SUMMARY OF ‘THE FIVE RULES FOR SUCCESSFUL STOCK INVESTING’ BY PAT DORSEY – Fintelligence

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Reading Time: 10 minutes


This book offers its readers much more than just stock investing rules. It discusses basic investment principles, what to do as an investor, what not to do and finally makes us understand the entire research process right from filtering companies for further analysis to finally valuing the stock.

Basic Principles of Investing

  1. It’s the business that matters  The company’s fundamentals have a direct effect on its stock price. Over the long run, as the business grows, so do the stock prices.
  2. Long-term approach. But why?
    • Stock prices in the short term can move around due to reasons which are almost impossible to predict.
    • Trading involves a lot of transactions which drives up the transaction costs and taxes.
    • And most importantly, investing for the long term gives us the benefit of compounding.
  3. Independent thinking  As an investor you have to be able to think independently without getting swayed by the experts. You have to develop your own opinion about the value of a stock and change your opinion only if the facts warrant in doing so. Investment success depends on personal discipline whether or not the crowd agrees with you.

Your goal as an investor should be, to find wonderful businesses at reasonable prices. You don’t need expensive software to be successful in the stock market. All you need is patience, an understanding of accounting and skepticism.

Five Rules of Successful Stock Investing

  1. Do Your Homework – Investors commonly make the mistake of not studying the company thoroughly before investing. You have to develop the understanding of accounting to know what condition the company is in. Spending time to research about the company by reading its annual report, understanding the competitive environment and going through past financial statements is extremely important as it can uncover a lot of facts which ultimately prove the investment to be poor. Unless you know the business inside out, you shouldn’t buy the stock.
  2. Finding Economic Moats – In any industry, the highly profitable companies tend to become less profitable over time, as other firms enter the market. In this scenario, an economic moat is what helps the company to sustain above average profits over a long period of time. These long periods of excess profitability, on average, lead to better long-term stock performance. Identifying these economic moats is thus a critical part of the investment process. Economic moats can be identified by answering a simple question – How does a company manage to keep its competitors at bay and consistently earn fat profits?
  3. Have a Margin of Safety – Margin of safety is when you buy a stock at less than its intrinsic value. Since future is very uncertain, you need an extra cushion in case things turn out worse than expected. Sticking to valuation discipline is extremely important since losing money is far more painful than not making money.
  4. Long term holding – Frequent trading leads to paying higher transaction costs and taxes. Whatever money you pay in these costs cannot be compounded the next year. For instance, every Re. 1 if saved on these costs can turn into Rs. 11.5 in 20 years (assuming 13% CAGR).
  5. Knowing when to sell –
    • You shouldn’t sell just because stock has dropped/skyrocketed. Share price movements covey no useful information because they can move in all directions unreasonably in the short term.
    • When you should sell:
      • If your initial analysis was wrong or you missed something.
      • The fundamentals have deteriorated
      • Stock price has risen too far above its Intrinsic Value.
      • There is something better you can do with the money.
      • If the stock carries too much weight in your portfolio.

Seven Mistake to Avoid

  1. Loading your portfolio with all-or-nothing stocks E.g. Small growth stocks in many cases.
  2. Believing that its different this time.
  3. Falling in love with products – Great products do not necessarily translate into great profits. When you look at the stock, ask yourself, “Is this an attractive business?” “Would I buy the whole company if I could”. If the answer is NO, give the stock a pass, no matter how much you like its products.
  4. Panicking when markets are down.
  5. Trying to time the market – It is one of the greatest myths of investing.
  6. Ignoring Valuation – The only reason you should ever buy a stock is that you think the business is worth more than its selling for, not because you think a greater fool will pay more for the shares a few months down the road.
  7. Relying on earnings for the whole story – In the end, cash flow is what matters, not earnings. Because earnings can be easily manipulated as compared to cash flows. You can spot a lot of blowups well in advance, if you pay attention to operating cash flows relative to earnings.
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If you avoid these seven mistakes, you will be well above an average investor.

Economic Moats

  1. Analyzing a company’s economic moat
    • Analyze the competitive structure of the industry. How do firms in the industry compete with each other?
    • Has the firm been able to generate superior ROAs and ROEs historically?
    • If yes, what is the source of its profits? Why is the company able to keep competitors from stealing its profits?
    • Estimate how long the firm will be able to hold off competitors.
  2. Evaluating profitability
    • Calculate ROE and ROE
    • How much free cash flow does the firm generate?
    • Calculate the firm’s free cash flow as a percentage of its sales
    • Calculate its Net Income as a percentage of its sales.

Firms which consistently produce solid ROEs, Free cash flow and decent margins are much more likely to truly have economic moats. However, a much more sophisticated way of measuring an economic moat is to calculate how much Return on Capital Employed (ROIC) the firm is generating over and above its Weighted Average Cost of Capital (WACC)

  • Building sustainable competitive advantage
  1. Real product differentiation through superior technology or features
  2. Perceived product differentiation through branding and reputation
  3. Driving costs down and offering the product at lower price
  4. Locking in customers by creating high switching costs
  5. Locking out competitors by creating entry barriers and success barriers

Analysing a Company’s Financial Statement  

  1. Growth – It can be organic (Selling more goods, raising the prices, selling new goods) or inorganic (buying another company). Here we need to look at four things –
    • Historical growth
    • Sources of growth
    • Quality of growth – If earnings growth outpaces its sales growth over a long period of time, you need to dig in the numbers to see how company keeps squeezing out more profits from stagnant sales.
    • Sustainability of growth in the future
  2. Profitability
    • ROA – It shows much return the business is making on its assets. It has two components – Net margin and Asset turnover. There are businesses like grocery stores which have low margins but then they try to turn over their assets quickly which can help them to have superior ROAs. On the other hands, businesses like luxury retailers, have low asset turnover but high margins.
    • ROE – It measures the efficiency with which the company uses shareholders equity. It has three components – Net margin, Asset turnover and Financial leverage. Here we need to look out for the third components i.e. financial leverage. Companies can boost their ROEs simply by taking on more debt (financial leverage).
    • Free Cash Flow (FCF) – It is arrived at by deducting Capital expenditure from ‘Cash flow from Operations’. It is the excess cash that really belongs to the shareholders. To analyze it, we can divide FCF by Sales to see how much free cash flow the company is generating from every Re.1 of sales.
    • Return on Invested Capital (ROIC) – ROIC improves on ROA and ROE because it puts debt and equity on equal footing by removing the debt related distortion that can make levered companies look very profitable when using ROE. It is calculated as – “Net operating profit after taxes (NOPAT) divided by Invested Capital”, where NOPAT is Net income after taxes but before interest. Invested Capital is “Total Assets + Non-interest-bearing Current Liabilities – Excess cash”
  3. Bear Case
    • List all the possible negatives of the company/business
    • What could go wrong with your investment thesis?
    • Why might someone prefer to be a seller than a buyer?

By doing this you will have the confidence to hang on to the stock during a temporary rough patch

This is a very unconventional but important exercise to do which only a handful of investors really practice.

Analysing a Company’s Management

  1. Compensation
    • Bonuses should be preferred over big base salaries because bonuses are dependent on certain performance targets being achieved.
    • These performance targets should be clearly disclosed. They should make the company better not bigger.
    • Compare the company’s management compensation with its peers after due regard to the size of the firm and its financial performance
    • Is the company loaning the money to its managers? If yes, at what interest rate? And is the loan finally repaid?
    • Does the management excessively use the stock options and dilute the equity of the company?
    • Does the management immediately sell the shares of the company after they have been granted options?
  2. Character
    • Study related party transactions in detail
    • Is the board stacked with managements family/friends?
    • Does the management honestly discuss its poor decisions and performance?
    • What is the employee turnover in the company?
    • Does the management provide enough information to properly analyze the business?
  3. Operations
    • Look for high and increasing ROAs and ROEs. Are ROEs increasing due to excessive leverage?
    • Does the management allocate its capital efficiently?
    • Is the management diluting too much equity?
    • Do the actions of the management match with what they claim to do?
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Identifying Red Flags

Six major red flags to thoroughly investigate (though some of them can be innocent):

  1. Cash flow from operations growing slowly as compared to sales
  2. Frequent one-time charges and write-downs.
  3. Frequent acquisitions
  4. CFO or Auditor leaving the company
  5. Accounts receivables growing faster than sales.
  6. Changes in Credit terms

Other pitfalls to watch out for:

  1. Treating ‘Gains from investment’ as operating income or deducting it from other expenses.
  2. Seeing whether the company has ‘Under-funded or Over-funded’ pension plan. If it is under-funded, the company will have to chip in the shortfall which will go to the retired employees instead of shareholders. You can compare ‘Defined benefit obligation’ with ‘Fair Value of plan assets’ to see if it is over or under funded plan.
  3. Some times the companies flow the gains from over-funded pension plans from the income statement. Over-funded plan only means that the shareholders will have to contribute less to the pension assets in the future. However, this over-funded plan’s gains don’t belong to the shareholders and hence should not be included while calculating net income.
  4. Inventory built up
  5. Changing accounting policies or assumptions.
  6. Capitalizing the costs which ought to be expensed out.

Valuation

Even the most wonderful business is a poor investment if purchased for too high a price. To invest successfully, you need to buy great companies at attractive prices. Here are some methods of valuation:

  1. Price Multiples
    • Price to Sales – It is useful for valuing companies with highly variable earnings. However, it is not very reliable since it doesn’t consider future profit generating capabilities of a company and also it cannot be used to compare different industries with varied profit margins.
    • Price to Book – It is based on the idea that future earnings are short-lived and all we can really count on is the firm’s tangible assets. Ben Graham was a huge advocate of book value. However, the world has changed since then. In the past, the market was dominated by capital intensive businesses that owned land, factories, etc. on which earnings were dependent. Today the firms are creating wealth through intangibles like processes, brand name, etc. most of which are not directly included in the book value. Although P/B isn’t much useful for service firms, it’s a good method of valuing financial firms since they have considerable liquid assets on their balance sheet and many of those assets are marked to market which makes the book value more reliable.
    • Price to Earnings – Earnings are a better proxy for cash flows than sales and more up-to-date than book value. Price to Earnings can be compared to another company in the same industry, the entire market or the same company at different time.
    • Price to Earnings Growth (PEG) – An additional element in this is – Growth. And with growth comes risk. When we compare two firms on the basis of PEG, we assume that both of their growths are equally risky. Instead, growth with less capital should be more valuable as they are less risky. If you see two firms with same growth but different P/E, don’t put your money on the one with lower P/E, instead, see which of the firms require less capital for the same amount of growth.
  2. Yields – Yield is an exact invert of P/E. Here we divide Earnings by Current market price. The nice thing about yields is that we can compare it with alternative investments as well, like bonds. One of the yield-based valuation methods is – Cash Yield, which is calculated as – Free Cash Flow divided by Enterprise Value. Here Enterprise value = Market capitalization of the stock + Long term debt – Cash. Enterprise value is the price that any investor will have to pay to buy the entire firm since he will not only buy the shares of the company but also its debt burden (net of cash). However, this measure cannot be used for banks and other firms that earn money via their balance sheets.
  3. Discounted Cash Flow (DCF) – The biggest drawback about the above ratios is that they all are based on price. They do not tell you anything about the value. Without knowing what a stock is worth you won’t know how much to pay for it Stock should be purchased at some discount to their intrinsic value. Without looking at the determinants of value, such as cash flow and return on capital we have no way of assessing of whether a P/E is too low or high. Hence, we need to estimate the intrinsic value of a stock which is basically the present value of its future cash flows. In order to do that we need to understand:
    • Cash Flows – Here we are talking about free cash flows because that is what can be taken out each year without harming the business
    • Discount rates – It can be calculated as Risk free rates (Interest on government bonds) + Risk premium. The key is to pick up a discount rate you are comfortable with. It isn’t an exact science.
    • Perpetuity values – We have cash flow estimates and we have the discount rate.Now, we only need a perpetuity valueto put the whole thing together. The common way to calculate perpetuity value is to take the last cash flow you estimated, increase it by a growth rate you expect cash flows to grow over a very long term and divide the result by discount rate minus the long-term growth rate.
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How to estimate the value of a stock using a 10-Year DCF Valuation Model:

The 10-Minute Test to filter stocks for research

With literally thousands of companies listed on the stock exchanges, the toughest challenge for any investor is to select the companies worth analysing. Here are some basic filters which, if applied, can eliminate a lot of poor stocks:

  1. Minimum market capitalization
  2. Exclude companies that have recently filed IPOs because they are rarely bargains. Companies sell their shares to the public only when they think they are getting a high price.
  3. Exclude companies that are still in the money-losing phase
  4. Exclude companies with consistently negative cash flow from operations because they will have to eventually raise debt (increase the risk) or issue equity (dilute the existing equity)
  5. ROE of at least 10% for non financial firms and 15% for financial firms.
  6. Company should have consistent growth.
  7. Exclude companies with Debt to Equity of more than 1, unless the business is stable or the debt as a percentage of assets has been declining over the years.
  8. Exclude companies that don’t generate free cash flows. However, the exception is when they are investing that cash wisely in projects that are likely to pay off well in the future.
  9. Exclude companies with frequent one-time charges. It may hint that the management is trying to burnish poor results.
  10. Exclude firms that dilute too much equity

If the company does pass this test, its worth a detailed examination as follows:

  1. Go through the financial statements of the company for the past 10 years and look for trends. Look for outliers or anything that’s unusual. This process should give you an initial map for further investigation.
  2. Read the entire Annual report. Pay special attention to – Company and Industry description, Risks and Competition, Legal issues and Management Discussion and Analysis.
  3. Compare the company’s management compensation with its peers.
  4. Go through the last two quarterly results and conference calls to understand if there are any changes happening in the company.
  5. Start valuing the stock.

Finally, the author dives deep into industries like Healthcare, Banking, Software, Telecom, Energy, etc. to discuss their nitty gritties and key metrics from an investment perspective. This part is not covered here as this article was intended to give you, the readers, an understanding of investing principles and the research process only.

About the author – Pat Dorsey is the founder of Dorsey Asset Management. Prior to starting Dorsey Asset, Pat was Director of Research for Sanibel Captiva Trust, an independent trust company serving high net worth clients. From 2000 to 2011, Pat was Director of Equity Research for Morningstar, where he led the growth of Morningstar’s equity research group from 20 to 90 analysts. Pat was instrumental in the development of Morningstar’s economic moat ratings, as well as the methodology behind Morningstar’s framework for analysing competitive advantage.   He has also authored – The Little Book that Builds Wealth.   Pat holds a Master’s degree in Political Science from Northwestern University and a bachelor’s degree in government from Wesleyan University. He is a CFA charterholder.  
Source: https://dorseyasset.com/who-we-are
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Amey Chheda
Amey is a Chartered Accountant, an Equity Investor, and a Blogger.
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