Episode 2: My Recipe of Sensible Stock Investing

Hey folks, welcome back. This post is a part of the series of episodes on My Recipe of Sensible Stock Investing. I know the break was too long and my apologies for the delay. Let’s begin without wasting any time. Let’s see where we were last time. I first mentioned the two golden rules and then we discussed about the ingredients and also where I get it from.

It is important to understand the two golden rules. The first golden rule says - Invest in a company that’s worth owning forever! What does it mean? It means that before analyzing a company we need to understand its business.

I look at the following aspects of a business:

· Its Products or Services (Patent / Secret)

· The Customers (Switching or Substitutes)

· The Raw material providers

· Company’s Brand recognition

· The Industry it operates into and the industries growth prospects (Entry barriers, Government Regulation)

· Management

These are a few basic necessary business aspects one should look at. But what are we looking for? We are looking for a company which has a competitive advantage in one or more of these aspects as compared to its peers. The company should stand out.

When you decide that the company is worth owning forever and it has a competitive advantage which it will be able to sustain, we move on to the next step: Golden Rule No. 2 which says - Buy shares at 50% discount or lower and sell at MRP provided it gives minimum 20% compounded annual rate of return.

To find out the company’s real worth and to be able to predict a future growth rates, we first see its past performance. There are hundreds of ratios, but we will focus on a few selected ratios (remember our ingredients) which represents the broader picture (There is a glossary at the end, where I have provided the formal definition as well as their formulae). Just take a look at this:

We will now learn how to mix all these ingredients and in what proportion so that we are all set to enjoy a lavish meal. Ready? Ok so here we go:

1. ROE: Return on Equity represents the ability of a company to generate profits utilizing the equity (i.e. the total shareholder’s funds). It measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

This is an important number. As a shareholder, I want to see the company earning a minimum return of 15% year on year on the money I have invested (You can set a minimum according to your understanding). A company with a higher ROE is always better as its ability to generate profits and grow at a faster rate is high. If the company has been doing so consistently in the past, it seems more likely that it will continue to do so.

2. ROIC: Return on Investment Capital is the rate of return a business makes on the cash it invests in itself every year. Some of you might be wondering what’s the difference between ROE and ROIC. Well ROIC is a more comprehensive measure of the company’s profit generating ability. Why? Because ROIC includes debt.

ROIC is a true measure of the company’s returns and gives a fair picture of the profitability as it includes the debt component. Companies can raise a lot of debt to increase their ROE (return only on the equity capital excluding debt); hence showing a rosier picture of the return, but the main factor that needs to be taken into consideration is the Debt.

I consider it as the most important number among others. It should be above 15% per year on an average for the last 10 years. We first want to see the 9 year average, then the 5, 3 and 1 year averages. And REMEMBER we want ROIC to be staying consistent or going up.

3. Net Sales, EPS and Book Value: Next I look at these numbers. Again I want to see a consistent growth of minimum 15% year on year as well as (average growth rates) over 9, 5, 3 and 1 year.

EPS tells us how much the business is profiting per share of ownership. Book Value is what you would be left wit if the business was sold off, paid off any debt and took the money that was left. It is also referred to as the Liquidation Value. BVPS (Book Value Per Share) is an excellent indicator of the long term growth.

4. Debt/Net Profit: This ratio tells us the time a company will take to pay off its entire debt if it continues to grow its profits at the current rate. So we don’t want this ratio to be more than 3.

Debt / Net Profit = .25

Based on the above analysis, you then have to arrive at an expectation of the rate at which the company will grow in the future. If I think that I understand the company’s business model and it has a competitive advantage which makes it stand out, then we classify it as a green company (in MoneyWorks4Me terminology).

Initially investors find it difficult to arrive at their own expectations. In that case one can refer to what the analysts are saying, what is the industry growth rate and check the company’s past growth rates all in combination. One can be a little conservative initially and once you have more confidence in your assessment, it’s all yours. But remember the 2^nd golden rule: Buy at 50% discount. So whatever you think the company is worth today (it’s MRP), buy it at a 50% discount to that.

I might have missed out on some important parts in an attempt to keep it simple enough for everyone to understand. Please excuse me for that and give me your views, suggestions and feedback. I will try to cover a few more aspects of taking stock investing decisions in the next post, till then sayonara.

P.S. I hope the recipe turns out to be a success. Do let me know as and when any of you try it out. Glossary will be here soon.

References:

Moneyworks4me.com

Rule#1 by Phil Town