Monday, June 21, 2010

My Strategy: Fool's Four Investing Guidelines

After watching Li Lu's talk on Value Investing for 1hr and 45mins (thanks to Bullbear Stock Investing Notes for great sharing), I think I'll probably call myself a hybrid investor. Okay, I created that term, basically I am a value + growth investor. Probably more on that some day, but today I want to share my investing guidelines that I always use when selecting or for most of the time rejecting stocks.

The Warren Buffett Way by Robert Hagstrom is the first investment book that I read and I am still following the 4 guidelines written in the book until today. From time to time, I've try to improve my skills but fundamentally I'll still stick to the 4 tenets mentioned.  Well, like what Li Lu said, thank god that I am still innocent when I first read the book. Here are the brief look on how I look at the 4 guidelines.



Business Tenets
This is normally what I first look at. Unlike Buffett, I don't start from the A and to the Z, but I rather select them randomly. The idea could come from research houses (although I normally don't read those from research houses' reports but I just see what they have), radios, online newspapers, of course blogs basically any where. In fact, I got one of the stocks in the great list after I overheard it over the radio. Hmm....how lucky? What do I do when something caught my eye? The first question is of course what business does it do? Is the business simple and understandable although I would rather call this predictable? And does the business has a great long-term prospect?

"I want to be in a business so good that even a dummy can make money" Buffett.

This is the quote that's always play in my mind when selecting a business because one day, a dummy will run your business. Think Genting Malaysia...ermm...no offence Mr.Lim. Knowing what the business does is important because it puts me in the right mindset of a industry and it gets me a list of a business competitors. And if I were to know that I'll be making money for sure, the business will have to be predictable, simple and easy to understand. And to know if the business is able to last for the next 20 years  or so, it must have a long-term prospect not a business that is "hot" for the moment.

Financial Tenets
Financial tenets is the complement of business tenets. This is where people know if that a business is really making money. Revenue and gross margin of a business tells a lot of story about a business. This is where I could find if the business have a good sales and competitive advantage. If a business have a wide (around 15% or more depending on its industry) and consistent gross margin, chances are it has a strong competitive advantage or no significant competitors yet. If it is improving, chances are it might have just fought off its competitors, restructuring, or gaining on its competitors and of course vice versa. There is one thing that you should take note, if you see revenue improves and gross margins reduced, it is likely that it has reduced its products or services price to boost revenue and likely to have lose its competitiveness. However that is not always true, but of  course a more thorough investigation is needed when you spot something abnormal.

And of course, there are others like the balance sheets, debt/equity ratios, liquidity ratios, amount of fixed assets, capex and others ratios. For me, I'm pretty sensitive with a corporate debt level and I do not agree with Mary Buffett where she says not having debt at all is the best. Sometimes, it serves the shareholders better when a company is taking debt so finance part of its business expansion or investment. Think about this, a business knows demand will rise for its products by 10% per year but it is now running a full capacity, it needs to expand. But building a new plant needs RM15mil and its current cash level is only RM10mil. So it is RM5mil short. The management know the business is able to generate free cash flow of RM5million per year. The decision is either borrow that RM5mil or wait for another year. If the interest rate is about 5% or so, it'll be better that the management borrow the money from bank. And sometimes, to be there to pick up the demand first is important to a business competitiveness. You wouldn't want your competitors to benefit from that. So debt is not always bad. You just have to make sure that it doesn't stretch its balance sheet too widely that it'll have trouble servicing the debts.

Did I say improving my skill from time to time? Yes. I did not pay too much attention to receivables before the LCL Corp case. In fact, before this LCL Corp is already in my shortlist and I am just looking at the management and its competitive strength overlooking its financial shortcomings. So this is a lesson for me.  Receivables in fact does tell a lot about a company and how it does its business. One can in fact close a pretty big deal by just offering longer credit repayment period.

The important thing when analyzing the financial statements is curiosity like what Li Lu said. A good analyst must be curious. Why is this and why is that? It'll be good for the analyst if he is able to explain those numbers presented in the statements.

Management Tenets
I would say, this is the hardest of all 4 but it is not impossible. To know if the management is honest or trust-able does not necessarily requires you to have a lunch with them. You can have those informations from their friends, relatives or even employees. Okay, that is tough as well, but the employees one aren't tough. What I normally do is to check the boards see if I knew or heard of any of them somewhere. If no, just Google them. All I need is one because I believe a good man would not do business together with a bad man. Well, that's me.

The other thing is to see if the management makes rational decision. One way is to look at their management history from financial ratios such as the ROE, a dollar for a dollar analysis and their dividend policy. ROE can tell us how well is the management doing with our money, equities. But, we still need to be careful on this because a company can have a huge ROE by just leveraging on its debt. When the management decided to retain company's earnings, we better make sure they make good use of it. If they use it to reinvest in the company, we have to make sure it bears fruits else they might as well just return it to the shareholders as dividend. A classic example of a corporate who keeps most if not all the earnings but do almost nothing if not not making bad investment with it is Genting Malaysia.

Value Tenets
If a company pass all the 3 tenets above, the final question is, how much would I pay for this company? This is where the valuation comes. It is the trickiest part, because this is where we try to predict the future outlook of a business and this is where most of the people usually gets it wrong. To be honest, I don't have a best guideline for you on this but it is important to have a margin of safety.

I use to use P/E ratio for valuation but I now prefer the discounted cash flow (DCF) valuation because I felt that this is a more business-like valuation. In short, DCF valuation is to calculate future cash that is to be added into your equity base through free cash flow. So, you are kinda like calculating the future book value but you discount it backwards to the current value. But I do use P/E ratio as a guide sometimes as if I see P/E like 50 or 70, that is definitely too expensive.

Since DCF valuation tries to predict overall the future look of a business, trying to get as right as possible is important which makes understanding the economics of the business vital. However, this is no exact science. Therefore, having a margin of safety is important.



So that's it. A brief explanation of the guidelines I use before making an investment decision. You'll notice that, following this guidelines will make you reject most stocks. That should make sense because if most of the stocks listed in KLCI are quality investments, most of use would have made hell lots of money.

This comment is based on my personal thoughts, opinions and my risk tolerance. It should not be considered as an investment advise. Please consult your financial advisor or do some research of your own before making any decision. You might have your own thoughts. I would love to here from you. You can always place your comments here and or email me privately at luzeeker@gmail.com 

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