The friend and enemy: Time

Time is the enemy of the poor business and the friend of the great business. If you have a business that's earning 20%-25% on equity, time is your friend. But time is your enemy if your money is in a low return business.

- Warren Buffett

Tribute to Bernake

Dashing in the air,
In a dollar-stocked plane
O'er the Wall St. he went
Laughing but in vain

Dollars on his wings
Making bankers’ spirits bright
What fun it was to throw
A doomed dollar that night

Oh, jingle bells, jingle bells
Jingle all the way
Santa ‘Ben’ is coming to town,
Riding on his plane

A month or two ago
We thought we'd take the ride
And soon recession came
No place was left to hide

The cost is 'zero' now
So borrow as much as you can
And if you can’t repay
Think of ‘Ben’ again

Oh, jingle bells, jingle bells
Jingle all the way
Santa ‘Ben’ is coming to town,
Riding on his plane.

equitymaster

Reputation

It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently.

- Warren Buffett

Deterioration in companies

When companies deteriorate, they usually do so for one of two reasons: Either there has been a deterioration of management, or the company no longer has the prospect of increasing the markets for its product in the way it formerly did.

- Philip Fisher

When to buy and when to sell

When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it's likely that the market is about to turn up. When the neighbours tell me what to buy and then I wish I had taken their advice, it's a sure sign that the market has reached a top and is due for a tumble.

- Peter Lynch

Stock forecasters

We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.

- Warren Buffett

Value stocks and grass

Value stocks are about as exciting as watching grass grow. But have you ever noticed just how much your grass grows in a week?

- Christopher Browne

Oppurtunity to learn some very old lessons

A pin lies in wait for every bubble and when the two eventually meet, a new wave of investors learns some very old lessons.

- Warren Buffett

Stock prices

Just because the price goes up doesn't mean you're right. Just because it goes down doesn't mean you're wrong. Stock prices often move in opposite directions from the fundamentals but long term the direction and sustainability of profits will prevail.

- Peter Lynch

Mattress in use: In USA

Most investors know Warren Buffett for his investing acumen. But few know that his sense of humor is equally legendary. The directors of his company, Berkshire Hathaway got a taste of the same when they received an email from the Oracle of Omaha. On learning that the US Treasury sold US$ 32 bn by way of 4-week bills at a yield of 0% - yes, you’ve read it right – he is believed to have said, "This should be bullish for Berkshire. With great foresight, I long ago entered the mattress business in a big way through our furniture operation. Now mattresses have become fully competitive as a place to put your money, and sales will soon take off." Indeed, with investors getting virtually nothing from their fixed return investments by way of interest rates, putting once hard earned money under a mattress seems a far better idea than depositing the same in banks.

Fourth law of motion

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increase.

- Warren Buffett

Help people

Help people. When people are desperately trying to sell, help them and buy. When people are enthusiastically trying to buy, help them and sell.

- Sir John Templeton

Market prices are frequently nonsensical

When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.

- Warren Buffett

The company to own

If you can find a company that can get away with raising prices year after year without losing customers (an addictive product such as cigarettes fills the bill), you've got a terrific investment.

- Peter Lynch

Anger

Anger tends to cloud judgement.

- Mahatma Gandhi

Eye for an eye

An eye for an eye, merely makes the whole world blind.

- Mahatma Gandhi

Forecasting

Accurately forecasting swings in investors’ emotions is not possible. But forecasting the long-term economics of investing carries remarkably huge odds of success.

- John Bogle

Buffett on terrorism

The probabilities are increasing, in an irregular and immeasurable manner, as knowledge and materials become available to those who wish us ill. Fear may recede with time, but the danger won't - the war against terrorism can never be won. The best the nation can achieve is a long succession of stalemates. There can be no checkmate against hydra-headed foes.

- Warren Buffett

Miseries of the man

Most of man’s miseries come from not being able to sit quietly in a room.

- Blaise Pascal

How many winners needed

It only takes a handful of big winners to make a lifetime of investing worthwhile.

- Peter Lynch

15 minutes a year for ....

I spend about 15 minutes a year on economic analysis. The way you lose money in the stock market is to start off with an economic picture. I also spend 15 minutes a year on where the stock market is going.

- Peter Lynch

Prejudices

With every new wave of optimism or pessimism, we are ready to abandon history and time-tested principles, but we cling tenaciously and unquestioningly to our prejudices.

- Benjamin Graham

Watch play field than scoreboard

It's true, of course, that, in the long run, the scoreboard for investment decisions is market price. But prices will be determined by future earnings. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard.

- Warren Buffett

Shares and book

Think about shares as you would a book: if you don’t understand it, put it down.

- Aberdeen Asset Management

What a fool or geinus can make

Any fool can make things bigger, more complex, and more violent. It takes a touch of genius - and a lot of courage - to move in the opposite direction.

- Albert Einstein

Grounds which don't shift forever...

Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.

- Warren Buffett

Trust your stocks as long as the fundamental story hasn't changed

When it comes to predicting the market, the important skill here is not listening, it’s snoring. The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.

- Peter Lynch

...the opposite occurs

It is the rare investor who doesn’t secretly harbour the conviction that he or she has a knack for divining stock prices or gold prices or interest rates. In spite of the fact that most of us have been proven wrong again and again, it’s uncanny how often people feel most strongly that stocks are going to go up or the economy is going to improve just when the opposite occurs.

- Peter Lynch

People do wrong things

We’re forcing people to do the wrong things. They look at what’s hot. They spend so much time trying to figure out if the market is going up. That’s so unimportant. It’s about earnings. They need to follow the earnings.

- Peter Lynch

Things are never clear on Wall Street

Things are never clear on Wall Street, or when they are, then it’s too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.

- Peter Lynch

Correction is not a disaster

Bargains are the holy grail of the true stock picker. The fact the 10 to 30 per cent of our net worth is lost in a market sell-off is of little consequence. We see the latest correction not as a disaster but as an opportunity to acquire more shares at low prices. This is how great fortunes are made over time.

- Peter Lynch

Business to choose

Go for a business that any idiot can run - because sooner or later, any idiot probably is going to run it.

- Peter Lynch

Who can follow the stock market

Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it.

- Peter Lynch

Wasting energy in forecasts

If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10 minutes.

- Peter Lynch

Stocks on shorter and longer term

Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide.

- Peter Lynch

Investing without research

Investing without research is like playing stud poker and never looking at the cards.

- Peter Lynch

How to pick a stock

If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them.

- Peter Lynch

Why the stock prices go up

I think you have to learn that there's a company behind every stock, and that there's only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to large companies.

- Peter Lynch

Stock market and wife

The correct attitude of the investor toward the stock market might well be that of a man toward his wife. He shouldn't pay too much attention to what the lady says, but he can't afford to ignore her entirely.

- Benjamin Graham

Insight into business

The great majority of operating businesses have a limited upside potential unless more capital is continuously invested in them. That is so because most businesses are unable to significantly improve their average returns on equity - even under inflationary conditions, though these were once thought to automatically raise returns.

- Warren Buffett

Enthusiasm in Wall Street

While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster.

- Benjamin Graham

Cost-cutting companies

Whenever I read about some company undertaking a cost-cutting program, I know it's not a company that really knows what costs are about. The really good manager does not wake up in the morning and say 'This is the day I'm going to cut costs,' any more than he wakes up and decides to practice breathing.

- Warren Buffett

Temperament to control

Success in investing doesn't correlate with I.Q. once you're above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

- Warren Buffett

How to time the buy

Stock market timing cannot be done, with general success, unless the time to buy is related to an attractive price level, as measured by analytical standards.

- Benjamin Graham

Right sector and right time

If you are in the right sector, at the right time, you can make a lot of money very fast.

- Peter Lynch

Cyclicals

Cyclicals are like blackjack: Stay in the game too long, and it's bound to take back all your profit.

- Peter Lynch

Power of compounding

Understanding both the power of compounding and the difficulty of getting it is the heart and soul of understanding a lot of things.

- Charles Munger

Quality of the business

When you mix raisins and turds, you still have turds.

- Charles Munger

Great business at a fair price

A great business at a fair price is superior to a fair business at a great price.

- Charles Munger

Change vessels instead of devoting energy on leaking boats

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, of course, in any business, good or bad). Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

- Warren Buffett

Secret of sound investment

Confronted with the challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety.

- Benjamin Graham

Inflation protection by tangible asssets - wrong

For years the traditional wisdom - long on tradition, short on wisdom - held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets. It doesn't work that way. Asset-heavy businesses generally earn low rates of return - rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

- Warren Buffett

What this implies is any asset heavy business (caution for the investors who follow the book value logic) carry higher risk to deliver returns to the shareholders than any business which is asset light but have intangible assets. An asset heavy business could be laden with assets like natural resources or plant & machinery or any other tangible assets. But over a longer period, the re-investment needs of these business would leave nothing for the shareholder and thus inflation adjusted returns from these business would not be worth to speak.

But business which own intangible assets of lasting value (e.g. Colgate brand has lasted more than century) coupled with minor tangible assets are hurt the least because of inflation. These business should have enduring franchisees which and the managements should have the focus to defend their moat and fortify it on a ongoing basis. Otherwise they would be a blip in the radar.

Don't buy what you don't understand

There are all kinds of businesses that Charlie (Munger) and I don't understand, but that doesn't cause us to stay up at night. It just means we go on to the next one, and that's what the individual investor should do.

- Warren Buffett

Reality

I think that one should recognize reality even when one doesn't like it - indeed, especially when one doesn't like it.

- Charles Munger

How to deal with Mr.Market

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic - he doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manicdepressive his behavior, the better for you. "But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice - Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game."

- Warren Buffett

Margin of Safety

We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

- Warren Buffett

What you know and what you don't know

Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons". At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes.

- Warren Buffett

Valuing a stock or a bond

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future ‘coupons’. Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity 'coupons'.

- Warren Buffett

October is a dangerous month

October is one of the particularly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February.

- Mark Twain

Qualities of Investor

The list of qualities (an investor ought to have) include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general panic.

- Peter Lynch

Wrong things

You only have to do a very few things right in your life so long as you don't do too many things wrong.

- Warren Buffett

Bear markets are not a calamity

For those properly prepared in advance, a bear market in stocks is not a calamity but an opportunity.

– Sir John Templeton

What is investing

Investing isn't just about probabilities. It's about consequences, and you've got to be prepared for them.

- John Bogle

The bottom is not known

When stocks are attractive, you buy them. Sure, they can go lower. I've bought stocks at $12 that went to $2, but then they later went to $30. You just don't know when you can find the bottom.

- Peter Lynch

Yesterday's growth

The investor of today does not profit from yesterday's growth.

- Warren Buffett

Not preditions, but correct false ones

My approach works not by making valid predictions but by allowing me to correct false ones.

- George Soros

Time to sell

If the job has been correctly done when a common stock is purchased, the time to sell it is - almost never.

- Philip Fisher

Intrinsic value

Even a very indefinite idea of the intrinsic value may still justify a conclusion if the current price falls far outside either the maximum or minimum appraisal.

- Benjamin Graham

Purchase when apprehensions are at peak

We have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

- Warren Buffett

Investment

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

- Benjamin Graham

You can't buy what is popular and do well

Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well.

- Warren Buffett

Critical investment factor

The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price.

- Warren Buffett

Diversification

To carry one's eggs in a great number of baskets without having the time or opportunity to discover how many have holes in the bottom is the surest way of increasing risk and loss.

- Warren Buffett

Emerging Industries

As investors our reaction to a fermenting industry is much like our attitude toward space exploration. We applaud the endeavor but prefer to skip the ride.

- Warren Buffett

Investement and adaptation

The underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate.

- Benjamin Graham

Insight into economy

In an economy, there were three entities that borrow - households, companies and financial intermediaries (banks and non banking finance companies). If one of the two entities was over-borrowed, the problem was manageable, but if two out of the three were over-borrowed “one has to be careful”.

- Dr Yaga Venugopal Reddy

Irrational market

Although markets do tend toward rational positions in the long run, the market can stay irrational longer than you can stay solvent.

- John Maynard Keynes

Shares are not lottery ticket

Although it's easy to forget sometimes, a share is not a lottery ticket...it's part-ownership of a business.

- Peter Lynch

Iron stomach

Someone has rightly said that in investing, one does not need great intelligence. An average intelligence supported by an iron stomach will do the trick.

- Anonymous

Cash?

You can't keep money around for ever. It's like saving sex for your old age

- Warren Buffett

Understand stock markets

You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets.

- Peter Lynch

Common stock values

In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.

- Benjamin Graham

Tech Companies

Technology companies should be valued at a discount to the shares of companies like Disney and Coca-Cola, which have long-term earnings.

- Warren Buffett

Diversification

Wide diversification is only required when investors do not understand what they are doing.

- Warren Buffett

What to look for in a business

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to 'be fruitful and multiply' is one we take seriously at Berkshire.)

There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.

Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.

To sum up, think of three types of "savings accounts". The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

- Warren Buffett on Berkshire Hathaway 2007 AR

Don't leverage

I do know that the economy, over a period of time, will do very well, and people who own a piece of it will do well. But they shouldn't own it on leverage.

- Warren Buffett

Winner

Here is an old but interesting story of two friends who went to a jungle. They saw a hungry lion there. As soon as they saw the beast, they understood that they are going to be history. One of those guys took a pair of brand new shoes and started wearing them. His friend was surprised at his action and asked him, "Do you think that you can run faster than the lion with those shoes on?" This guy replied him, "Dude, I need not run faster than the lion. I just need to run faster than you!

Wall Street people

Wall Street people learn nothing and forget everything.

- Benjamin Graham

Investment opportunities

Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised.

- Warren Buffett

Holding period

Our favourite holding period is forever.

- Warren Buffett

Speculative counterparts...

Where the company has the highest credit rating because both its past record and future prospects are most impressive, we find that the stock market tends more or less continuously to introduce a highly speculative element into the common shares through the simple means of a price so high as to carry a fair degree of risk.

- Benjamin Graham

One formula.. doesn't work

People always want a formula – but it doesn’t work that way – you have to estimate total cash generated from now to eternity, and discount it back to today. Yardsticks such as P/Es are not enough by themselves.

– Warren Buffett

Ignorance with leverage

When you combine ignorance with leverage, you get some pretty interesting results.

- Warren Buffett

Satisfactory investment results

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

- Benjamin Graham

How to become rich

I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.

- Warren Buffett

Qualitative Vs Quantitative decisions

The really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

- Warren Buffett

Bear Market

A bear market is a financial cancer that spreads. Intermediate rallies (occasionally very strong ones) keep the hopes of investors alive. Furthermore, by continuously publishing bullish reports, brokers and economists, like good nurses, keep the flame of hope from burning out. But after 18 to 36 months of continued losses, total capitulation usually sets in and a major low occurs.

- Marc Faber

Invest in companies you like

Why not invest your assets in the companies you really like? As Mae West said, Too much of a good thing can be wonderful.

– Warren Buffett

What is not simple is speculative

Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics, the more uncertain and speculative are the conclusions we draw therefrom.

- Benjamin Graham

Market doesn't beat...

The market does not beat them. They beat themselves, because though they have brains they cannot sit tight.

- Jesse Livermore

Temperament

The most important quality for an investor is temperament, not intellect... You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.

- Warren Buffett

Wait

We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely.

- Warren Buffett

Judging investment risks

By confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.

- Benjamin Graham

Right or wrong

You are neither right nor wrong because people agree with you. You are right because your facts and reasoning are right.

- Benjamin Graham

Look for the big

Our exemplar is the older man who crashed his grocery cart into that of a much younger fellow while both were shopping. The elderly man explained apologetically that he had lost track of his wife and was preoccupied searching for her. His new acquaintance said that by coincidence his wife had also wandered off and suggested that it might be more efficient if they jointly looked for the two women. Agreeing, the older man asked his new companion what his wife looked like. "She’s a gorgeous blonde," the fellow answered, "with a body that would cause a bishop to go through a stained glass window, and she’s wearing tight white shorts. How about yours?" The senior citizen wasted no words: “Forget her, we’ll look for yours.

- Warren Buffett

Buffett’s investment philosophy ...

Whenever we buy common stocks...we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts — not as market analysts, not as macroeconomic analysts and not even as security analysts.

- Warren Buffett

Market quotes

(Remember) the market is there to serve us, not instruct us. It just tells us prices. If something is out of line, then you can do something about it - the critical part is how you handle that piece of information, how you play out your hand. Let the market serve you rather than instruct you, and you can’t miss.

- Warren Buffett

You are correct because....

Being contrarian has no special value over being a trend follower. You are correct because the facts are right. In focusing on business and investment decisions, look for things that are important and knowable.

- Warren Buffett

Commodity boom

We have failed to profit from one of the biggest commodity booms in history and will probably continue to fail in that way.

- Charles Munger

Bear Markets

I buy stocks when the lemmings are headed the other way.

- Warren Buffett

Condition to buy a stock

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.

- Warren Buffett

Successful Investor

The courage to press on, regardless of whether we face the calm seas or rough seas, and especially when the market storms howl around us, is the quintessential attribute of the successful investor.

- John C. Bogle

Investments

The best way to think about investments is to be in a room with no one else and just think...if that doesn't work, nothing else will.

- Warren Buffett

Rearview Mirror vs Windshield

In the business world, the rearview mirror is always clearer than the windshield.

- Warren Buffett

Margin of Saftey

Confronted with the challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety.

- Benjamin Graham

Concentration and Diversification

Diversification may preserve wealth, but concentration builds wealth.

- Warren Buffett

Emotions and Investors

Individuals who cannot master their emotions are ill-suited to profit from the investment process.

- Benjamin Graham

Time to buy

I've found that when the markets are going down and you buy funds wisely, at some point in the future you will be happy. You won't get there by reading 'Now is the time to buy'. These things never go off that way.

- Peter Lynch

Understand and don't understand

You have to segregate businesses you can understand and reasonably predict from those you don’t understand and can’t reasonably predict. An example is chewing gum versus software.

- Warren Buffett

Long term and standard deviation

A percentage point added to your long-term return is priceless. A percentage point added to your standard deviation is meaningless. To equate the meaningless to the priceless one for one strikes me as being absurd.

- John Bogle

Owner of shares

An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business

- Warren Buffett

Time the friend

Time is the friend of the wonderful company, the enemy of the mediocre.

- Warren Buffett

The Lord and the market

The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.

- Warren Buffett

Investigate and Invest

Before you invest, investigate.

- Warren Buffett

Difficult business

In a difficult business, no sooner is one problem solved than another surfaces.

- Warren Buffett

Perverse human characteristic

There seems to be some perverse human characteristic that likes to make easy things difficult.

- Warren Buffett

What and at what price

We have tried occasionally to buy toads at bargain prices with results that have been chronicled in past reports. Clearly our kisses fell flat. We have done well with a couple of princes - but they were princes when purchased. At least our kisses didn't turn them into toads. And, finally, we have occasionally been quite successful in purchasing fractional interests in easily-identifiable princes at toad-like prices.

- Warren Buffett

Turnarounds

Both our operating and investment experience cause us to conclude that 'turnarounds' seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.

- Warren Buffett

Market: Voting machine as well as Weighing machine

...in the short term, the market is a 'voting' machine (whereon countless individuals register choices that are product partly of reason and partly of emotion), however in the long-term, the market is a 'weighing' machine (on which the value of each issue (business) is recorded by an exact and impersonal mechanism).

- Benjamin Graham

Keep it away from heart

Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

- Warren Buffett

Stock Prices

Basically, price fluctuations have only one significant meaning for the 'true' investor. They provide him an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

- Benjamin Graham

Management and Business

If a management with a good reputation tackles a bad business, it is the reputation of the business that remains intact.

- Warren Buffett

Institutional Investors

We believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a 'romantic'.

- Warren Buffett

Purchase Price

Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.

- Warren Buffett

Understand Business

Don't try and figure out what the market is doing. Figure out a business you understand, and concentrate.

- John Maynard Keynes

Stock Price

If a business does well, the stock eventually follows.

- Warren Buffett

Falling Share Prices

Long-term shareholders benefit from a sinking stock market much as a regular purchaser of food benefits from declining food prices. So when the market plummets — as it will from time to time — neither panic nor mourn.

- Warren Buffett

Margin of Saftey

No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what is called the 'margin of safety' - that is by never overpaying, no matter how exciting an investment seems to be, can you minimize your odds of error.

- Benjamin Graham

Volatility

Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

- Warren Buffett

Excitement, Expenses & Market timing

Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

- Warren Buffett

Envy the irrational emotion

People don't necessarily feel better or happier when they have more money - they feel happier when they have more money than their friends and neighbours. Psychologists have shown that we are happy when we get a 5% salary increase... that is, until we learn that our peers all got 7% and we turn distinctly unhappy. As William Shakespeare said, "But, O! how bitter a thing it is to look into happiness through another man's eyes!". If our stock portfolio is achieving the long-term goals we have rationally set, let us be thoroughly happy for ourselves as well as anyone fortunate enough to outperform us. Investing is not a zero-sum game, so the happiness and success of our friends is not directly to our detriment.

- Prof. Sage

Rational decisions and emotions

Fear and greed press internal buttons that suggest action, and such action is almost always contrary to your long-term best interests. The instant gratification of acting in accordance with our emotions is sometimes almost impossible to resist. In the long-term we're all dead anyway, our mind tells us, searching for every possible justification for altering or ignoring our rational goals. But then Homo sapiens are not exactly famous for being rational. People refuse to drink juice from a new urine collection bottle. People won't eat soup that was stirred with a new comb or flyswatter. Few people will eat fudge or chocolate when it is shaped like dog feces. None of these rationalisations make sense. And neither do most of investment decisions when they are driven by emotions.

- Prof. Sage

Conflict of Emotions and Goals

Emotions create a sense of urgency that draw our attention away from long-term rational goals in order to avoid or pursue what is perceived to be a more pressing hazard or reward. My long-term goal may be to be faithful to my wife, but when the attractive young girl across the table takes off her shoe and runs her toes up my leg with the seductive smile and wink - very strong emotions suggest short-term actions that would be contrary to my long-term goal

- Prof. Sage

Warren Buffet on how he looks at acquisition

We continue, however to need "elephants" in order for us to use Berkshire’s flood of incoming cash. Charlie and I must therefore ignore the pursuit of mice and focus our acquisition efforts on much bigger game.

Our exemplar is the older man who crashed his grocery cart into that of a much younger fellow while both were shopping. The elderly man explained apologetically that he had lost track of his wife and was preoccupied searching for her. His new acquaintance said that by coincidence his wife had also wandered off and suggested that it might be more efficient if they jointly looked for the two women. Agreeing, the older man asked his new companion what his wife looked like. "She’s a gorgeous blonde," the fellow answered, "with a body that would cause a bishop to go through a stained glass window, and she’s wearing tight white shorts. How about yours?" The senior citizen wasted no words: "Forget her, we’ll look for yours."

What we are looking for is described on page 25. If you have an acquisition candidate that fits,call me - day or night. And then watch me shatter a stained glass window.

Sourced from here

Understanding Business Statistics

Today we're going to switch a little from hard core analysis into a more basic analysis of stock statistics. This week's article will discuss business metric statistics, next week's article will focus on valuation statistics, and the final week we'll look at financial health measures. While many likely will recognize these, and many already know them, this will give less experienced investors an idea of what these statistics mean, how to calculate them, and what is "good" or "bad".

1) Gross Margin

What does it tell you?

Gross margin is the amount of each sale that is not taken up by direct product or service costs.

How do you calculate it?

(Revenue - Cost of Goods or Services) / Revenue

What's good or bad?

Gross margin is highly dependent on the business, but in general, the higher the better. An excellent value is over 50%. Many companies do not report gross costs separately.

Simple example

A supermarket buys a box of macaroni for 0.70 from Kraft. It then sells it to you for 0.80. It gets to keep 0.10 for itself (gross profit). The gross margin is therefore 13% (0.10 / 0.80).

2) Operating Margin

What does it tell you?

Operating margin is the amount of each sale that is not taken up by costs associated with running the business.

How do you calculate it?

(Revenue - All Operating Costs) / Revenue

What's good or bad?

As with any margin value, it depends on the business. Really great business models can have operating margins north of 30%.

Simple example

After making it's 0.10 gross profit on the macaroni, the supermarket has to subtract 0.02 to go towards paying it's employees, advertising on television, paying for trucks to deliver it's food, etc. The leftover profit is 0.08. Operating margin is therefore 10% (0.08 / 0.80).

3) Net Margin

What does it tell you?

Net margin is the amount of each sale left to the business after all costs, including tax and interest on debt, are accounted for.

How do you calculate it?

(Revenue + Non-Operating Revenue - Total Costs) / Revenue

What's good or bad?

By now you know that all margin figures are relative to competitors! In general, a net margin over 15 or 20% is the sign of an excellent business.

Simple example

The supermarket has some cash in the bank earning interest, but also some debt on which interest must be paid. Broken down to the single box of macaroni, it earns 0.001 of interest, but owes 0.003 of debt (a net interest cost of 0.002). Leftover profit is 0.078. Net margin is therefore 9.8% (0.078 / 0.80).

4) Return on Assets

What does it tell you?

For all property, machinery, trademarks, cash, etc. - all assets owned by the company - how much profit is earned from them?

How do you calculate it?

Net Profit / Total Assets

What's good or bad?

In The Little Book That Beats The Market, Joel Greenblatt lays out a hard percentage to look for - 25%. In reality, this is much higher than many stocks that appear on the screen. A good benchmark to look for is 15%, but the higher, the better.

Simple example

A lemonade stand holds $400 in assets - $200 for the mini-fridge, $100 in cash at the bank, $50 for the stand and signs, and $50 for the lemonade, pitchers, cups, and ice. Over a year, the stand earns $75 in profits. Return on assets is (75 / 400), for a good 19% return on assets.

5) Return on Equity

What does it tell you?

How much profit is earned from the net worth of the company?

How do you calculate it?

Net Profit / Total Equity

What's good or bad?

MagicDiligence feels that return on equity is a poor statistic. It can often be very high for companies in poor financial shape, as equity is very low due to high levels of debt. For companies with low debt, a good figure to look for is 25% or higher.

Simple example

The lemonade stand holds $400 in assets, but the mini-fridge was bought on a credit card, therefore the stand owes $200 of debt. Therefore, net worth is (400 - 200), or $200. Therefore, return on equity is (75 / 200), a 38% return on equity.

6) Return on Invested Capital (ROIC)

What does it tell you?

How much profit is earned from assets that are specifically deployed to earn money?

How do you calculate it?

This one is trickier. You first must calculate the net assets deployed to earn money. In general, this is:

Invested Capital = (Total Assets - Cash - Investments) - Current Liabilities + Short-term Debt

Then you use operating profit (EBIT - this is what we used to calculate Operating Margin in step 2), and subtract out the tax rate:

ROIC = (EBIT * (1 - tax rate)) / Invested Capital

What's good or bad?

Return on invested capital is useful because it's meaningful regardless of the business. A good ROIC is over 25%. An excellent ROIC is 30% or more.

Simple example

Our lemonade stand has $400 in assets, but the $100 in the bank is not being deployed to make money. Therefore our invested capital is $300. For the sake of simplicity, we'll say the stand does not pay taxes. Therefore, ROIC = (75 * (1)) / 300), or 25%.

7) Pre-Tax Return on Tangible Invested Capital (ROTC)

What does it tell you?

Finally, we get to one of the two golden statistics of the Magic Formula. Return on Tangible Capital is the same as ROIC, except we don't include intangible assets (like trademarks, overpayment for acquisition - goodwill, etc.) that are difficult to value. Also, we do not subtract out a tax rate, as they are variable between businesses.

How do you calculate it?

Take Invested Capital from item 6 and subtract out goodwill and intangible items from the balance sheet. Then:

ROTC = EBIT / Tangible Invested Capital

What's good or bad?

ROTC is a great statistic because it provides a meaningful comparison of businesses regardless of sector or tax rate or debt structure. It's also impossible to calculate for many Magic Formula stocks, as the Tangible Invested Capital figure is negative! Negative values and values over 40% are very positive, especially if the company holds a lot of cash.

Simple example

Think of a company like Microsoft. Software requires no warehouses to store inventory or factories to build products. Hard assets are minimal - the company relies on the ideas and skills of it's programmers and trademarks. This is a good business to be in, as there are no factories to upkeep or inventory to sell off to make room. These are the kinds of companies the Magic Formula looks to find, and MagicDiligence looks to review.

Sourced from here

Understanding Valuation Measures

Today we're going to switch a little from hard core analysis into a more basic analysis of stock statistics. Last week's article discussed business metric statistics, this week's article will focus on valuation statistics, and next week we'll look at financial health measures. While many likely will recognize these, and many already know them, this will give less experienced investors an idea of what these statistics mean, how to calculate them, and what is "good" or "bad".

First, let's take a moment to define what we're trying to measure. Valuation is a measure of how expensive a stock price is relative to the underlying business. There are several different attributes we can use to determine valuation. Just as you might judge the price of a car based on it's styling, engine power, features, and brand, you judge the price of a business based on it's earnings, net assets, cash flows, and revenues.

1) Price to Earnings Ratio (P/E)

What does it tell you?

How expensive a stock is relative to reported net profits. A higher P/E ratio indicates a more expensive stock relative to earnings.

How do you calculate it?

Stock Price / Earnings Per Share (trailing twelve months)

Forward P/E is used to determine what the P/E ratio should look like a year from now, based on earnings projections. This is useful if trailing earnings included sizable earnings gains or losses that were one-time in nature. It is calculated similarly:

Stock Price / Earnings Per Share (expected 1 year ahead)

What's good or bad?

The market at large has averaged about 15-17 P/E for much of the last 30 years. Some sectors average lower P/E ratios (like energy), and some average higher P/E ratios (like technology). As a rule, a P/E ratio under 10 is very low, and one over 30 is considered rather high.

Simple example

Johnson and Johnson (JNJ) earned a net profit of 3.63 per share of stock in 2007. The stock price today is 62.63. Therefore P/E is (62.63 / 3.63) = 17.24.

2) Price to Book Ratio (P/B)

What does it tell you?

"Book value" refers to the net worth of the company's property, buildings, equipment, cash, and other assets, minus bills outstanding, wages owed to employees, debt, and other liabilities. In essence, book value is what the company would be worth if liquidated. Most companies sell at a premium to book value because the company can generate profits from these assets.

How do you calculate it?

Stock Price / Book Value Per Share (most recent quarter)

What's good or bad?

Price to book is most useful for valuing companies where growth in assets is the goal of the business. Banks, insurance companies, and investment firms are good examples. It is a poor statistic for valuing companies where assets are primarily non-physical, like software and media companies. Benjamin Graham was a well known proponent of buying stocks under book value - although this is difficult to do today. A price-to-book value under 1.0 is really cheap, and under 2 is often considered a favorable valuation for asset based businesses.

Simple example

Johnson and Johnson's reported net equity (same as book value) was about $15 per share for 2007. Using a stock price of 62.63, this gives us a price to book ratio of (62.63 / 15) = 4.18.

3) Price to Sales Ratio (P/S)

What does it tell you?

Simply compares the stock price to the amount of sales per share the company has brought in over the last 12 months.

How do you calculate it?

Stock Price / Sales per Share (trailing twelve months)

What's good or bad?

The P/S ratio is highly correlative with net margin (discussed in last week's article). Higher net margin leads to a higher P/S ratio, because the company converts a higher percentage of sales to profits. The P/S ratio is considered less useful than the other valuation statistics by MagicDiligence. I recommend only using it to compare against other companies in the same business, or against historical averages of the stock being considered.

Simple example

Johnson and Johnson earned about $20.99 in sales per share of stock for 2007. Using the stock price of 62.63, this gives us a price to sales ratio of (62.63 / 20.99) = 2.96.

4) Price to Cash Flow (P/CF)

What does it tell you?

This ratio is very similar to P/E, except it uses the cash flow per share instead of earnings. This cuts out non-cash earnings and charges like depreciation and changes in working capital. This is a better measure of the actual dollars being generated by the business. Cash flow is generally what most people think of when doing their own finances.

How do you calculate it?

Stock Price / Cash Flow per Share (trailing twelve months)

Cash flow can be garnered from the Statement of Cash Flows, under Cash Provided By Operating Activities.

What's good or bad?

Studies have been published that show that companies with higher cash flow numbers than earnings are better performers over the long run. Compare P/CF with P/E and if it is a lower number, consider this a positive sign.

Simple example

Johnson and Johnson delivered 5.28 of cash flow per share in 2007, well over it's 3.63 of reported earnings. This is because the company accounted for depreciation of it's equipment, amortization of it's intangible assets, and other accounting tricks that allow the company to pay lower taxes. But the actual amount of cash the business raked in was significantly higher, giving a P/CF of (62.63 / 5.28) = 11.86, well under the P/E of 17.24. This is a positive sign the company may be undervalued, as Wall Street focuses on P/E to a much larger extent.

5) Price to Free Cash Flow (P/FCF)

What does it tell you?

Same as P/CF, except we subtract out cash needed to replace obsolete equipment and ongoing maintenance expenses. This is considered "free cash flow", that the company can use however it sees fit to reward shareholders. Examples of use of this free cash can be share buybacks, dividend payouts, or investment in growth opportunities.

How do you calculate it?

Free Cash Flow = Operating Cash Flow - Depreciation

This is a simple generalization - most textbooks will say to use Capital Expenditures instead of Depreciation. But MagicDiligence feels this is the best equation for the majority of stocks, as Capital Expenditures often includes growth based investments such as new stores or plants.

Price to Free Cash Flow = Stock Price / Free Cash Flow per Share (ttm)

What's good or bad?

Again, if a company can generate more free cash than it reports in earnings, this is the sign of a very well run business. Companies that generate free cash flow well under earnings generally require a lot of capital investment to sustain the business - an undesirable trait.

Simple example

From Johnson and Johnson's 5.28 of cash flow per share, we deduct 0.96 per share of depreciation expense, which is roughly equivalent to maintenance costs. This leaves us with a free cash flow per share of 4.32. Therefore P/FCF is (62.63 / 4.32) = 14.51. This is still well under the P/E of 17.24, a positive sign.

6) EBIT / Enterprise Value (Earnings Yield)

What does it tell you?

This is the second "golden statistic" of the Magic Formula. In effect, Earnings Yield is the inverse of P/E, but also subtracts out variables such as tax rate and investment income, while adding in the effects of debt. It tells you the percentage of earnings you are getting for each share of stock.

How do you calculate it?

EBIT stands for "earnings before interest and taxes". This is also known as operating earnings (see last week's article for details).

Enterprise value is simply market capitalization plus debt. It represents the price a suitor would have to pay to acquire all of the company.

Earnings yield is simply the quotient of these two statistics:

Earnings Yield = (Operating Earnings / Enterprise Value)

What's good or bad?
Joel Greenblatt decided to use this formula because it is a reliable measure of valuation between companies, regardless of industry. Because of this, a true "good" or "bad" value can be obtained. Look for over 9% earnings yield as the sign of a relatively cheap stock.

Simple example

Earnings yield is calculated more on an overall basis instead of on per share figures. Johnson and Johnson reported operating earnings of 13.7 billion for 2007. Currently, market cap is 181 billion and debt is 9.5 billion, leading to an enterprise value of 190 billion. Earnings yield is (13.7 / 190) = 0.0721, or 7.21%. This is not bad, but below what is required to make the Magic Formula screen.

Sourced from here

Free Cash Yield: The best valution statistic?

Valuation of stocks is a topic on which mountains of material has been written, and it has been discussed on the internet ad-nauseam. It's easy to see why - valuation is probably the single most important part of consistently picking winning investments. Get it right (or close to right), and you give yourself a great chance of significant gain with minimal risk. Get it wrong and... well, you know the rest!

In fundamental stock analysis, there are a number of valuation statistics, many of which have been discussed on this blog before. The most popular, of course, is the price-to-earnings ratio, or P/E. This ratio is easily calculated and can be found almost anywhere you can find a stock price. But is it really the single best valuation statistic to use to determine quickly whether a company may be undervalued?

First, the benefits. As mentioned, P/E is easily accessible. Second, it is a good point of comparison. If a stock's P/E ratio is lower than the overall market's, lower than it's primary competitors, and lower than the specific stock's historical average, the stock is likely to be undervalued and warrants additional inspection.

But there are drawbacks to the P/E ratio as well. First, P/E can be widely skewed by one time charges or benefits. For example, if a company sells off a portion of it's business, the gain on the sale is recorded as earnings, raising the "E" portion of the ratio and bringing the overall P/E down. If we don't dig deeper to ensure that the P/E ratio we're comparing against competitors, the market, and historical average represents an accurate number for the core business, we can be fooled into thinking it's undervalued.

Second, P/E includes charges and benefits not related to the core business. Non-operating income and charges such as interest paid on cash and investments, other investment gains and losses, income taxes, and other items are included in the P/E. Since these can vary considerably between companies, but have no bearing on how good or bad the business itself is, they can skew the ratio, making comparisons with competitors less than perfect.

Joel Greenblatt provides us with a similar, but better, statistic in The Little Book that Beats the Market: Earnings Yield. In essence, earnings yield simply flips the P/E ratio upside down, making the ratio into a percentage. For example, a 15 P/E becomes a 6.7% earnings yield. Turning P/E into a yield percentage is useful, because we can then compare it against bond or treasury yields. The current yield on a 10 year treasury is about 3.5%, so the stock would appear to give us 3.2% extra return for the risk involved.

But Mr. Greenblatt goes farther with his version of the earnings yield. For "E" portion in his version refers to operating earnings. Operating earnings are also known as EBIT - earnings before interest and taxes, which strips out the non-operating costs and revenue from the result, allowing for a more meaningful comparison between companies. The "P" portion refers to Enterprise Value. Enterprise value is simply market capitalization (the price the market has put on the company, or share price times number of shares), plus debt, minus cash on hand. By making these changes, Greenblatt incorporates balance sheet risk (or lack of) into his earnings yield calculation, while making it a better comparison between companies and against treasury and bond yields. Clearly, his version of earnings yield is a better metric than straight P/E.

One problem remains... earnings as reported is not always a tangible figure. A lot of assumptions are used by accountants to come up with earnings figures. First, they must decide what is actually a sale - some customers may never pay, and contracts can always be renegotiated or canceled, even after being reported as revenue in the income statement. Also, income statements include assumptions for such things as depreciation of property and equipment, the eventual value of stock options granted, and so forth.

This is why the cash flow statement exists. A company can use accounting tricks to fake earnings, but cold hard cash is harder to fake - the company either collected it or it didn't. What's more, the true value of a business is simply the discounted sum of all future cash flows, according to accepted finance theory. So, cash earned is clearly a better measure of business performance than earnings. Free cash flow is a step better, as it subtracts out the costs the company must pay to keep the business operating (such as equipment repairs, computer replacements, etc). MagicDiligence uses the depreciation figure to approximate these costs.

Once we have the free cash flow figure, we simply plug that in as the "E" portion of Greenblatt's earnings yield equation, and we have free cash flow yield. This is a powerful figure - it measures a company's cash generation, balance sheet risk, and share price all at once, and allows a meaningful comparison against both other stocks and fixed income assets like bonds and t-bills. No other valuation statistic gives you this much relevant information.

For those who are lost, I'll run through a simple example using my favorite lab rat - Johnson & Johnson (JNJ). To calculate earnings yield, here are the values you need from the 10-K. They've been gathered for this example:

* Net Cash from Operations (Cash Flow Statement)

* Depreciation and Amortization (Cash Flow Statement)

* Cash and Short-term Investments (Balance Sheet)

* Long-term Debt (Balance Sheet)

* Diluted Shares Outstanding (usually in the Income Statement, although sometimes you need to look in the footnotes).

* Current share price (Yahoo! or wherever)

The values from the last 10-K are (in millions):

* 15,249

* 2,777

* 9,315 (7,770 cash + 1,545 short-term investments)

* 7,074

* 2,910.70

* 64.88

First, we calculate free cash flow by subtracting depreciation from net cash earned:

* Free cash flow = (15,249 - 2,777) = 12,472

Next, we calculate enterprise value. First calculate market capitalization by multiplying share price by number of shares. Then add debt and subtract cash and short-term investments to that figure:

* Market Cap = (64.88 * 2910.70) = 189,000

* Enterprise Value = (189,000 + 7,074 - 9,315) = 186,759

Free cash yield is then FCF/EV, or:

* Free cash yield = 12,472 / 186,759 = 6.68%

This seems like a fair premium to the low treasury bill rate, for such a quality company. Stocks get into real bargain territory when free cash yield approaches 10% but remember, fundamental analysis is needed before putting your hard earned money into the stock.

Sourced from here

Tips for choosing Small Cap value stocks

1) Find the Big Fish in Small Ponds

It is fundamentally difficult for small capitalization stocks to build and maintain a competitive moat. For one, these companies do not have the economies of scale that large, multi-national corporations have developed that gives them the ability to squeeze suppliers on price, spend hundreds of millions on marketing, or afford huge sums for research and development. Many small companies do indeed grab market share by being first to market with new technology or ideas, but this advantage rarely lasts. In the best case, the company is purchased at a premium by a larger competitor. At worst, the company is copied and then priced or marketed out of existence. The outcome for these companies is speculative, and at MD we're not speculators but investors.

So how do we find small caps with a reasonable competitive advantage? One way is to find companies that dominate very small, limited markets. This is known as the "Big Fish in a Small Pond" scenario. Because of the limited market opportunity, larger firms generally don't bother to compete there. This can allow a relatively small company to control the market, consistently able to raise prices and perhaps move into closely related industry. The outcome of this is high returns on capital for long periods of time. Of course, we don't want to buy these until they are cheap!

For an example of this, consider Winnebago (WGO). At under 500 million market cap, this is clearly a small cap stock. Motor home manufacturing is not a lucrative market with wide appeal. Because of this, few new competitors bother to enter it - only about 10 companies control the market. Winnebago is the big fish in this small pond, with over 20% share. Because of this, the company has been able to maintain (and even increase) pricing, continue to build brand equity, and reward shareholders with dividend hikes and buybacks. Winnebago has averaged well over 20% return on equity for over 10 years - a sign of a potential competitive moat.

2) Management Matters

In general, Wall Street overvalues management. Businessweek and Forbes paste the faces of successful CEOs all over the front page in recognition of a few quarters of beating estimates. But there is ample evidence that previously great managers have limited effectiveness when running a poor business. See Alan Mullaly at Ford (F), David Neeleman at Jetblue (JBLU), or Eddie Lampert at Sears (SHLD).

With small caps, the story is different. Here, managers often wear several hats and are responsible for strategy and implementation, making great minds even more important. A great strategy can easily fail if not well implemented. Even more evidently, great implementation of a poor strategy is a sure path to small cap failure.

To value management, look for founder CEOs that own a large stake in the company - preferably 10% or more. This aligns their interests with yours. Founder CEOs of small caps with strong profitability records likely have a good strategy and have been successful putting it to work. Beware of small caps with vagabond management or those that use shareholder capital to give themselves generous salaries or perks.

3) Debt is Dangerous

This one is obvious - excessive debt is especially dangerous when dealing with small caps. Some large companies can afford to carry large debt loads, as they are virtually assured of future cash flows and can easily survive major economic downturns. Hershey (HSY) is a good example of this.

Few small caps have the luxury of knowing that their cash flows can survive virtually any economic situation. Also, banks sometimes consider small companies more risky, and price debt at higher interest rates for them. Therefore, every dollar of debt owed requires a higher return on capital than a similar dollar of debt in a big, stable corporation. Clearly, debt is a bigger burden for small caps.

Ideally, you want to pick small caps with no debt whatsoever. Minimal debt can be helpful, but be wary of stocks with a debt-to-equity ratio over 30%.

4) Diversify

When investing in widely diversified stalwarts like Johnson and Johnson (JNJ) or GE (GE), each of whom has been around over 120 years and controls multiple product segments, there is almost no chance of losing all of your investment. With small caps, on the other hand, even the most carefully chosen pick can easily see it's business opportunities disappear. Most of these companies rely either on a single product or a small selection of products in a very focused market. The lack of product diversification is dangerous because if that one market is affected by any adverse factors (from technology changes, new competition, even changing consumer tastes), the small cap company can be dragged down with it. Thus, lack of product diversification is the single biggest risk in small cap investing.

Take for example an MFI stock, Select Comfort (SCSS), the maker of the Sleep Number bed. Just a year and a half ago this company looked like a great buy, driving returns on equity well over 30% and growing revenues and earnings in the 20% range (and with no debt to boot). But a number of challenges all hit the company at once. The housing market went into a deep decline, competitors like Tempur-Pedic (TPX) gained ground, and soon Select Comfort found it's only product under siege. Sales and earnings tanked, and the stock has dropped from the mid-20's into penny stock range.

For these reasons, you MUST diversify when buying small caps. Even the most attractive opportunities are not immune to stock price swan dives.

5) Never Forget the Fundamentals

The last rule may seem obvious, but it's a rule nonetheless - don't forget the fundamentals! Particularly, look for a reasonable history of above average returns on capital (20-25% return on equity, 25% or higher return on invested captial), and solid free cash flow margins (at least 5%). Any fad stock or technology leader can generate high returns on capital for a year or two, but only a company with a sustainable market and business model can maintain these returns for 5 years, preferably more. As always, don't be lured by earnings growth alone... if the company is making sales it won't be able to collect on, those earnings are no good. Focus on cash flow instead of earnings.

Another great sign in a small cap is the payment of dividends. Dividends are a very underrated part of total stock returns. In his book The Future for Investors, Wharton professor Jeremy Siegel calculates that reinvested dividends would have accounted for the majority of S&P 500 index returns over the past 60 years. Not only this, but the payment of dividends is tangible proof of a company generating excess cash flow. Instead of blowing those extra cash flows on overpriced acquisitions, they are paid out to their rightful owners - the shareholders. Paying out this excess cash also optimizes return on capital.

Don't be Afraid of Small Caps!

Many investors are lured away from small caps by their financial advisors. Some reasons for this are legitimate - small caps require a lot more research time and are subject to more risk. But as I showed in the first article of this series, the rewards are well worth the effort. The Magic Formula screen is filled with both quality and questionable small cap stocks. Some of these will fade into obscurity, and some will rocket back to their true value - and keep going up. The MD mission is to keep you away from the former and get you into the latter.

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5 Reasons to own Small Cap stock

This is the first in a series of articles examining how and why to own small cap, value based stocks. This is an important component of the Magic Formula, and most companies on the overall screen fall into this category.

1) They Outperform Every Other Class of Stock. Period.

Ibbotson Associates analyzed data from 1926 to 1997 and concluded that small cap value stocks outperformed the general market by 4.3% annually - more than any other class of stocks. Vanguard has published data that shows that, from 1927-2004, small cap value outperformed large cap value, blended, and growth portfolios. A Fama and French study shows this class outperforms all others in recessionary periods as well. Another study by Fund Evaluation Group shows that small cap value has outperformed every other group, and by a wide margin.

If we want the best returns for our portfolios, we have to invest in the best performing class of stocks.

2) The Market's Valuation of Small Cap Stocks Is Inefficient

Stock analysts overwhelmingly cover large, well known companies. Their clients prefer to be in stocks of companies they know, and the investment firms they work for are forced to purchase large cap stocks so as not to exceed statutes by owning too much of a firm. When funds are operating with billions of dollars of assets, it doesn't make sense to invest in small companies - any investment returns from these will not materially affect the fund's performance because the position is too small.

One of the best books ever written on investing, Peter Lynch's One Up On Wall Street, explains this phenomena well. Lynch earned stellar returns running Fidelity's Magellan fund by buying hundreds upon hundreds of small positions in promising small cap stocks and holding them until the market realized their value.

Small cap stocks are valued inefficiently because of the lack of research on them, leading to misunderstanding of a company's business or prospects. Add to this the general investment community's unwillingness to invest in small caps, and you have a perfectly inefficient market for them, leading to bargains.

If we want the best returns for our portfolios, we have to take advantage of inefficiencies in the system.

3) Small Caps Can Become Big Caps

This one is obvious - you're not going to find the next Microsoft or Wal-Mart by investing in Microsoft and Wal-Mart. When Microsoft started trading on the NASDAQ in 1986, it's market capitalization was about 700 million. Today, it's worth 260 billion - giving you back your initial investment 370 times over (and that's not including dividends!).

Relating to point #2, once small cap stocks grow to a certain size, institutions and mutual funds can safely invest in them without worrying about statutory regulations or problems of scale. This leads to an influx of institutional money, sending stock prices up even farther. As market cap grows, these stocks get added to various indexes, which leads to investment by index funds that track them.

Small caps by their very nature have more and larger avenues of growth than large capitalization stocks. This, plus the intricacies of the financial markets, give them several advantageous characteristics for share price appreciation.

If we want the best returns for our portfolios, we need to own the best opportunities for revenue and earnings growth.

4) Small Caps Are Attractive Buyout Bait

Large companies are always struggling to deliver growth to their shareholders. Adding meaningful growth to a company with billions of dollars in revenues and earnings is not easily done. These large companies are often bureaucratic nightmares, slow to adapt with new trends and not nimble enough to stay ahead of changing markets.

Instead of taking the time, patience, and effort to develop new businesses, these cash rich mega-corporations often turn to acquisition as a quick fix for growth. Also, private equity groups will often buy these companies to restructure and then take them public again, reaping a big windfall. Buying small companies, even at a significant premium to market price, is often a drop in the bucket that delivers new opportunities in an instant. Take a look at some recent small-cap buyouts:

* Getty Images - bought for a 48% premium to the trading price.

* PETCO - bought for a 45% premium to the trading price.

* Russell Athletic - bought for a 35% premium to the trading price.

These are just a few examples. Small caps get acquired for significant premiums very frequently. If we want the best returns for our portfolios, we have to position ourselves for big buyout profits.

5) Warren Buffett Says So

No less an authority than Warren Buffett himself has guaranteed that he could earn 50% annual returns investing sums of around 1 million. How would he do this?

"...look for small securities in your area of competence where you can understand the business"

If we want the best returns for our portfolios, we'd be wise to listen to the world's greatest investor!

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