What to buy: Quality of Management

In order for a stock to be a huge winner in the long term, one of the most important aspects is the quality of the management. They should have unquestionable integrity and competitive management ability.

Without breaking any laws, there are infinite ways in which those in control can benefit themselves at the expense of shareholders. For example, in the presence of stock options as a compensation package, they can retain a big portion of earnings for unattractive projects and investments for the purpose of boosting up stock price. In this case, shareholders would be better off getting a dividend. Another is to adjust estimates and assumptions on the financial statement to meet the expectation of Wall Street and get rewarded for their “performance”. With complex accounting rules and operations, some of the misconducts are literally impossible for investors to detect. Therefore, if management has any history of misconducts and crimes, the investors had better stay away from the stock regardless of other matters.

In terms of the management ability, there are three main areas that should be focused on. First, you need to know how well the management runs their day-to-day operations, compared to their competitors. A good manager doesn’t get up one day and say, “I will improve the condition of my firm”. Truly outstanding managers are the ones who do it on a daily basis without even realizing that they are doing it.  They should be able to break down its overall costs into small pieces (e.g. costs of different products and divisions) so as to know where they need to pay attention the most.  The worst case is that management may not be aware that some of their supposed-to-be-profitable operations are run at a loss, which results in decrearsing rather than increasing the overall profits.

Second, management should be long-term oriented. As mentioned above, many managers are compensated for their short-term performance, which makes them short-term oriented. Outstanding firms are the ones that deliberately hold back maximum immediate profits if it has greater overall profits over a period of years. If you are a long-term investor who seeks for more than 1000% long-term profits at the expense of 20% short-term increase, the management should also do the same thing.

Third, management must be equipped with excellent capital allocation skills. In many cases, outstanding managers climb up the hierarchy with little knowledge about investing. Over many years of experience under their belts, they are the experts of running the firm, but not managing money. Thus, they leave what they earn from the operation to institutional investors, hire a CFO, etc. If those in charge of the capital allocation decisions are incapable, it is the same as pouring water into a basket that has a hole at the bottom. One day, you might scratch your head and wonder why it takes so long for the basket (i.e. stock price) to be full (i.e. rise).


Equity Analysis: Earning Curve

One of the key drivers of stock movement is earnings of the business. More importantly, what determines your investment success is future earning curve rather than that of the past.

Then, what can you do to predict the future earning curve? Many investment professionals have put increasing importance on the trend of earnings where future earnings are estimated by projecting the past trend into the future. It may seem like a sound analysis, but it may not. While the past trend is a fact, the future trend is only an assumption. Therefore, too much emphasis on the trend is prone to creating errors in overvaluation or undervaluation since how far ahead the trend should be projected varies depending on analysts. From my point of view, it is always good for an analyst to fully understand the earning structure of the firm and to be as conservative as possible to mitigate the errors of possible overvaluation.

Another thing that an analyst should watch out is the fact that accounting rules give firms wide discretion in calculating their earnings. More often than not, managements get rewarded primarily based on short-term measures such as annual earnings and return on invested capital. Within the legal boundary, the management has the incentive and capability to “make” the number by exploiting the accounting rules. For investors, it is always safe to avoid companies that use a lot of estimates and assumptions, and for analysts, it is their responsibilities to read and understand the footnotes of annual reports in addition to the financial statement.

Equity Analysis: P/E Ratio

The P/E ratio is used probably as the most common ratio to value a business because it is easy and quick. Roughly speaking, buying the P/E of 10 means that it takes 10 years for the company to pay back your investment, provided that its annual earning remains the same during that period. Many professional investment analysts like to compare it for one firm with that of others in the same industry.

As far as I am concerned, however, it can be only used as a crude yard stick that may give you a hint that the company is selling relatively cheap or expensive. Without further research, such figures can be misleading.

One reason is that quality of earning is not the same from company to company. For some, much of what they earn must be reinvested back to the business to sustain their competitive position in the industry. For others, only a little amount is needed. The main culprit is capital expenditure. Many capital-intense companies on average should spend a lot more as capital expenditure than what they depreciate on the book. This makes the quality of their earnings go down by the difference. If you buy, say, an oil drilling company just because its P/E ratio is low, it may be a mistake.

In addition, the earning should be durable and should come from its main business operation. If the earning comes from one-time profit or accounting gimmicks (for example by adjusting inventory, predicting bad debts, forecasting unusual gains or losses improperly, etc), it is not the true earning. Thus, it should not be used as a measure of valuation.

Lastly, you should also keep in mind the future growth of the earning. If there is enough room for the earning to grow in the near future, a high P/E ratio may be justified. However, you should watch out for a high P/E company only with rosy prospects and without fundamentals.

With the frequent and easy use of database, it has become increasingly hard to find undervalued companies just by plugging in such ratios as P/E and B/M in a computer. Based on my experience, many great buys appeared where P/E ratio looked very expensive. For example, a company with excellent underlying economy may experience a temporary difficulty in generating the earning, which results in the very high P/E temporarily.

What to buy: Quality of Product

In this day and age, it is almost impossible to escape your eyes from seeing stock ticker symbols and quotes since they are everywhere on the Internet, TV, blackberry, etc. As far as I am concerned, however, it is not the price to which you should pay attention first when it comes to looking for what to buy. It is what they sell. The stock price is important at the end of your valuation to be compared with the intrinsic value that you estimate, not the beginning of your valuation, unless it is a clear arbitrage opportunity.

Many people often forget that a piece of stock represents a piece of ownership to the company. In the short term, the arbitrage opportunities can be profitable if implemented with caution, although it is just a one-time profit. In order to make a successful investment decision in the long term that will give you repetitive compounding profits, it is crucial for you to look at and understand what they sell first.

There are countless companies selling various products and services, but there are relatively a few firms selling quality products.
What I mean by the quality products is as follows:

1. Maintainable Monopoly Power
Monopoly is bad for the society, but excellent for the company. A firm to be a long term winner should have some sort of monopoly that is maintainable against competitors and that doesn’t violate the law. It may come from geography, brand name, know-how, technology, low-cost operation, etc.

2. Repeat Customers
A product needed only once in a lifetime is excellent for customers, but bad for the company. The product should have the intrinsic quality that makes the customers buy over and over in the future.

3. Benefits customers, suppliers, and employees
To sum up, everyone should be happy. If customers are not happy, but the firm is profitable because of the monopoly power, the firm becomes soon susceptible to political pressure and regulations. People know that the consequences of frequent and prolonged strikes are obviously detrimental to the firm.
What people may not recognize is that the firm’s degree of profitability that resulted from happy customers and good personnel relations is far greater than the direct cost of regulations and strikes. Although it is hard to quantify the firm’s success in this area, you can ask your friends and families (i.e. customers), and you can also get a feel by visiting stores. In terms of the quality of labor policies, you can look at labor turnover in one company as against another in the same industry, and the size of the waiting list of job applicants.


Value vs. Growth

The financial community has a tendency to put stocks into specific categories for reasons of comparisons, although it may not be appropriate. One of such common divisions is value vs. growth. What they generally call “value” stocks is what I call “cheap” stocks, and what they generally call “growth” stocks is what I call “expensive” stocks. One of the frequently used measures to separate the value stocks from the growth stocks are low P/E ratio, high B/M ratio, and low dividend yield. Stocks with opposite characteristics are called growth stocks.

Just because such ratios make it easy for researchers to collect data from their database doesn’t mean that it can be used to make a conclusion, “Value stocks have performed better than growth stocks in the past”. Rather, it should say, “Cheap stocks have performed better than expensive stocks in the past”, which sounds obvious since stock price tends to converge to its intrinsic value in the long term. In the long term, the price of the cheap stocks goes up and vice versa for the expensive stocks. Then there’s no need for you to scratch your head and figure out why the “value” stocks have performed better than the “growth” stocks, and you can save much of your brain power and time.

From my point of view, first, the growth stocks should be defined as stocks that will grow in the future, not the ones that have grown in the past. For example, if a company XYZ has grown rapidly in the past and there is only small room for it to grow down the road, then it should not be called “growth” stock just because it has grown fast in the past, or just because the financial community assigned it high P/E ratio, low B/M ratio, etc. In addition, the value stocks should be defined in that its intrinsic value (i.e. the present value of all the future cash flows) is well below the market price, not the ones with low P/E, high B/M, etc. What determines the stock price in the future is its future performance, even though it is hard to quantify.

Second, the growth stocks are in the subcategory of the value stocks, not the two independent things. In other words, the growth is just one of many elements that can be used to derive the value of a company. Therefore, in many cases, great growth stocks are the great value stocks.


Is Diversification Necessary? If so, how much?

It is generally, and overwhelmingly, accepted that the diversification is essential for an investor to reduce risk. I, more or less, agree.

Simply put, if I understand the businesses well, I only need a small amount of diversification. If I don’t understand the businesses and am uncertain, I need an intensive amount of diversification.

One thing to note is, however, that investment failures are costly, but inevitable parts of investing even for a few highly intelligent investors just as in the case where an even excellent corporation can’t avoid a number of costly failures in their R&D to come up with a super hit product. Therefore, a modest amount of diversification is necessary for unexpected surprises in your investment. Then how much diversification is needed? In investment class, students learn that a portfolio has undiversifiable systematic risk and diversifiable unsystematic risk, and investors should only bear systematic risk which can’t be diversified away. I disagree. From my perspective, historical price performance tells you a little to none about future price performance. Therefore, a portfolio that bears only systematic risk, calculated from its historical price, will inevitably have unsystematic risk in the future.

Then what is the appropriate way to diversify your portfolio?  I would say it is different from people to people.  If you were CEO of a company and understand the company well, it would be unreasonable to buy many other companies that you don't understand just for the sake of diversification.  Since you know the intrinsic value, you can buy and sell if it deviates a lot from its intrinsic value.
In addition, the diversification should be different depending on which stock you buy.  If you buy a stock, say, Procter & Gamble or Berkshire Hathaway, then you have already done a fair amount of internal diversification since both of them own a number of companies from a number of different industries internally.  On the other hand, if you purchase a bunch of stocks in the same industry, it would not be enough diversification regardless of how many stocks you buy and what your portfolio beta is.

Is the Market Efficient?

Efficient market hypothesis claims that there is no way for an investor to make profits consistently in the future by making use of information available, and it is pure luck to beat the market in a row just as flipping a coin and getting heads in a row. If it were true, there would be no need for investment professionals to exist since people will be better off just investing in the market (i.e. index fund).

Thankfully, I disagree. Otherwise, I wouldn’t study finance at UIUC. First, when evaluating a business, the most common way, and I think the most appropriate way, is using Discounted Cash Flow (DCF) analysis. Simply speaking, the intrinsic value of a business is calculated by adding all the future cash flows during the lifetime of the firm and discounting them back to the present. If the market is efficient, then the prices of the firms in the market should already incorporate the future cash flows. I want to point out, however, that nobody actually knows about the future for certain. Since nobody knows, it is not proper to say the price in the market is efficient. The efficient market hypothesis, of course, says that it incorporates all the available information today, not the future cash flows but what makes the price of a stock go up (i.e. your investment performance) is not the today's earnings and news. It is the future earnings and news.

Second, if the market is efficient, we can’t have someone like Warren Buffett, Peter Lynch, George Soro, etc who have consistently beaten the market. You might argue that it is pure coincidence as in the coin-flipping game where about 10 people out of 10 millions will end up getting heads 20 times in a row by pure luck. As Warren Buffett once mentioned, however, if a group of the consistent market beaters come from the same place, you would be curious as to what is special about them. Most students taught by Ben Graham along with Warren Buffett have overall records to outperform the market over the past decades.

Is “risk-free” investment really risk-free?

The U.S. government bonds are usually thought of as risk-free investment. However, it might be a risky investment in the long term. Let’s say you have money that you don’t need for the next 20 years, and the annual inflation rate is 3% ~ 5% during the period. Historically, the returns on the Treasury Bills were a bit more than those of the inflation rate, and in many occasions, it failed to exceed the inflation rate. However, the returns on stocks have always been superior than the inflation rate in the long term.

The idea is simple. If your return is below the inflation rate, your purchasing power declines. You can’t buy the same amount of goods as before. Since the “risk free” investment (i.e. Treasury Bills) are more prone to the danger of giving returns under the inflation rate than “risky” stocks, I would call “risk free” as risky in the long term.