity. In these type of activities high premium has to be placed on avoiding mistakes and reducing loss. Part 4 of this book, covering chapters 16,17 and 18 discusses ways in which Buffet avoids losses. 

Losses occur due to three reasons.
  1. Taking bigger risks and exposure to a higher probability of losses
  2. Investing in an instrument that failed keep pace with inflation and interest rates
  3. Not holding the instrument long enough to let the intrinsic value to be realized
Suppose you start with three portfolios A, B and C each holding $10000. Each portfolio gives an annual return of 10 percent regularly for 30 years. Portfolio B gives Zero returns in the 10, 20 and 30th years. Portfolio C gives negative 10 (-10) percent returns in 10, 20 and 30th years. At the end of 30 years, Portfolio A will have about $171000, Portfolio B will have about $131000 and portfolio C will have about $96000. Even minor inconsistency in returns in Portfolio B and Negative returns in just three of the 30 years in Portfolio C had significant impact on the Compounded portfolio returns at the end of 30 years. 

Warren Buffet looks for stocks with consistency in earnings rather that fluctuating earnings. Consistency significantly improves long-term compounded earnings. 

Key aspect of avoiding losses is in handling the market risk. This means that you should be able to anticipate the market downturn and exit promptly. The fag end of a bull market is characterized by abnormal PE expansion without the corresponding earnings growth.

Given below are some of the factors that Buffet considers while deciding to enter or exit the market.
  1. Relationship between stock yields and bond yields. When bond yields are rising (Interest rates are rising and bond prices are falling) and overtakes stock yields, market is generally overvalued. Stocks are most attractive when stock yields are higher than bond yields.
  2. Rate of climb in market. If stock prices are climbing at a higher rate than the GDP, it is not sustainable.
  3. Abnormal PE expansion
  4. State of the Economy: When the economy is performing at full capacity the potential for further earnings growth will be limited. You can use 15% rule to gauge if stocks are worthy of holding. 
One of the strategies which Buffet reduces his losses is by buying convertibles, instruments with a fixed coupon and an inbuilt option to buy stocks at a predetermined price. During market downturn Buffet may buy convertibles to receive coupon payment that could beat bond yields.

Another strategy is to hedge his future stock purchases by selling put options on the stock. Assume that you plan to buy shares of TCS currently trading at 2500 per share. Your target price is 2200. You sell put option on TCS at 2300 and receive a premium of Rs.100. If the share price of TCS falls below 2300, the buyer of the call will exercise the put forcing you to buy TCS at 2300. (If it doesn't, you pocket the premium). If the Put is exercised, your net price is 2200, ( 2300 - 100 premium you received), which is your target price.

Yet another strategy is 'Takeover arbitrage'. This involves buying a share in a company when a takeover is announced and selling the same when the takeover is executed. The lower the time difference between the takeover announcement and the execution, the higher the return.

How can an investor profit from arbitrage? Follow these rules:
  1. Invest in cash deals and not stock deals
  2. Invest only in deals that have been announced
  3. Determine expected rate of return upfront
  4. Don't rely exclusively on arbitrage as an investment strategy. Arbitrage can only be a secondary strategy.
  5. Buy on margins if you think that the deal is a sure thing.
Final part of the book discusses some very good investment habits propounded by Buffet. The list of these habits can be found here.

That is it. This complete the review of this book.

The main value add from my perspective is that I intuitively understood the linkage between Stock Yields and Bond Yields. Till now whenever I heard anyone talking of this linkage, I was confused and not clear of the complete impact of this information.

Another important value add is the Bond Parity Rule. After reading this book, my quality of my analysis and my purchase decisions will definitely undergo improvement.

Arbitrage as a strategy is another approach that I should follow. I remember Fame Studios takeover by Reliance Mediaworks. Fame was trading at around 45 and Reliance announced takeover at 85 rupees. After the takeover announcement the share price of hit regular Upper Circuit Filter till the price reached more than the takeover price. It means that arbitrage as a strategy could be difficult for retail investors.

Another key value add for me is the realization that despite my being an MBA in Finance and have been an investor in Stock Market from about 2004, how little I know of its workings (Check out this post). I can talk a lot about Equity Investing and its role in one's retirement portfolio. I can expound on why equity investing is better than real estate investing. But this book burst a few bubbles here (I am pointing to my head). I had earlier mentioned that after reading this book, I intuitively learned about the linkage between Stock Yields and Bond Yields. Another lesson that I learned is about the 'Buyers Remorse' that occur after one buys stocks and prices go down. In other words, one is happy when price of tomato goes down and buys more, but one is sad when price of stock goes down and buys less (if at all). Till reading this book, I was not clear why this was happening. Now I know. When it comes to Tomatoes, one is planning to buy it perpetually and can do a 'Cost Averaging'. However, when it comes to stocks, for many people, it is a one time transaction, like buying a TV, or marriage. Cost averaging do not happen. This also means that methods that encourage cost averaging, like SIPs (Systematic Investment Plans) and SEPs (Systematic Equity Plans) can help remove the Buyers Remorse, since with those tools, you will be buying stocks perpetually and thus averaging your costs.

It was Winston Churchill who said, "Till I was 16, I used to think how illiterate my parents were. When I reached 21, I was surprised to see how much they had learned in the last 5 years" !.

That is what is happening to me as I read, review and summarize these invaluable books...

Over all a great read. Strongly recommended.

No comments:

Post a Comment

As a policy I publish all the comments except SPAMS. Please be moderate and constructive in your comments