Stock investing: Don't confuse a great company with a great investment

 18 Feb 2013 19:10
 by ROHIT GUPTA

Efficient market theory and the multitude of (highly) paid analysts would appear to make individual stock picking a "losers game". However, there is an alternate view, that provides small investors - willing to do their homework - an advantage.

Individual Investors:

1. Mutual funds are not serving best interests of investors

As mutual fund fees are paid as a percentage of assets under management (AUM), the overriding drive amongst fund managers is for asset size. This leads to increased marketing as also push to bring out new niche funds. Both negatively impact consumers via higher expenses and increased volatility.

2. Bias in analyst industry: Most analyst only cover one industry.

As an investor, you do not need to restrict yourself to any one industry, but choose those offering highest potential returns, across industries.

3. Diversification only addresses a part of total risk - it does not address market risk (risk of the total market going up or down).

- Beyond 6 or 8 stocks (in different industries), overall market risk is not eliminated by merely adding more stocks. In a practical sense, fund managers add stocks more driven by fund size and legal considerations, than merely stock considerations or diversification.

Individual investors are not similarly constrained and can limit to few optimal picks.

Investment 101:

When you buy a company's stock - in effect you are buying its cash flows based on future profits. The key to investing is not how much a company/ industry will impact society or how much it will grow - but its ability to make sustainable profits.

- Avoid the mistake of confusing a great company with a great investment - the two can be very different.

Investment Philosophy:

1. Rule #1: Never lose money. Rule #2: Never forget Rule #1.

Look down, not up. If you don't lose money, most of the other alternatives look good.

- Large losses are very difficult to recover from, and must be avoided. While a 10 per cent loss, will require a 11 per cent gain to recover, a 50 per cent loss, requires a 100 per cent gain to recover (and a 75 per cent loss - a 300 per cent gain!).

2. Risk is not the same as volatility - higher risk does not mean higher reward.

- The standard beta definition (price volatility of a particular stock relative to the market as a whole) - measures risk in a erroneous way - equating volatility with risk. A measure of relative short term volatility vs. longer term potential for loss.

- As investors, one is not concerned with volatility, per se, but the possibility of losing money (or not achieving a satisfactory return). A stock that has fallen from $30 to $10 is considered more risky than one that has fallen from $12 to $10, even though the latter is available at a greater discount (and the expectation of reward maybe greater!).

- Sometimes risk and reward are correlated in a positive fashion e.g. - a higher payout for undertaking a risky venture. The exact opposite is true with value investing. The greater the potential for reward, the less risk there is.

3. Understand the difference between price and value.

- "Price is what you pay. Value is what you get." The basic concept is that an asset has an underlying value or "intrinsic value" that is separate from its price. A business is valuable whether you intend to sell it or not because it generates cash flows.

4. In the short run, the market is a voting machine, but in the long run, it is a weighing machine

- In the short run, prices can differ widely from value, but in the long run, price and value tend to converge. You don't need to concern yourself with market psychology, price charts, or anything else not related to the intrinsic value of the company.

5. Make sure that you have a margin of safety

- Stock Market Returns are a combination of (i.) investment returns (Earnings growth + Dividends), and (ii.) speculative returns (changes in P/E ratio).

- As impossible to know future P/E ratio - valuation is critical. Return is dependent on the Price you buy at. Buying at lower PE lowers risk by allowing for a "margin of error" as well as opportunity to benefit from growth.

Investment Strategy:

1. Look at stocks as a business. In buying a stock, you are buying future cash flows. Focus on return on capital. As markets are very competitive, and predicting future, very difficult, focus on businesses that posses a long term advantage. An economic moat.

- Moats not based on (i.) Products, (ii) Market share, (iii.) Execution, or (iv.) Management but, (i) Intangible Assets (brand, patents, regulatory licenses), (ii) High switching costs, (iii) Network economics, and (iv.) Cost advantages (location, process or scale).

- Do not fall in love with product, but where model allows long term pricing power or cost advantage. Key financials include (i.) Free Cash Flow, and (ii.) Return on Capital.

2. Determine the true value of a business and buy stocks in these companies when they go on sale. Valuation may not be a pre-requisite for successful investing, but it does help make more informed decisions

- Dozens of valuation models but only two approaches: intrinsic and relative. Intrinsic valuation, based on expected cash flows and associated risk. Relative valuation based on market pricing of similar assets. While purists on both sides - no reason to choose one over the other, as can use both. Invest in stocks that are under valued on both intrinsic and relative basis.

- Basic difference in intrinsic and relative valuations, is based on different views on market efficiency (or in-efficiency). Intrinsic valuation assumes, markets make short term mistakes, that can occur across sectors or entire market, but correct longer term. Relative valuation assumes, that while markets make mistakes on individual stocks, they are correct on average.

- To make money based on undervalued intrinsic value - market will have to corrects its valuation. And that may not happen soon. So a long term approach is a pre requisite to using intrinsic valuation.

3. Have a margin of safety.

- A margin of safety exists when the purchase price of an investment is lower than intrinsic value. Not only does this provide strong protection against downside risk, but also provides a good chance at earning high returns.

- Look at discount of 25 per cent - 50 per cent, depending on width and depth of economic moat.

- Use a market's fluctuations to your advantage. However, good companies are not always available at a discount. You must be, do your home-work, and have the courage to take a stance that's different from the crowd.

4. Make a profit by selling your business at above their intrinsic value. Hardest part of investing is knowing when to sell.

- Constantly monitor the companies you own, rather than the stocks you own.

- Sell not on stock price, but on values of company - (i.) initial assumptions wrong, (ii) company dynamics changed, (iii) better investment opportunities arise, or (ii) stock too large a percent of holding.

Rohit has 22+ years of consumer banking experience across India, Indonesia, Singapore, Malaysia, Mexico and Turkey. He has a personal web portal ( www.yourrule72.com) and may be contacted at rohit@yourrule72.com.  The opinions expressed here are solely his own.