Investing Series Part 2: Intelligent Investing for the Average Investor

Author's Note: This article mainly serves as a guide for active investing (stock picking) for the average investor. Stock picking/active investing is not suitable for everyone. For those who want a more passive approach, I suggest a balance mix of ETFs (50% stock/50% bond ETF division and then re-balance annually).  However, if you want to learn the basics of stock pick, read on.... 

To succeed, one must have a mind-set of an investor, not a speculator:

The statement above took the author over 5 years to learn properly. It is very easy to pay attention to the stock ticker and the current price than to think about the underlying business. Everyone needs to be reminded from time to time that a stock represents an ownership of a business, not just a paper (or electronic ticker) with a price on it. If the business does well, your stake in that business should increase in value and vice versa. It's simple as that.

Investors need to be patient as owners and must ignore short term fluctuations of the stock market. Imagine if you buy a house, will you check with a real estate broker what is the price of your house every morning at 9:30am? What about at 9:35am? The answer of course speaks for itself but unfortunately, many investors will likely check the price of their stocks at 9:30am, 9:31am....all the way till 4:00pm. Now that's speculating.

Understand Mr.Market but don't listen to him

Mr. Market is an allegory of the stock market made up by Ben Graham, the mentor of Mr.Buffett. Mr.Market is a fellow who comes to you daily to quote prices of many businesses and he is happy to buy your interests in those businesses or sell his interests at the price he quoted. Mr.Market is very emotional. He sometimes quotes a ridiculously high price because he only sees the positive sides of those businesses. He sometimes also quotes a ridiculously low price because he thinks the business is worthless.

Warren Buffett reminds investors of two important facts about Mr.Market investors need to know and remember at all times:

1) You don't have to transact with him every day. Only do so if you can take advantage of his quotes. If he quotes a low price, you buy from him. If he quotes a high price, you sell to him. Most of time, it is simply better just to IGNORE him.

2) It is Mr.Market's pocketbook (pocketbook describes the book traders use to keep track of their stock inventory back in Graham's days), not his opinions that should interest you. Many investors think Mr.Market is correct on the valuation of businesses and follow his opinions.

Basic skills needed

Although investing is a game the average Joe can succeed at, there are some of the skills that are essential for an investor: 

• Basic accounting knowledge (understanding of income statement, balance sheet and cash flow statements). Accounting is the language of business; therefore, investors need a basic understanding of accounting
• Have patience. As Peter Cundill used to say, "patience is patience is patience"
•  A basic understanding of the business model of the underlying company. If you don't understand how the firm actually makes money (i.e. Enron), you have no right to be the owner of that company
• Able to differentiate between "price" and "value". Remember "price" is what you pay, "value" is what you get
•  Have the attitude of an owner, not a speculator. If you buy a stock and not worry if the stock market closes down for the next 10 year, you are truly thinking like a owner.

Order of Operations:

1) Have an understanding of the industry and business. Pull up its annual reports from either SEDAR (for Canadian companies), EDGAR (US companies) or on the investor relations site and start reading. Understanding characteristics of the underlying business is important. What are the key successful factors in a particular industry. Does the company possesses those key success factors? Does it have a competitive advantage vs. other competitors. In this step, it is beneficial if the investor has worked in or has a good understanding of that specific industry.  Never ignore a section in an annual report just because it looks long. The risk-factors (Section 1A of 10-Ks) section should never be ignored.  The management discussion & analysis (MD&A) section is an important section of the annual report where the management explains its outlook for the company and industry.

2) Listen to a few recent quarterly conference calls (most companies have webcast links on their investor relations). This will give you a recent update on the company and industry.

3) Take a look at its financial statements in the annual report. Don't forget to read the footnotes to the statements! Analyze them using techniques such as common-size, trend analysis and ratio analysis will help investors generate a good picture of the company's financial trends. It may be helpful to remove the effect of one-time items such as a goodwill write-downs or other asset impairments.

4) Analyze the key operating or financial ratios relevant to the industry that the company operates in. i.e. banks investors need a careful look at lending margins (Net Interest Margin), loan losses (Provisions for Credit Losses) and capital ratios (Tier 1 common equity ratio, leverage ratio). For life insurance companies, interest rate levels, swap spreads and corporate bond spreads are analyzed. For retail companies, same store sales (SSS) growth and sales per square foot/meters are analyzed. For telecoms, average revenue per user (ARPU)  and the churn rate are analyzed. For oil and gas companies, focus is on the growth in reserves (such as 2P) and production (production in barrels per day). Don't worry if you do not know the key ratios above. Just read the annual reports of the companies and you'll slowly learn what those ratios mean. 

5)  Figure out the intrinsic value of the company (see next section)

A basic framework for valuation:

Investors can either use a cash flow based approach or a earnings based approach. A cash based approach takes all future cash flows generated by the company and discount them to calculate the present value of the company. An earnings based approach uses an average earnings multiplied by an appropriate long term multiple.

For the cash based approach, the measure investors should use is Free Cash Flow (FCF). As an approximation, FCF = Cash from Operations (from cash flow statement) - capital expenditures (often a line in the cash from investing section). Investors need to estimate future FCF and then discount them back to the present to figure out current value. The definition of FCF used here is cash flow to the whole company (firm) so the equity value is calculated by subjecting total net debt value (short term debt + long term debt- cash) from the calculated present value of the FCF values. 

The earnings based approach is very similar to a P/E multiple approach. However, investors should use an average earnings number in the "E" instead of forward earnings (next 12 month) used by most Wall Street analysts. Many companies are cyclical or have large swings in earnings so an average number will smooth out those fluctuation to provide a better picture of the long term earnings power. Using an average earnings number also implies the multiple must represent a fair long term multiple for that company. (most are in range of 10-15 times earnings). This approach was practiced by Buffett's mentor Graham since 1930s and he calls it the "earnings power" approach. 

Conclusion and the "Margin of Safety Principle"

In Chapter 20 of the Intelligent Investor, Ben Graham summed up sound investing in 3 words: "Margin of Safety". What does that mean?

Because there is uncertainty regarding the future and it is likely your calculation of intrinsic value is very different from the actual value, a margin of error is needed. This margin of error is an investor's margin of safety.  If the stock price is at $25 and you think it is worth $30, the $5 difference does not offer a large margin of safety. For a DCF model, a small change in discount rate will likely change the intrinsic value. For an earnings multiples model, a change in the multiples will impact  the calculated value significantly.

How does an investor guarantee adequate margin of safety? Graham suggested that the intrinsic value should be at least 50% higher than current price to provide that safety cushion. Some deep value investors even suggest that calculated intrinsic value should be at least 100% higher than current price. From the author's own prospective, he wouldn't consider putting any money unless the upside is at least 33%, preferably 50% or more. 

All in all, investing is a marathon, not a race. Investors should purchase a stock when it is cheap enough justified by its fundamentals, not because you heard a rumor that the company may go up at a cocktail party. Investing, as Warren Buffett would say, is simple but it's definitely not easy. For anyone wants a superior return, hard work is needed. No pain, no gain, it's that simple.  

Appendix: Collection of quotes investors should know:

Aside from the ones already mentioned above, below are some of the quotes every investor should be aware of.

"If a business does well, the stock will eventually follow" Warren Buffett

Comment: The stock price may fluctuate day to day but it is ultimately the underlying business that matters. If current stock prices are depressed for whatever reason and the business is still doing well, expect stock price will rise in the future.If the company, on average, earns 20% (return on capital) per year, then the stock price should rise by 20% per year in the long run.

"Be fearful when others are greedy, be greedy when others are fearful" Warren Buffett  

Comment: Buffett did not earn billions by luck. This is one of his important principles. Investors have to realize when others are very fearful, it is a sign of opportunities. Buffett took advantage of many panics such as 1962 salad oil scandal to buy American Express (AXP), the 1974 panic in Washington Post (WPO) stock due to a political threat, and 1990 S&L crisis to buy Wells Fargo (WFC).

"Invert, always invert" Charlie Munger

Comment: This quote was actually from algebraist Jacobi. Many investment decision can be improved by looking at the problem backwards. i.e. To find good investments, the direct method is to search for excellent stocks to buy. The inverted approach is to avoid all bad stocks and the remaining choices will be good. 

"If I have to identify one factor to successful investing, it's cheapness" Howard Marks

Comment: No matter what asset you buy, if you buy it at a reasonable and cheap price, you'll do well. A great example Mr.Marks likes to point out is that if you bought the nifty-fifty stocks (a group of high growth blue chip stocks), you would have lost money in the 1970s. However, if you bought a group of junk bonds (bonds of financially distressed companies), you return was fantastic. It may counter-intuitive that risky junk bonds actually performed better than high quality blue chip stocks, but the reason was price. Junk bonds were ridiculously cheap before the 1980s LBO boom but blue chip stocks were highly overvalued (some traded near 90X earnings). Marks always made fun of the definition of junk bonds in the old Moody's manual  "a bond that does not possess the characteristic of an investment" 

"Bull-Markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria" Sir John Templeton

Comment: A very concise sentence to describe market cycles. You want to buy when everyone pessimistic (i.e. 1933,1938,1970,1974, 2002, 2009) and be wary/sell when everyone is caught in euphoria (1929,1937,1968,1973, 2000, 2007)

"Those who do not remember the past are doomed to repeat it" George Santayana

Comment:  For a successful investor, a study of past market cycles (bear/bull market) may help them understand market cycles and improve investing decisions. Those who neglect to study the past, is likely to  repeat past mistakes. One common mistake was leverage. Leverage always caused problems. Mr.Marks summed it nicely in a good equation: Volatility + Leverage = Dynamite 

"History doesn't repeat itself, but it does rhyme" Mark Twain

Comment: Adding to Santayana's quote, investors need to remember every market cycle may be different but the underlying factors of greed and fear that caused those cycles will always be the same.