Thursday, December 28, 2017

Book Review #32: The little book that builds wealth: Author: Pat Dorsey

Note: I have updated this book review with contents of presentation made by Mr.Dorsey at Texas Lutheran University (TLU). You can watch the presentation here. All the updates are marked in italics

The book is written by Pat Dorsey who is a director of equity research at Morningstar Inc. He played an integral part in the development of the Morningstar Rating for stocks as well as Morningstar's economic moat ratings. 

In addition to this book, Mr.Dorsey is also the author of the book 'Five Rules for Successful Stock Investing'.

The book, 'The Little Book that Builds Wealth', aims to provide a conceptual anchor to help you evaluate stocks and build a rational portfolio. It is spread over 14 Chapters.

The approach followed by Morningstar is as follows. Each analyst builds a detailed discounted cash flow model to arrive at a company's fair value. The analyst then assigns a moat rating -Wide, narrow or none. The objective is to identify companies with wide moats available at discount to fair value.

Making investment decision based on company's economic moats is a smart long-term approach.

The book details the economic power of moats by studying how specific companies with wide moats have generated above-average profits over many years.

The book aims to provide a solid foundation for making smart investment decisions.

The investment strategy should be to buy wonderful companies at reasonable prices and let those companies compound cash over long periods of time. The steps to implement this strategy are:

1. Identify businesses that can generate above average profits for many years.
2. Wait until the shares of those businesses trade for less than their intrinsic value and then buy
3. Hold those shares until either the business deteriorates, the shares become overvalues, or you find a better investment. This holding period should be measured in years, not months.
4. Repeat as necessary

As per the author, 'Return on Invested Capital is the best benchmark for a company's portfolio. It measures how effectively a company uses all of its assets - Factories, people, investments - to make money for shareholders.

The book is broadly divided into two parts. The first part covers understanding of  'Economic Moats'. These are traits that endow companies with truly sustainable competitive advantage. There are four parameters to valuing a company. These are, risk, earnings growth,  return on invested capital and durable competitive advantage. 

The last factor is also known as economic moat. Economic Moats are structural and sustainable qualities that are inherent to the business.Moats generally manifest themselves in pricing power. A company that can't raise prices is unlikely to have a strong moat. The wider it is, the better is the company as an investment destination. Four factors can generate economic moat. These are availability of intangible assets like patents and brands, high switching costs for the customer, network effect and cost advantages. Cost advantages could be due to better processes, location near to the customer group, access to unique assets or economies of scale generated due to wider distribution network, cheaper manufacturing and access to niche markets. 

Once a foundation for moats is established in the first part of the book, the second part discusses the erosion of moats, role of Industry Structure in creating moats and how management can create or destroy moats. There is discussion on valuation as well so that the investor can decide if they are paying a fair price for the moat. The final chapter of the book covers four reasons why an investor should sell her stock. 

This is a good book that provides an overview of the value investing. This book is targeted towards beginners and gives a fair grounding on the concepts of value investing and sates the reader's curiosity to explore the wide and beautiful world of value investing.

Read on for the chapter summary...

Chapter 1: Economic moats
This chapter covers the importance of moats. Moats is defined as 'Durable Competitive Advantage that can provide strong and increasing free cash flows for the company over extended periods of time'. Hence these companies are more valuable than the companies without moats. Since moats provide durable competitive advantages, when you buy shares of companies with moats, you are buying a stream of cash flows that are protected from competition for a long period of time. Thinking about moats can protect your investment capital in a number of ways. One, it enforces investment discipline, making it less likely that you will overpay for a hot company with shaky competitive advantage. While the hot companies may have fat margins and profits in a short term, it is the duration of the profits and margins that matter. Moats provide us a framework of separating the fly by night companies from those with durable advantage.

Another reason why moats are important is that they significantly reduce the risk of permanent capital loss. Companies with moats are likely to increase their intrinsic value over time, so if you wind up buying their shares at a value that is somewhat high, the growth in intrinsic value will protect your investment returns.

Companies with moats also have greater resilience and can recover quickly from temporary troubles (remember Bata and Nestle?). This resilience of companies with moats is a huge psychological backstop for an investor who is looking to buy wonderful companies are reasonable prices, because high quality firms become good values only when something goes awry. If you analyze these companies thoroughly, you will know if the troubles of the company are temporary or permanent and take the necessary investment action.

Finally, moats can help you define your 'circle of competence', a set of industries where you  develop expertise.

The idea of this book is to help you identify companies with moats and those without...

Bottom line to Chapter 1:

1. Buying a share means that you own a tiny piece of business.
2. The value of the business is equal to all the cash it will generate in the future
3. A business that can profitably generate cash for a long time is worth more today that a business that may be profitable only for a short time
4. Return on capital is the best way to judge a company's profitability
5. Economic moats can protect companies from competition helping them earn more money for a long time, and therefor making them more valuable to investors

Chapter 2: Mistaken moats:
The four common 'mistaken moats' are:

1. Great Product: This can be copied or competition can design a similar product at much less cost.
2. High market share: This can be quickly eroded. The investor should focus on how the market share was achieved. If the market share is achieved due to a moat, then it is good. Market share is mostly an outcome of the moat rather than a moat in itself.
3. Great Execution: This can be replicated, especially if there is an outside force pushing standardization
4. Great Management: Moats are structural in nature and the cash flow continues over a relatively long term. This has mostly nothing to do with the management.

So what generates moats for a business. There are four characteristics that are mostly create moats.

1. Intangible assets like brand, patents or regulatory licenses.
2. High Switching costs
3. Network economics
4. Cost advantage stemming from process, location, scale or access to unique asset which allows them to offer goods or services at a lower cost than competition.

Bottom line to chapter 2

1. Moats are structural characteristics inherent to a business. Some business are simply better than others.
2. Great products, market share, great execution and great management do not create moat.
3. The four sources of structural competitive advantage (moat) are intangible assets, customer switching costs, network economics and cost advantages. Any company with solid return on capital and any one of these characteristic is worth a decko.

Chapter 3: Moat 1: Intangible assets
There are three intangible assets that can create a moat under certain circumstances. First is the brand. Brand can generate customer loyalty. A brand can become a moat if they can raise prices without fall in market share. (Green Trends is an example. Once they go there, ladies continue to go to that place only. Maggi noodles could be another example). Brand is an economic moat if it results in either 'willingness to pay more' or in 'lowering of search costs'.

While talking about the power of brands, Mr.Dorsey explains why Amazon brand is very powerful. Mr.Bezos understood very early that 'online retail' is different from 'offline retail'. Trust plays a big part in online retail. You trust Amazon with your personal details, including credit card details, you buy the product without seeing it trusting that the quality will be good, you trust that the product will be delivered to you on the promised date, you trust that company will seamlessly take back a product once it is returned etc. Bezos understood the value of trust in online retail. That is the power of brand Amazon.

Brands are valuable if they can deliver a consistent or aspirational experience.

Patents can create an economic moat if the the firm has a demonstrated track record of innovation shown by large number of patents it has. The problem with patents is that they are heavily challenged in courts.

Regulatory licenses are most effective as a moat when the company needs approval to enter the industry, but is not subject to price control. Utilities and Pharma are a comparison. While both need regulatory approval to set up business, the government controls price that can be charged by utilities.

A typical example of regulatory licenses acting as a moat is the NIMBY (Not in my back yard) companies like waste management which need licenses but discourages new entrants from coming in due to structural barriers to entry.

Bottom Line to Chapter 3

1. Popular brands are not always profitable brands. Brands should deliver consistent or aspirational experience.
2. Legal challenges are a great risk to patent moat
3. The best kind or regulatory moat is one created by a number of small-scale rules, rather than one big rule that could be changed.

Chapter 4: Moat 2: Switching costs
Switching costs are a valuable competitive advantage because a company can extract more money out of its customers if those customers are unlikely to move to a competitor. Customer may not want to switch from company's product to a competitor's product due to three reasons. One, the product is at the core of the customer's business, ERP is one example. Or Oracle Database is another. Two, switching over to another product could cause a lot if integration issues since this product could be a part of an integrated ecosystem. The third reason is that you provide a product with a high benefits to cost ratio. Henkel adhesives or enzymes used in probiotic yogurt are examples. Their impact on final product cost is negligible, but the benefit they provide is very high. Hence even a 20%  rise in the cost of these products will not significantly impact the final product cost. 

Switching costs as a moat is widespread. This type of moat can be powerful and long lasting but very difficult to identify.

Chapter 5: Moat 3: Network effect
A company benefits from Network effect when the value of a company's product or service increases as the number of users increase. The more the number of users the more the benefit and ease of transactions for the new users in the network. The network effect can be broad - there are many users transacting in the company's product or service or it can be deep - there are many different products or services of the company that the users are transacting with.

Some examples are Credit card companies (like Amex) where the larger the number of the attached merchants, the more users can use the credit cards of the company, Auction Sites (like eBay) where more the number of existing users, more products and features can be rolled out for new users, Option Exchanges (like CBOE)  where the buying and selling of the options is restricted to the same exchange (unlike stock exchanges), some money exchange sites (like Western Union), third party logistics service providers who connect buyers and sellers of shipping and logistics services etc.

The author seem to have changed his opinion on Western Union after writing this book. In this presentation, he talks about Western Union. Eventhough company has the largest number of branches in the world. However, most of the transactions are between a few select cities. For example, not many people are sending money between Dhaka and Mexico City. So competitors can easily get into these niche corridors and impact the profitability of Western Union. Money transfer is a 'Corridor Effect' and not a 'Network Effect'. 

Since the size of the existing network determine the market power of these companies, it creates a barrier to entry for competitors who has to replicate the network. Hence the companies in the industry tend to form natural oligopolies.

Some of the characteristics of network effect are:

1. Network effect can quickly dissipate due to external activities. For example, if the investor is allowed to buy options in one exchange and sell it in another, the competitive advantage of the option exchanges will quickly dissipate.
2. Network effects are seen in businesses that deal in information or knowledge transfer. The reason is that these companies sell 'Non rival' goods, which can be used by many users in parallel.
3. For a company to benefit from network effect, it has to operate in a closed network. As the network opens up, the effect will wane quickly.
4. The benefit of having a large network is non-linear. It means that the value of a network increases at a faster rate than the absolute size of the network. (Multiplier Effect)

Chapter 6: Moat 4: Cost advantages
Cost advantages matter most in those industries where price is a large portion of customer's purchase criteria. Mostly these are in the commodity sector. Cost advantage is valuable when your ASP, Average Selling Price, keeps falling from year to year. Cost advantages stem from four different sources.

1. Cheaper processes
2. Better locations
3. Unique assets
4. Economies of scale

This chapter covers the first three sources above.

Cost advantages arising out of better and cheaper processes can be transient. However, during the time the company owns the process, it can make windfall profits. While processes can be replicated, sometimes structural issues with the competition can provide a long window of opportunity. Process based cost advantages can create a temporary moat if incumbents are unlikely to replicate them immediately. Process based moats are worth watching closely, because the cost advantage often slips away as competitors either copy the low-cost process or invent one of their own.

Chapter 7: Size advantage: Economies of scale
When it comes to economies of scale, the absolute size of a company matters much less than the size relative to the rivals. To understand economies of scale, we have to understand the difference between Fixed Costs and Variable Costs. Fixed costs are the upfront costs that you have to incur even before you make a single unit of sale. Fixed costs normally cover the cost of machinery, vehicles, salaries, rent etc. Variable costs are the costs that increase with the number of units sold. The main example of variable costs could be the raw material costs - the more you sell, the more you have to buy raw material to produce the products that you sell.

The more the level of fixed costs relative to variable costs, the more the scale advantages the company has. There are three categories of scale based advantages:

1. Distribution
2. Manufacturing
3. Niche Markets

Large distribution networks can be a source of tremendous competitive advantages. The portion of fixed costs are very high for these network and any incremental revenue leads directly to the profits of the company. Large distribution networks are extremely hard to replicate and are often sources of very wide economic moats

Same is the case with manufacturing. Once a fixed cost of setting up a factory is incurred, the incremental revenue can directly go into the profits of the company since the ratio of Fixed Costs to Variable costs is high in this case. Niche refers to markets where the size is not big enough for multiple companies. One or two companies that target this Niche can make tons of money. Even a small company that is strong in a niche market can have a wide moat that is difficult to replicate. Private infrastructure is a good example. In India, GMR owns and operates multiple airports including Bangalore, Hyderabad and New Delhi.

Chapter 8: Eroding Moats
Moats can be quickly eroded due to changes in the business environment. If you can get an early read on a weakening competitive advantage, you can improve the odds of preserving your gains. There are two sides to this threat. For a company that sells technology, threat of a better technology is a given. However, technological disruption is a severe threat when it affects non-tech companies because these companies can look like they have very strong competitive advantages before a technological shift permanently eroded their moat. Examples abound. Eastman Kodak before digital photography was a cash making machine selling photo films. BSE, with its manual transactions was the King before NSE came into prominence with electronic trading. Telephone companies ruled the roost before the age of VOIP and Skype.

Another type of change that can erode a moat is the change in the structure of industries. For example, the advent of big ticket retail chains has eroded the pricing power of their suppliers.

The changes need not be local. The entry of low-cost Chinese labour has eroded the competitive advantages of many US manufacturers.

Yet another change could be the entry of an irrational competitor. For example, when British Government started deciding on the pricing policies for Rolls Royce after the take over, the changes impacted the few competitors in the aircraft engines business.

Companies using excess cash to move into unrelated businesses can severely erode the moat.

Another change that could erode the moat will be the transfer of bargaining power from the seller to the buyer, as Oracle experienced for its support services.

Chapter 9: Finding moats
It is easier to find moats in some industries than others. It is easier to find a moat in an asset management company than an auto components manufacturer. In technology, a software product developer could have a wider moat than a hardware manufacturer. Former gets integrated into the customer business and lead to switching costs, while the later is standardized and easily replaceable with a competitor product.

For Telecom companies, a favourable regulatory environment (like in UAE) creates a moat. While media is more susceptible to competition and moat erosion, control of vast amounts of content can act as a moat for  some media companies.

While Pharma companies are subject to regulatory environment, a wider product portfolio gives them a moat. Also small Pharma companies in specialized niche areas can enjoy moats for a long time.

Companies that provide services to the business can enjoy a wide moat largely because these firm integrate themselves so tightly into their client's business processes that they create very high switching costs giving them pricing power and excellent ROIC.

Companies in consumer sector usually enjoy a wide moat mostly because of the brand loyalty. In this sector, on should look out for small companies in niche areas.

While oil and gas sector is a commodity and hence do not have a moat, some industries that cater to Oil and Gas sector can have a wide moat. One example is the pipes manufacturers.

To measure a company's profitability, we look at how much profit the company is generating relative to the amount of money invested in the business.

There are three ways to measure the return on capital

One is the Return on Assets (ROA). This measures how much income a company generates per dollar of assets. A non-financial company that can consistently generate an ROA of 7 percent or above is likely has some kind of moat.

Return on Equity (ROE) measures the profits per dollar of shareholder's capital. One flaw of this measure is that firms can substantially increase the ROE by taking a lot of debt relative to equity. As a rule of thumb, you should look for ROE of 15 percent and above.

Return on Invested Capital (ROIC) measures the return on the capital invested in the firm including both equity and debt. This helps remove any effect of the firm's financing decision (debt vs equity).

Chapter 10: The big boss: Does management matter?
Managements do not matter much. This goes against popular wisdom. Some industries are more conducive to digging a moat than others. Company's structural characteristics have much more effect on the company's long-term performance than the quality of management. Why then management receives so much of attention? Two reasons. One, the media needs heroes. Two, it is human nature to look for a causal agent to assign success or pin blame. Of course there are companies where the management quality created a moat. Starbucks and Dell being examples. But these are exceptions and not the rule.

Moats can buffer management mistakes. So how to differentiate good managers from bad?

Good managers are constantly looking to widen the moat. Bad managers invest cash outside company's moat, thus lowering ROIC. This is called 'Deworsification'

In summary, while great managers can add value to the business, management by itself is not a sustainable competitive advantage (aka moat).

Chapter 11: Where rubber meets the road: Examples of competitive analysis
This chapter talks about a three step process to determine if the companies have moats.

Step 1 focus on the historical performance of the company. Has the firm historically generated solid returns of capital? If the answer to the above question is no, then the next question to ask if the firm's future is likely to be different than the past. It the answer is no to this question also, then we can conclude that this company do not have an economic moat.

If the answer to the first question in step 1 is 'Yes', we move to step 2. In this we check if the firm has any one of the competitive advantages that we discussed earlier vis. High switching costs, Network economics, Low-cost production, economies of scale or Intangible assets (like brands or patents). If the answer to this question is No, we can conclude that this company do not possess an economic moat.

If the answer to the question in step 2 is 'Yes', we move to step 3. Here we assess the durability of the moat. The question is 'How strong is the company's competitive advantage? Is it likely to last a long time or a relatively short time? Based on the duration of prevalence of the competitive advantage, we classify them as 'Narrow Moat', or 'Wide Moat'

Chapter 12: What's a moat worth?
All the chapters till now focused on the step 1 of the Investment Strategy discussed in the Introduction. That is 'Identify businesses that can generate above average profits for many years.' This chapter and the next focus on the step 2 of the strategy 'Wait until the shares of those businesses trade for less than their intrinsic value and then buy'. The focus of this chapter is on calculating the Intrinsic Value of the company. Valuation of a company is difficult due to two reasons. One, every company is slightly different, which makes comparison between peers a tough exercise. Parameters like growth rates, ROIC, strength of the moat..all differ from company to company even in the same industry. Two, value of a company is directly tied to its future financial performance which is unknown.

You need not know the precise value of a company before buying its shares. All you need to know is that the current price is lower than the most likely value of the business. One of the ways is to compare the growth rate implied in the price to your estimate of the potential future growth.

What is value? As per the discounted cash flow method, the intrinsic value of a company is the present value of all the free cash it will generate in the future. Free cash is the cash flow net of operating and capital expenditures. While estimating the future cash flows, four things are important. The risk of the cash flows materializing, the growth rate of the cash flows, ROIC and the duration of the excess cash flows (economic moat).

There are three types of tools for valuing companies, price multiples, yields and intrinsic value. This chapter focus on the valuation of the company. Over long stretches of time, there are two things that pushes the stock price up or down: the investment return, driven by earnings growth and dividends and speculative return, driven by changes in the PE multiple. The investment return reflects the financial performance of the company while the speculative return reflects that exuberance or pessimism of the market.

When we focus on companies with economic moat, we are maximizing our investment return, which we can estimate and is under our control,  and minimizing our negative speculative return which we cannot control.

Overestimating a moat means paying for value creation that will never materialize. Underestimating moat means paying a high opportunity cost.

Why do most of the investors not benefit from moat? A moat takes years to materialize. However, most of the investors do not have that amount of timeframe

One way of finding moat is look for qualitative data which you can only get by talking to the stakeholders and visiting markets.

Chapter 13: Tools for valuation: How to find stocks on sale?
The focus of this chapter is on price multiples. These are the most commonly used, and misused, valuation tools.

The first multiple is the Price to Sales (PS) which is current price divided by the sales per share. This is mostly useful for cyclical companies or companies that are having some kind of trouble. Low margin businesses have low PS ratios compared to high-margin business like pharma. This ratio is most useful for companies that have temporarily depressed margins, or that have room for improvement in margins.

One useful way to use price to sales ratio is to find high-margin companies that have hit a speed bump. These companies might be facing temporary problems, but beaten down by investors. If the company can return to former level of profitability, then the stock is probably quite cheap. This is one instance where PS ratio is better than PE ratio. PE on an under-earning company might be high since earnings are low. Lesson: Look for companies where PS is lower than PE

The second multiple is the Price to Book (PB). Book value can be thought of as representing all the physical capital invested in the company - factories, computers, real estate, inventory etc. The rationale for using book value in certain cases is that the future earnings and cash flows are ephemeral, while the stuff that a company physically owns has a more tangible and certain value.
When using book PB ratio, you have to be clear as to what 'B' represents or do not represent. For an asset intensive firm, the Book value represents all the assets of the company. However, the value of intangible assets like patents, brands or human assets are not reflected in the book value.

Also, book value can be inflated through good will which is the value the company paid for acquiring another company over and above the value of its physical assets. Since low PB ratio is better than high PB ratio, the use of goodwill can inflate the book value and lower the PB ratio.

Where is it best to use PB? It is useful for companies in the financial services. Since most of the assets are 'marked to market', the book value of the company is a good reflection of its tangible value. Only caveat here is that an abnormally low PB ratio can indicate that the book value is not realistic and may contain a lot of NPAs

The third multiple is the Price to Earnings (PE) multiple. PE ratio is useful because earnings are a decent proxy for value creating cash flow, and because earnings results and estimates are readily available. These are tricky because earnings are a noisy number and because a PE ratio has to be seen in comparison.

Another challenge with this ratio is that while there may be only one P, there could be different versions of E including Trailing Twelve Months (TTM), calendar year, fiscal year and estimated future PEs. Forecasting earnings are risky because it is observed that they normally pessimistic before a beaten down company rebounds and is optimistic just before a high-flier slows down.

What this means that you have to come out with your own views of earnings to be used in the PE ratio. Once this is done you can use PE to compare it with a competitor, industry average or the same company at different points in time.

The fourth multiple is the Price to Operating Cash Flow (PC) multiple. Cash flow can present a more accurate picture of the company's profit potential because it simply shows how much cash is flowing in and out of a business, whereas earnings are subject to a lot of adjustments. This ratio is also a bit steadier than earnings. For example, it is not affected by non-cash charges that come from a corporate restructuring or an asset write-down. Cash flow also takes capital efficiency since company's need less working capital will show more cash flow than earnings. Since cash flow do not take depreciation into account, asset intensive companies will have higher cash flow than earnings. This could overstate their profitability. 

These are the four multiple based valuation metric. The next set of metrices are yield based metric.
Advantage is that yield can be compared with bond yields. 

There are two yield based matrices. One is the earnings yield and the other is the cash return. 

Earnings yield is the inverse of PE ratio. If the PE is 20, then earnings yield is 5%.

Cash Return is an improvement over earnings yield. It tells us how much cash flow a company is generating relative to the cost of buying the whole company, including the debt burden. This measure improves on the earnings yield since it looks at Free Cash Flow and incorporate debt into company's capital structure. Cash return is calculated by the formula:
(Free Cash Flow + Interest Expense) / (Market Capitalization + Long - term debt - Cash)

Now that we have covered four multiples and two yields, the question is to know how to use these measures. The following five tips are useful.

1. Always remember four drivers of valuation: risk, return on capital, competitive advantage and growth. All else being equal, you should pay less for higher risk and more for companies with the remaining three. 
2. Use multiple tools. If multiple tools align, it is a sign of a truly undervalued company
3. Be patient: Not making money is more important than losing money.
4. Be tough: Buy when everyone else is selling
5. Be yourself: Put effort in understanding moat and valuation before you invest. 

Remember, the best business in the world will be a bad investment if purchased at an unattractive price.

Chapter 14: When to sell
There are four reasons to sell a stock. They are:

1. You made a mistake
2. The company has changed for the worse
3. There is a better place for your money
4. The stock has become a large portion of the portfolio

You sell a stock if you have made a mistake in your original investment thesis. You missed some critical information while analyzing the company. At the time of purchasing the stock, write down the reasons why you purchased the stock. Review the assumptions regularly. Every time the facts go against the assumptions, sell the stock.

Another reason to sell the stock is when the company's fundamentals deteriorate completely

Third reason to sell is that you have come across a better investment opportunity. Remember that sometimes it is worthwhile staying in cash. For example if the stock has gone significantly out of value, it is better to sell it and stay in cash. 

The last  reason for selling a stock is that it has become a very large portion of your portfolio. So you sell the overweight ones to re-balance your portfolio.

Note that none of the above four reasons is based on stock price. They are all dependent on what happens or likely to happen to the values of the companies. Also, do not look at the past performance of the company before investing in it. Money is made in future, not in past.

Global Investing: Local differences in different countries can create moat. For example, a car washing company can generate moat. Also, accounting standards differ across companies. This can cause significant value. For example, in Europe, companies can write off inventory over three years. This is a significant opportunity since the inventory do not lose real value. 

Finally a quote to end the post: As per Bill Miller, "All of the information is in the past, all of the value is in the future". 

Tuesday, December 26, 2017

Thumb Rule of Financial Planning: Mostly applicable in India

1. 30% of your income must be used for *Monthly living expenses.*

2. 30% of your income must be used for *Liabilities repayments*, if any.

3. 30% of your income must be *SAVED* and *INVESTED* for your future LIVING.

4. 10% of your income must be spared for *entertainments, travel, hobby, vacations etc*

5. Six months expenses must be available as savings for *Emergency Fund* (should be invested in LIQUID FUND, FD etc) 

6. *Home loan* eligibility to be checked before buying property for availing Home loan Tax benefits. Getting *Encumbrance certificate and Town Survey Land Register (TSLR)  with Sketch* of property is important before finalizing any property purchase.

7. Buying *Second house for investment is not advisable* ( _Survey reports say, it will fetch you only around 3% return_) Having *one house for your own, no loans to repay, stable job and  good health* will give you peace of mind while in the *prime age group of 20 to 45.*

8. After 45 years of age, *do not enter into any BIG TICKET LIABILITIES* which will make life miserable (Higher education of children and their wedding will happen when you are around 45 to 50 age only, so plan now for the same.) 
9. Operate an *Either or Survivor Bank* Savings Account if you are employed. If you have small business *both spouses to operate Joint bank* accounts.

10. Property must be *registered on both Husband and wife name*. (As per Legal Act – after husband first legal heir is wife, after wife it will go to children only) 

11. Undertake regular check on *Nominations at all financial instruments.* if not nominated, do it now.. 

12. Only in Insurance policy, *claims are payable to the Nominee.* In other financial instruments legal heirs' certificate is a must to get back the settlement. A will becomes *invalid if it's not registered* in your local Registrar office even though it's signed and stamped by a practising Advocate. The best advise on will related matters come from an experienced and honest *Document Vendor.* Insist your Notary or Advocate to register the document with a *copy of the will kept in the local Registrar office* even if he has stamped and signed it.  

13. Must have *Term Insurance* to financially *secure future* of your dependants..

 *Conventional Insurance products* can serve as Debt oriented investments and provide assured returns in the present falling interest regime with Tax benefits. 

14. *Don’t take any financial investment decisions EMOTIONALLY*,  and also Avoid last minute *tax saving investment* decisions, plan well in advance.. 

15. *MEDICLAIM is must* (in spite of Group Mediclaim coverage given at office) (After retirement there is no mediclaim coverage, after 50-55 years of age, it's very tough and costly to enter into *Mediclaim*) 

16. For your *jewellery LOCKER*, Only one lakh is payable by bank, if theft or fire happen at bank. Back up with *separate locker insurance* personally it required. 

17. Similarly,  *Government guarantees only 1 lakh for your FD* also. (Fixed deposits with Banks upto Rs. 1 lakh only are backed by *deposit insurance).* Back up with additional insurance cover.

18. You must know all *Tax implications.* You cannot avoid paying tax. But you can minimize by way of tax planning and investments.. Speak to your experienced *Chartered Accountant.*

19. All *financial documents must be kept safely* and keep family members informed of the same.. 

20. *Financial investments* must be followed through your well known and trust worthy *Personal Financial Advisor..*

21. *Review your portfolio every 6 months..*

These are general suggestions, personal Finance and investment decisions depends upon case to case_

*Have a Healthy and Wealthy new year 2018

Friday, December 22, 2017

Some Ageless Financial Advice...

Some very important financial tips that everyone should know ....

1. Avoid buying property on loans as it eats most of your earnings unless you have a clear plan for its repayment. It's important to monitor cash flow. Though, the house will be your asset, your liability will be much more.

2. Start a SIP at a very young age. Try to save atleast 15–25 % of your earnings.

3. Avoid buying a car unless you use it everyday.
4. Do not let this sentence scare you. “Mutual fund investment are subject to market risk. Please read the offer documents carefully before investing”. Most people avoid investing in mutual funds just because of this one warning. Yes, there is a market risk, but look at the history and growth of mutual funds.

5. Try having a simple wedding.

6. Atleast 20% of your wealth should be liquid so you can utilize it when necessary.

7. Considering inflation, you are actually losing money if it is in savings bank account. Do not keep huge money in savings bank account.

8. If you invest in stocks, pay due attention.

9. If you invest in stocks have a separate account for delivery investment and Intraday investment. It is easy to monitor this way and also makes tax calculation easy

10. Do not have a belief that property and car make you rich. Its what you save and invest, that is important.

11. Never invest in insurance for returns. Insurance is not an investment option. It is a risk management tool.

12. Never use credit cards for lavish spending. Use credit cards intelligently and for needs not for wants.

13. Cancel all credit cards before you die. Or inform family about all your accounts, credit cards, loans and saving now itself.  Even a small residue will cost your family much.

14. Invest on yourself and then on other investments.

15. Always try to balance your earnings with your savings first, then on  spending and loans. Never take unnecessary loans. Always have reserve and utilise them and unless no other go never take loan.

16. Always have a plan for future events on your career, life, spending and finance.

17. Always have a reserve on your savings for contingency and urgent situations.

18. Your personal life and health are the most important investment. Do have a regular health check and do healthy workout every day. Stay healthy and live happily.

19. Always remember death can come please do buy adequate term Insurance if you have dependents.

20. Prepare a Will. It may avoid unnecessary fights after you die.

21. Most importantly follow these advice.

Wednesday, September 6, 2017

Book Review #31: The Little Book of Value Investing: Author: Christopher H Browne

Over 176 pages and 21 Chapters,  the book 'Little Book of Value Investing' by Christopher Browne packs quite a punch. Content rich, this book has insights in almost every page. This is a kind of 'Intelligent Investor' on Steroids.
Chapter 1: Buy stocks like steaks....on sale
Value investing is an approach of buying stocks which are trading well below the intrinsic value. It is a model that will help identify good companies at attractive valuations
It is like buying items on sale
The opposite approach is the Growth Investing that focuses on the fads of the day. One normally pays higher price for growth stocks
Over any time period, Value Investing has outperformed growth investing
Chapter 2: What's it worth?
Value investing involves two fundamental principles: Intrinsic Value and Margin of Safety
This chapter focus on the Intrinsic Value
Intrinsic value can be defined as a price paid in an arms length transaction between a knowledgeable buyer and a knowledgeable seller.
Understanding of Intrinsic value helps the investor to sell Over priced stocks and buy underpriced stocks (relative to Intrinsic Value). Intrinsic value helps investor take advantage of mispricing in stocks.
Two approaches to identifying Intrinsic Value: One, Ratio method, by looking at a set of financial ratios and two, Appraisal method, analyzing like a banker appraising the value of the business.
Chapter 3: Belts and Suspenders for Stocks
The focus of this chapter is on Margin of Safety.
If you buy a stock at a significant discount to its intrinsic value, you have a margin of safety. If you buy a stock with a margin of safety, there are two ways in which you will benefit. One, as the gap between your purchase price and intrinsic value narrow and two, due to the secular increase in intrinsic value of the company.
Graham used to by stocks selling at two thirds or less of their intrinsic value. It was his margin of safety for two reasons. One, the stock could rise 50% and will still be trading around the intrinsic value. Also, if the market hit a rough patch, he had the comfort of knowing that what he owned was worth more than what he paid for.
Margin of safety also prevents investors from taking too much risks, for example, investing in companies with high amount of debt. Margin of safety also prevents the investor from excessive concentration in individual stocks by encouraging diversification. Margin of safety also allows you to be a contrarian. During negative events, when there is overall gloom around, focusing on Margin of Safety will throw up wonderful opportunities to invest in.
Finally Margin of safety not only applies to buying shares, but also applies to selling them. You sell stocks when they are priced above their intrinsic value.
Chapter 4: Buy earnings on the cheap
The starting point to find value is to identify companies trading at low PE ratio. Inverse of PE ratio is called Earnings yield which helps compare investment opportunities. The advantage of buying low PE stocks is that negative expectations are factored in and any positive news can bump up the stock price significantly. Reverse is true for high PE stocks. Good news will have no impact on their price while any bad news can bring down their share price dramatically.
Chapter 5: Buy a buck for 66 cents
Another value investing approach is to buy stocks trading below their net worth. The ratio is price to book value. This was a favorite of Ben Graham. The assumption here is that the companies will strive to improve their book value and sooner market value will catch up with the book value. This is a good ratio to evaluate companies in banking and financial services.
Chapter 6: Around the world with 80 stocks
Why should you go global? The reason is that more than 50% of the world's largest companies are outside of US. For a value investor, this is too big a market to ignore.  One of the benefits of trading in international markets is portfolio diversification. There are other advantages. One, due to legal requirements, the valuation criteria could be different, for example valuing the asset at costs as against market value. Another could be due to different valuation approaches, for example Europe follows a top down, macro economy based valuation while us follows stock specific bottom up valuation. Also country specific issues could provide value investing opportunities.
Chapter 7: You don't need to go trekking with Dr.Livingstone
While global markets provide portfolio diversification, it is not necessary that a value investor should invest in all markets. The author is comfortable investing in developed markets with democratic, capitalistic traditions. Author shuns emerging markets because of their lack of transparency and impulsive decision making. 
Chapter 8: Watch the guys in the know
Stock purchases by company insiders is an early indicator of potential value mismatch. If this is accompanied by low price to book value, it is a due sign that  things could turnaround soon. As per author selling by insiders is not as predictive. Another way companies could signal value is buy announcing a buy back. A buyback, especially when done below the book value can increase the share price. Other types of investor purchases to look out for are when someone buys more than five percent of the stocks in the company or purchases by an activist investor. Some times purchases by knowledgeable investors are the catalysts required to unlock value.
Chapter 9: Things that go bump in the market
Correction, both market and stock specific, is a great opportunity to pile on good stocks at bargain prices. Good companies with strong balance sheets tend to recover quickly from downturns. One should be careful not to catch a falling knife.
Chapter 10: Seek and you shall find
Today technology offers opportunities to identify stocks reasonable valuation. Ben graham used to trade in stocks that were selling at two thirds of their net current assets. One of the information to look for the buying history of the mutual fund managers who run value funds. Another one maybe to look for merger and acquisition in the industry. Which technology it has become much easier, and paradoxically much more difficult, to identify the new value opportunities
Chapter 11: When is a bargain not a bargain? 
One of the reasons why stocks become cheap is when they have high amount of debt on their balance sheet. As per Graham the debt to equity ratio should be less than 0.5. Another reason for low price could be when the company misses earnings estimate. Stocks in cyclical industries maybe under priced due to cyclical downtown and could take a long time for the cycle to reverse. Other reasons could be adverse labour contracts, under funded pension, increased competition, product obsolescence etc. One of the worst reasons for share price drop is corporate accounting fraud.
So how can we protect our money?
One stick to industries that we know and understand. Two, look for moat also known as competitive advantage. The favourite industries of the author are banks and consumer staples. The most important suggestion is this chapter is to set up a 'no thank you' file of big companies that you want to avoid investing in.
Chapter 12: Give the company a physical
From this chapter we are getting into the realm of financial analysis. We start by analyzing the balance sheet. The key aspects in balance sheet are liquidity and debt.  There are two ratios related to liquidity.  First is current ratio is calculated by dividing current liabilities from current assets.  The ideal value is 2. The second ratio is called the quick ratio (also called acid test ratio) which is calculated by the formula current assets minus inventory divided by current liabilities.  The ideal value is 1. These ratios should not be looked in in isolation.  It is important to to compare with peers in the the industry as well as trend within the company.  For example progressively deteriorating ratio could signal potential issue.
When it comes to debt,  the key ratios are the leverage ratios and coverage ratios. Leverage is shown by Debt by Debt to equity ratio.  This ratio could vary from industry to industry but in general the lower the ratio the better.  The important coverage ratios are interest coverage ratio and financial charges coverage ratio.  The higher the coverage ratio the better.
Ask with liquidity ratios we should look for comparative values with the peers as well as Trends within the same company.
Earlier we discussed the importance of book value. Book value is, in general, calculated as total assets minus total liabilities. The higher the value the better. While calculating the total assets one should ignore intangible assets like goodwill. If long term liabilities are growing faster than the long term assets it's a warning signal.
Balance sheet analysis is just the first step. A true balance sheet is a sign of companies strength, its ability to withstand temporary downturns. Next step analysis of income statement. 
Chapter 13: Physical exam, Part 2
First step is to look at at look at to look at at the revenues are the revenues increasing or decreasing? Also look at the segment wise revenue.  It is possible that a profitable segment is hiding the inefficiencies in other segments.
Next look at at the cost of good sold look for the trains is cost of good sold as a proportion of sales increasing and decreasing remaining stable increasing proportion of cost of good sold could indicate that the company is not able to pass on the cost the customers
The difference between the revenue and the cost of good sold is good sold is is called gross profit gross profit margin is calculated by dividing gross profit on the sales look for a steady gross profit margin
Operating profit is calculated by reducing selling and other administrative cost from the gross profit declining operating profit could indicate management that is not able to control the overheads
Other income is a key component that one should be careful about this is a non recurring income and should be removed from the net profit calculation
Net profit is calculated by reducing taxes interest and other income from the operating profit net profit margin is calculated by dividing net profit by the sales. Look for stable or increasing net profit margin.
Earnings per share is calculated by dividing the net profit by the number of shares outstanding. One should look for fully diluted earnings per share which also considers potential increases in shares outstanding through stock options or warrants. A significant difference between regular EPS and fully diluted EPS is a strong warning signal.
As discussed in the previous chapter trends are more important than standalone values
Chapter 14: Send your stocks to the Mayo Clinic
Once you identify potential investment opportunity, it is time to dig deeper by putting the company through a rigorous analysis. There are 16 groups of questions that one should ask of the company under analysis.
1.      What is the outlook of pricing for company’s products? Can company rise prices without impacting volumes?
2.      Can the company sell more without incurring additional costs?
3.      Can the company increase profits on existing sales by cutting down costs, for example. Can the company control its costs? For instance, cookie company has no control over sugar prices
4.      Can the company control expenses like SG & A?
5.      If the company raises sales, how much of it will go into bottom line? Company can increase sales by giving discounts. However, this will not improve the profitability of the company
6.      Can the company be as profitable as it used to be, at least as profitable as its competitors?
7.      Does the company have one time expenses or income that will not repeat in future?
8.      Does the company have unprofitable operations that they could shed?
9.      Is the company comfortable with wall street’s earnings estimate?
10.  How much can the company grow over the next 5 years? How will it achieve the growth? Do the management have a realistic plan to achieve the growth?
11.  What is the plan for the excess cash?
12.  What does the company expect its competitors to do?
13.  How does the company compare financially with other companies in the same business?
14.  What is the resale value of the company?
15.  Any plans to buyback its stock?
16.  What are the insiders doing?
Chapter 15: When in Rome....
If you are following a global approach to value investing, it is imperative to know the different accounting standards being followed by different countries. This accounting difference could throw out some good surprises.
Chapter 16: Trimming the hedges.
When you are investing in international markets, you are incurring three types of risks, one is the stock specific risk, two is the Systemic Market Risk and three, currency risk. Currency risk in international investing is the risk that the currency being used to invest will move in a direction that is detrimental to the investment.
Let us assume that you invest 100 USD in India Market. You covert it to INR @65 and invest 6500 in Sensex. After One year your investment has grown to 7000. You sell and convert the same to USD.
At the time of selling,
If INR / USD is 70 (INR has depreciated), you end up with 100 USD. No gain
If INR has depreciated to 60, you end up with 116 USD, a gain of 16%.
So you know that as a foreign investor, you will face losses if the home currency depreciates. You can handle this potential losses by hedging, for example by selling Indian Currency forward contracts. In this case you are both long (by buying stocks) and short (selling currency forward contracts), so that you are hedged against exchange rate risk.
Another point of view is that if you are invested for the long term, the exchange rate fluctuations tend to cancel each other out (for example in the last 4 years, INR USD has seen a high of 70 and a low of 63) and hence it does not matter if you are hedged or not.
Chapter 17: It is a marathon, not a sprint
The key point in this article is never to time the market. Do not try short term trading,  stay invested in your value picks. In a study conducted in the US market, in a span of 60 months, most of the gains have come in about 7% of time. The remaining 93% of time produced scanty returns.
(On a personal note, my investment in Sterlite Technologies is an example. I purchased this stock at around 60, 5 years ago. In these 5 years stock had jumped about 4 times to around 240 today. However, a huge part of that jump came in a span of about a month.)
Short term trader also end up losing on brokerage, commissions and taxes. World over, short term capital gains are taxed at a higher rate than long term capital gain.
So in summary, invest, do not trade.
Chapter 18: Buy and hold? Really?
This chapter considers the important aspect of asset allocation, specifically between equity and debt. Traditionally there are generic rules like ‘100 – Age’ to decide the proportional allocation between the two. If your age is 30, 70% (100 – 30) should be allocated to equity and balance to debt.
Author is not in favour of these approaches. Being a firm believer in equity investing and the power of compounding, his solution is simple. Be predominantly invested in equities. Keep a three year debt investment that will give you commensurate returns based on your expenditure expectations. Invest the remaining in equity. When the equity is increasing, use the returns from the equity to meet your monthly expenditure needs. You should dip into your debt investment (nest egg) only when equities are down. In case you take money out of your nest egg, top it up as soon as markets start moving up again. This approach will help you to capitalize yourself with equity return when the markets are going up and with debt returns when markets are going down and equity has to be conserved.
Peter Lynch, in his book ‘Beating the street’, suggests 100% allocation into equities and taking money out of equity irrespective whether market is up or down. The suggestion by the author is just a minor tweak on the suggestions by Lynch.
I like this approach. Very practical.
Chapter 19: When only a specialist will do
The secret to winning the investment game is to pick good managers and stick with them. If you are not a financial wizard who does his own investing, the chances are that you will require an investment manager sooner or later. A good manager can add significant percentage points to your returns. This chapter focus on the questions to ask while selecting the fund manager. There are four sets of questions  / criteria that you have to evaluate before you select a fund manager.
1.      Simplicity of investment approach. The manager must be able to explain his investment approach in simple language without confusing the listener with jargon. The simplicity in the answers show the clarity of thought.
2.      Track Record: You have to look at the track record through a complete market cycle to gauge the capability of the manager
3.      Is the fund manager still with the fund or the track record in point 2 above is of a different fund manager who has moved on?
4.      Investing own money: Where do fund managers invest their own money? Is the approach consistent
Chapter 20: You can lead a horse to water but....
It is beyond doubt that Value Investing has proven to be an excellent approach towards building wealth. If so, why are there very few money managers who practice this approach? First reason is that value investing is contrarian in nature. It involves buying stocks that are unpopular and holding them for a long period of time. This is a risky strategy for a money manager whose performance is evaluated on a monthly basis.
Another reason why money managers shun the value investing approach is the herd instinct. In Wall Street, if you buy the latest fad which is being chased by your peers and if you lose money, no one will criticize you. However, since value stocks are shunned by the street, a value investor will be a loner and he will be blamed for going against the herd if things go wrong.
Chapter 21: Stick to your guns.
As businesses evolve and change the criteria for identifying value investing opportunities also change accordingly. Graham who was the pioneer in value investing used to look for companies selling at two thirds of the net current assets value.  When manufacturing industry became the key industry in the United States price to book value became the criteria of choice to identify value. Soon, as services industry became prominent with their low asset base and low book values,  price to book value became meaningless and investors shifted to earnings based model of valuation.  Then came the phenomenon of leveraged buyout and the appraisal methodology became one more weapon in the armory of the value investor. Even as criteria to identify value keeps changing with the times, basic principle of value investing remains as timeless as ever.  Invest in companies trading significantly lower than their intrinsic value and then wait for market to identify its intrinsic value.  It may take time and patience.  Sometimes market may go up significantly while your investment remain lacklustre. Sometimes you may sit on cash with no value opportunity available to invest in as the market has run up considerably.  It is at these times that one must not lose faith (in the approach)  and patience. If you have done the homework properly and identified value stocks, eventually  you will be rewarded handsomely.
This is a book for the new investors. I will give it a score of 3/5

Tuesday, September 5, 2017

Book Review #30: The Little Book that Still Beats the Market: Author Joel Greenblatt

This is a sequel to the more famous book 'The Little Book that Beats the Market', by Mr.Greenblatt. This book is very easy to read and review since there is no new idea in this book. The book is a weak attempt to explain the 'Magic Formula' and is more of an effort to prove (to the sceptics) that the 'Magic Formula' works over time and over different groups of stocks.

What does an investor want? She wants to own shares of companies in the best business at very good market price. This is what Magic Formula tries to provide. Magic Formula itself is very simple. Identify the companies with the highest ROCE and the highest Earnings Yield and keep them for one year. At the end of one year, sell off them based on the tax rules prevalent in the country. High ROCE will ensure the attractiveness of the business and high earnings yield will ensure that the share is purchased at an attractive price.

How does MF work? Use a screener to screen companies with their ROCE in the financial year that just ended. Give the companies ranking from 1 thru N where 1 is given for the stock with the highest ROCE. Run another screen to identify the companies with their Earnings Yield. Use the same ranking to rank the companies based on the Earnings Yield with 1 for the highest Earnings Yield. Now sum up the ranks and buy the top 30 stocks with the highest cumulative ranks.

Magic Formula uses the following equations to calculate ROCE and Earnings Yield.

ROCE = EBIT / (Net Fixed Assets + Net Working Capital)

Earnings Yield =  EBIT / Enterprise Value (Market Value of Equity + Market Value of Debt)

The advantage of using EBIT is that it helps in comparison of performance of various companies without the complications of Taxation. The denominator in the ROCE equation is the cost of generating that EBIT.

As can be seen, Magic Formula is quite simple. However, there are some cautions.

1. If using the MF, one should have a portfolio of about 30 stocks to get the best returns. If an investor uses Magic Formula to buy one or two stock, he may end up losing. The reason is while the individual stocks within the MF may have fluctuating returns, as a whole, the formula works at a portfolio level.

2. For best results, spread the purchases of magic formula stocks. For example, buy about 7 - 8 stocks in a month for 4-5 months till you reach list of 30 stocks. This will even out the systematic risk.

3. Keep the stocks for at least one  year for the best results.

4. Do not keep stocks for more than a year (+/- a few days). Sell of loss making stocks before 365 days to get Short term capital loss benefits and sell profitable stocks immediately after 365 days to get the Long Term Capital Gain benefits.

5. Every year, run the formula again and buy the new stocks that meet the criteria.

Magic Formula works in US Contexts. For India Context, some tweaking may be required.

Mr.Greenblatt has an engaging style of writing interspersed with pithy witticisms. So the book is an easy read.  

This book did not add a lot of value to me. Probably the prequel might. However, that book is very expensive and I am waiting for a correction to buy that book.

My score is 3 / 5 for this book.