- Is the business simple and understandable?
- Does the business have a consistent operating history?
- Does the business have favorable long-term prospects?
- Is management rational?
- Is management candid with its shareholders?
- Does management resist the institutional imperative?
- Focus on return on equity, not earnings per share
- Calculate “owner earnings”
- Look for companies with high profit margins
- For every dollar retained, make sure the company has created [or can create] at least one dollar of market value
- What is the value of the business?
- Can the business be purchased at a significant discount from its value?
- How to Value a Business
- How to Think about Market Prices
To ascertain the probability of achieving a return on your initial stake, Buffett encourages you to keep four primary factors clearly in mind:
- The certainty with which the long-term economic characteristics of the business can be evaluated
- The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows
- The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself
- The purchase price of the business
- Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
- Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
- How effective are the company’s research-and-development efforts in relation to its size?
- Does the company have an above-average sales organization?
- Does the company have a worthwhile profit margin?
- What is the company doing to maintain or improve profit margins?
- Does the company have outstanding labor and personnel relations?
- Does the company have outstanding executive relations?
- Does the company have depth to its management?
- How good are the company’s cost analysis and accounting controls?
- Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
- Does the company have a short-range or long-range outlook in regard to profits?
- In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
- Does management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?
- Does the company have a management of unquestionable integrity?
- Don’t buy into promotional companies.
- Don’t ignore a good stock just because it trades “over the counter.”
- Don’t buy a stock just because you like the “tone” of its annual report.
- Don’t assume that the high price at which a stock may be selling in relation to earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price.
- Don’t quibble over eights and quarters.
- Don’t overstress diversification
- Don’t be afraid to buy on a war scare.
- Don’t forget your Gilbert and Sullivan, i.e., don’t be influenced by what doesn’t matter.
- Don’t fail to consider time as well as price in buying a true growth stock.
- Don’t follow the crowd.
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- Avosid buying the big winners (i.e., eliminating “ugly” companies where the best opportunities may lie)
- Change the game plan after underperforming for a period of time
- Change the game plan after suffering a loss (regardless of relative performance)
- Buy more after periods of good performance
- While studying the footnotes iskucial, the big picture is most important: Earnings yield and ROIC are the two most important factors to consider, with the key being figuring out normalized earnings.
- High earnings yield, based upon normalized earnings, is important in order to have a margin of safety. High ROIC (again based on normalized earnings) simply tells you how good a business it is.
- Independent thinking, in-depth research, and the ability to persevere through near-term underperformance, are three keys to being a successful value investor.
- Worrying about near-term volatility has nothing to do with being a successful value investor.
- Think of a concentrated portfolio as if you lived in a small town and had $1 million to invest. If you have carefully researched to find the best 5 companies, the risk is minimal (As Charlie Munger says, “The way to minimize risk is to think.”)
- Special situations are just value investing with a catalyst.
- International investing may offer the best opportunity, at least in terms of cheapness.
- Finding complicated situations that no one else wants to do the work to figure out is a way to gain an advantage. (You have discussed and given examples of many such situations in your book, You Can Be a Stock Market Genius.)
- Looking at the numbers best way to learn about management. What have they done with the cash? What are the incentives? Is the salary too high? Is there heavy insider selling? What is their track record?
- Focus on understanding and buying good businesses on sale, and don’t worry about the macro economy. Everything is cyclical, so value can always be found somewhere.
- Focus on situations that are not of interest to big players (usually small- and mid-cap, although currently large caps are cheap; spin-offs may be such opportunities, but the key is to figure out the interests of insiders; bankruptcies, restructurings, and recapitalizations may also be such opportunities).
- Trust no one over 30, and no one under 30; must do your own work, rather than simply ride coat-tails.
- Risk is permanent loss of invested capital, and not any measurement of volatility developed by statisticians or academicians.
- All investing is value investing and to make a distinction between value and growth is meaningless.
Risk: All investment evaluations should begin by measuring risk, especially reputational
- Incorporate an appropriate margin of safety
- Avoid dealing with people of questionable character
- Insist upon proper compensation for risk assumed
- Always beware of inflation and interest rate exposures
- Avoid big mistakes; shun permanent capital loss
Independence: “Only in fairytales are emperors told they are naked”
- Objectivity and rationality require independence of thought
- Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment
- Mimicking the herd invites regression to the mean (merely average performance)
Preparation: “The only way to win is to work, work, work, work, and hope to have a few insights”
- Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day
- More important than the will to win is the will to prepare
- Develop fluency in mental models from the major academic disciplines
- If you want to get smart, the question you have to keep asking is “why, why, why?”
Intellectual humility: Acknowledging what you don’t know is the dawning of wisdom
- Stay within a well-defined circle of competence
- Identify and reconcile disconfirming evidence
- Resist the craving for false precision, false certainties, etc.
- Above all, never fool yourself, and remember that you are the easiest person to fool
Analytic rigor: Use of the scientific method and effective checklists minimizes errors and omissions
- Determine value apart from price; progress apart from activity; wealth apart from size
- It is better to remember the obvious than to grasp the esoteric
- Be a business analyst, not a market, macroeconomic, or security analyst
- Consider totality of risk and effect; look always at potential second order and higher level impacts
- Think forwards and backwards – Invert, always invert
Allocation: Proper allocation of capital is an investor’s number one job
- Remember that highest and best use is always measured by the next best use (opportunity cost)
- Good ideas are rare – when the odds are greatly in your favor, bet (allocate) heavily
- Don’t “fall in love” with an investment – be situation-dependent and opportunity-driven
Patience: Resist the natural human bias to act
- “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily
- Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake
- Be alert for the arrival of luck
- Enjoy the process along with the proceeds, because the process is where you live
Decisiveness: When proper circumstances present themselves, act with decisiveness and conviction
- Be fearful when others are greedy, and greedy when others are fearful
- Opportunity doesn’t come often, so seize it when it comes
- Opportunity meeting the prepared mind; that’s the game
Change: Live with change and accept unremovable complexity
- Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you
- Continually challenge and willingly amend your “best-loved ideas”
- Recognize reality even when you don’t like it – especially when you don’t like it
Focus: Keep things simple and remember what you set out to do
- Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat
- Guard against the effects of hubris (arrogance) and boredom
- Don’t overlook the obvious by drowning in minutiae (the small details)
- Be careful to exclude unneeded information or slop: “A small leak can sink a great ship”
- Face your big troubles; don’t sweep them under the rug
- Foremost principle of operation is to always maintain a high degree of risk aversion
- Limit bets to only those situations which have a probability of winning that is well above 50% and in which the downside is limited.
- Cash is the ultimate risk aversion
- Using beta and volatility to measure risk is nonsense
- Average down – as a stock falls, the risk is lower
- Targeting investment returns shifts the focus from downside risk to potential upside.
- Gross Margin: Simply put, gross margin is the part of sales revenue a company retains after incurring direct costs associated with producing the goods and services it sells. It tells us whether the core of a business is profitable, and also indicates the company’s ability to weather shocks. The key is to look for trends – stable gross margins are always better!
- Operating Margin: Essentially it tells us how much profit a company makes on a rupee of sales, after paying variable costs of production (such as wages) but before paying interest or tax. It tells us how well the firm is able to manage costs and gives us an indication of the profitability of the firm.
- Return on Capital Employed: It connects the Profit and Loss statement with the balance sheet by comparing profitability to the level of assets. The idea remains the same, look for consistent trends. In an Indian context, Saurabh Mukherjee, CIO at Marcellus Investment Management and author of ‘Coffee Can Investing’ recommends investing in companies which have consistently shown 15% ROCE for each of the past 10 years.
- Cash Generation and Conversion: Terry also likes to monitor the relationship between operating cash flow and operating profit. Operating cash flow indicates if a business can generate sufficient positive cash flow to maintain and grow its operations, otherwise it may require external financing.
- Debt-to-Equity: Too much debt (relative to equity) can signal trouble for the company. The debt-to-equity ratio is a measure of financial risk. Too much debt may also lead to inflexibility in raising funds when required.
- Interest Coverage Ratio: This ratio determines how comfortably a company can pay interest on its outstanding debt. The interest coverage ratio can be calculated by dividing a company’s earnings before interest and taxes (EBIT) during a given period by the company’s interest payments due within the same period.
- Cyclical and/or overly dependent on one product (e.g., anything housing related in 2000s. – Ed.)
- Cycles sometimes become secular (steel, autos)
- Fad does not equal sustainable value (Coleco, Salton, renewable energy)
- Illegal does not equal value (online poker)
- Hindsight as the driver of expectations
- Technological obsolescence (minicomputers, Eastman Kodak, video rentals)
- Rapid prior growth – “Law of Large Numbers” (telecom build-out)
- Marquis management and/or famous investor(s)
- New CEO as savior – ignoring Buffett’s maxim (Conseco)
- The “Smart Guy Syndrome” (Take your pick!) (Lampert/ESL/SHLD? – Ed.)
- Appears cheap using management’s metric
- EBITDA (cable TV, Blockbuster) (EBITDA[anything else] too. – Ed.)
- Ignore restructuring charges at your own peril (Eastman Kodak)
- “Free” cash flow…? (Tyco)
- Anything non-GAAP, industry specific, and/or new deserves special cynicism. – Ed.
- Accounting issues
- Confusing disclosure (Bally Total Fitness)
- Nonsensical GAAP (subprime lenders)
- Growth by acquisition (Tyco, roll-ups)
- Fair Value (Level 3 assets)
A lot of our best shorts have looked short all the way down. Just because something is cheap doesn’t make it a good value. A lot of times the company can get into distress due to a declining business. That defines a value trap.
- The sector is in long-term secular decline
- There is a high risk of technical obsolescence
- The business model is fundamentally flawed
- The balance sheet is highly leveraged
- The accounting is aggressive
- Estimates are frequently revised
- Competition is fierce and growing
- The business is susceptible to consumer fads
- Weak corporate governance
- Growth by acquisition
- Always start with source documents
- Don’t short on valuation alone. Focus on businesses where something is going wrong.
- “We look more at the business to see if there is something structurally wrong or about to go wrong, and enter the valuation last.”
- Better yet, we look for companies that are trying – often legally but aggressively – to hide the fact that things are going wrong through their accounting, acquisition policy, or other means.
- Financial services, consumer products, natural resources are all good hunting grounds
- Always read all of the documents.
- The best short ideas often looking cheap all the way down and often ensnare a lot of value investors
- No derivatives or leverage
- Avoid open-ended growth stories, which often have a life of their own (think AOL in 1996-1999)
- Not about knowing better knowledge of a product or market cycle
- Track the cash flows
- Focus on return on capital
- Is this company able to stand alone without aid from the capital markets? Or is it in a cash flow spiral and cannot exist apart from capital raising or loans?
- Companies who cannot earn their cost of capital will eventually have an existential crisis
- Bet against companies whose finances are dependent on manias and fads