Today I am going to talk about the value investor who has once serviced the likes of Benjamin Graham, Warren Buffett - Christopher H. Browne. He was the partner of Tweedy, Browne Company, where he serviced the famous investors listed just now. He is a famous value investor, his mutual funds (which take a value investing approach) outperformed the market returns for a period of at least 10 years in the 1990s. Now that we know more about him, allow me to make my comments about this book.
Things that I like about the book:
I really enjoyed this book is really good for people to take up value investing and want an introductory book for it. Inside it, parameters such as ROC, PE, PB, FCF, current ratio, debt-to-equity, net profit margin (yes, I listed them out) were explained in a comprehensive manner and what these parameters may entail when we look at the financial reports of the companies.
After reading the book, I had this urge to start looking at companies' financial reports so that I can find these companies. Yes, I get affected by the books that I read too. Browne also repeatedly emphasized the importance of sticking to value investing even when no one is doing it. (This is as, there are researches which show that value investing is able to outperform the market in the long-run)
Things that I dislike about the book:
This is the 3rd little book that I have picked up. I felt that the previous books have set the bar too high and I expected another easy but important lesson from this book as well. There is a need to warn you guys, there are no graphs/ charts for you to understand easier, there are also no recap portions at the end for you to know the main points of the chapter.
But other than that, I really enjoyed the book, I believe anyone who is interested to do value investing/ to learn about value investing to read it. With that, let me move on to the investing method that was outlined in this book. I have categorised them into 3 major steps:
1. Using parameters, screen stocks that are cheap enough:
This can be done through parameters like PE (Price to Earnings) (You can choose trailing PE if you are more conservative, or forward PE if you are more adventurous. It can be from 5-15 depending on the economic condition of the market), PB (Price to book value, less than 1 would mean that the market value of the company is lower than the value of the asset it owns. This would be what Benjamin Graham would want). You can also look at the FCF (Free cash flow), which is a measure of the profitability of the company. As studies have shown, purchasing stocks at low prices would allow for the highest growth potential.
The first step would allow us to have a comfortable list of cheap stocks to work with. The reasons for this cheap valuation of the stocks by the market can be due to a) High Debt b) Fall short of earnings prediction c) Labor constraints d) Competition e) Obsolescence f) Corporate/accounting fraud. Not all of them have a long-term effect on the stock price on the company. Hence, it is important for the second step to allow us to further filter out the companies that have red flags.
2. Time to read the financial report!:
From the above parameters, I have managed to filter out 8 companies using macrotrends.net. According to the book, what I will need to do now is to read the balance sheet (an indication of the company's health) & income statement (how much the company is making) portion of the financial reports of these 8 companies (for the past 5 years)
These are the things that I should look out for red flags in the balance sheet:
a) Current ratio (Current Assets/ Current debt) - it should be constant or increasing, it indicates that the company is able to service its short-term debt. A good estimate would be 2
b) Book value (Long-term asset - (Long-term debt + intangible asset)) - This would mean that the company is profitable can is paying down its long-term debt obligations. Hence, it would be increasing over the years.
c) Debt to equity (Debt/ Equity) - This would allow us to understand if the company's growth is fuelled by debt or by equity. We should use this to compare the company against its competitor (for the company's competitive edge)
d) Low debt - Having low debt would mean that the company that we are interested in have a better capacity to ride out tough times.
These are the things to look out for in the income statement:
a) Year-on-year (YOY) revenue/sales - Should be increasing, we should try to understand the source of the revenue, especially if it is coming from strong/weak divisions.
b) Cost of goods sold - production cost to produce the goods that brought in the income. Cost / revenue over the years would show us if the company's profits are being squeezed
c) Operating expense / revenue - What I understand this is the overhead ratio, the lower it is, the better the management is at cutting cost.
d) One-time-charge - These are important, especially when there are "repeating one-time-charges" that occurred for several years in a row. This would mean that the company may be trying to hide things from its shareholders
e) ROC (Earnings/ (Equity + Debt)) - This is important to compare against its competitors
f) Net profit margins (Earnings/revenue) - It should be increasing, which shows that the management can find areas to cut cost, increase profitability or introduce innovative products into the market.
Do note for step 2, a lot of the things are qualitative and not quantifiable. Browne has a rule of thumb for us: If we cannot understand the financial report, we should not buy it. '
3. Understand the underlying business:
According to Browne, this part is where great investors differentiate themselves from the crowd. It is the step where you should stay in your area of competency (As you would understand that business the best). It is a series of questions that you need to ask objectively about the business.
1. Outlook for product pricings - Is it possible to increase the price to raise its profitability without affecting the demands of the products/services?
2. Outlook for demand quantity - How can the company sell more of their products/ services? It is limited by things like population, capital, location?
3. Outlook for controlling expenses - How easy would it be for the company to reduce its operating expenses? What are the constraints? They can be laws, trade deals, location, labor unions, pension plans. These are the commitments that companies would have a harder time to lower the expenses
4. Can the company retain their profitability from competitions?
5. What does the management do with excess cash? - Is competently deployed/reinvested for high-profit margins? Or given out to investors as dividends?
6. How do the competitors perform - In terms of ROC? Debt? Net profit margins?
7. Are there share buybacks? - Shown to increase shareholders' value
8. Are there insider buying? - Do note that Browne did not use insider trading, but buying. He used this as an indication that the management knows about recent favorable developments for the companies and would want to capitalize on it.
Alright, you have gone through the 3 steps and you have a list of around 20-30 stocks (Browne recommends 80). Now, all you need to do is to buy them and wait for profits (yes, buy and hold). Browne has also explained that value investing would not work all the time or it will take a loooooooooooooong time for it to work.
Hence it would be important to keep around 3 years of expenses in cash/cash-equivalents to ride out 3 years of downtime (for loss of jobs and stock market crashes). Which I agree with, as the longest drop is 3 years.
He also highlighted one important principle at the end; Value investing does not have a fixed parameter that we can look at in every economy.
1. When Benjamin Graham was doing it (1930s), it would make sense to look at PB ratios, as the economy was driven by manufacturing companies.
2. In the late 1900s, there was a move to a service economy (banking, high-tech research, media). Hence, it would make sense to look at the net profit margins, FCF, ROC.
3. Now (2000s), the US economy is driven by technological, high-tech manufacturing, and consumer-centered companies. Hence we would need to learn what are the best parameters that would reflect the true long-term values of these companies.
Industry trends would come and go (as explained by a random walk down wall street), but companies are essentially businesses and they should be measured by their profitability, price, moat, and the managers' ability to deliver value to their shareholders. And I believe that that is the essence of value investing - Buying great business at good prices for a long time.
I love this book. It is indeed a great introduction to value investing. I will definitely use the knowledge here with my fun money in the future
1. Using parameters, screen stocks that are cheap enough:
This can be done through parameters like PE (Price to Earnings) (You can choose trailing PE if you are more conservative, or forward PE if you are more adventurous. It can be from 5-15 depending on the economic condition of the market), PB (Price to book value, less than 1 would mean that the market value of the company is lower than the value of the asset it owns. This would be what Benjamin Graham would want). You can also look at the FCF (Free cash flow), which is a measure of the profitability of the company. As studies have shown, purchasing stocks at low prices would allow for the highest growth potential.
The first step would allow us to have a comfortable list of cheap stocks to work with. The reasons for this cheap valuation of the stocks by the market can be due to a) High Debt b) Fall short of earnings prediction c) Labor constraints d) Competition e) Obsolescence f) Corporate/accounting fraud. Not all of them have a long-term effect on the stock price on the company. Hence, it is important for the second step to allow us to further filter out the companies that have red flags.
2. Time to read the financial report!:
From the above parameters, I have managed to filter out 8 companies using macrotrends.net. According to the book, what I will need to do now is to read the balance sheet (an indication of the company's health) & income statement (how much the company is making) portion of the financial reports of these 8 companies (for the past 5 years)
These are the things that I should look out for red flags in the balance sheet:
a) Current ratio (Current Assets/ Current debt) - it should be constant or increasing, it indicates that the company is able to service its short-term debt. A good estimate would be 2
b) Book value (Long-term asset - (Long-term debt + intangible asset)) - This would mean that the company is profitable can is paying down its long-term debt obligations. Hence, it would be increasing over the years.
c) Debt to equity (Debt/ Equity) - This would allow us to understand if the company's growth is fuelled by debt or by equity. We should use this to compare the company against its competitor (for the company's competitive edge)
d) Low debt - Having low debt would mean that the company that we are interested in have a better capacity to ride out tough times.
These are the things to look out for in the income statement:
a) Year-on-year (YOY) revenue/sales - Should be increasing, we should try to understand the source of the revenue, especially if it is coming from strong/weak divisions.
b) Cost of goods sold - production cost to produce the goods that brought in the income. Cost / revenue over the years would show us if the company's profits are being squeezed
c) Operating expense / revenue - What I understand this is the overhead ratio, the lower it is, the better the management is at cutting cost.
d) One-time-charge - These are important, especially when there are "repeating one-time-charges" that occurred for several years in a row. This would mean that the company may be trying to hide things from its shareholders
e) ROC (Earnings/ (Equity + Debt)) - This is important to compare against its competitors
f) Net profit margins (Earnings/revenue) - It should be increasing, which shows that the management can find areas to cut cost, increase profitability or introduce innovative products into the market.
Do note for step 2, a lot of the things are qualitative and not quantifiable. Browne has a rule of thumb for us: If we cannot understand the financial report, we should not buy it. '
3. Understand the underlying business:
According to Browne, this part is where great investors differentiate themselves from the crowd. It is the step where you should stay in your area of competency (As you would understand that business the best). It is a series of questions that you need to ask objectively about the business.
1. Outlook for product pricings - Is it possible to increase the price to raise its profitability without affecting the demands of the products/services?
2. Outlook for demand quantity - How can the company sell more of their products/ services? It is limited by things like population, capital, location?
3. Outlook for controlling expenses - How easy would it be for the company to reduce its operating expenses? What are the constraints? They can be laws, trade deals, location, labor unions, pension plans. These are the commitments that companies would have a harder time to lower the expenses
4. Can the company retain their profitability from competitions?
5. What does the management do with excess cash? - Is competently deployed/reinvested for high-profit margins? Or given out to investors as dividends?
6. How do the competitors perform - In terms of ROC? Debt? Net profit margins?
7. Are there share buybacks? - Shown to increase shareholders' value
8. Are there insider buying? - Do note that Browne did not use insider trading, but buying. He used this as an indication that the management knows about recent favorable developments for the companies and would want to capitalize on it.
Alright, you have gone through the 3 steps and you have a list of around 20-30 stocks (Browne recommends 80). Now, all you need to do is to buy them and wait for profits (yes, buy and hold). Browne has also explained that value investing would not work all the time or it will take a loooooooooooooong time for it to work.
Hence it would be important to keep around 3 years of expenses in cash/cash-equivalents to ride out 3 years of downtime (for loss of jobs and stock market crashes). Which I agree with, as the longest drop is 3 years.
He also highlighted one important principle at the end; Value investing does not have a fixed parameter that we can look at in every economy.
1. When Benjamin Graham was doing it (1930s), it would make sense to look at PB ratios, as the economy was driven by manufacturing companies.
2. In the late 1900s, there was a move to a service economy (banking, high-tech research, media). Hence, it would make sense to look at the net profit margins, FCF, ROC.
3. Now (2000s), the US economy is driven by technological, high-tech manufacturing, and consumer-centered companies. Hence we would need to learn what are the best parameters that would reflect the true long-term values of these companies.
Industry trends would come and go (as explained by a random walk down wall street), but companies are essentially businesses and they should be measured by their profitability, price, moat, and the managers' ability to deliver value to their shareholders. And I believe that that is the essence of value investing - Buying great business at good prices for a long time.
I love this book. It is indeed a great introduction to value investing. I will definitely use the knowledge here with my fun money in the future
Till next time,
Stay vested, stay frugal my friends
Dionysius
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