Friday, March 21, 2008

Improving on Value Investing Techniques

After reading a few books on value investing, I realized that my framework, though sound, was not water-proof enough in the sense that I did not have a quantitativ framework for computing the intrinsic value of companies. Though it is good to get a rough idea of a company's intrinsic value in terms of its customers, market share, margins, competitors etc., it will be even better still to follow this up with a proper framework and template for assessing a company, so as to make appropriate comparisons with other companies within the same industry or companies which may share the same ratio comparisons (e.g. same store sales growth standards). Such quantitative methods may seem tedious at first but they do add a useful dimension when assessing the suitability of a company for long-term investment.

While reading "Value Investing for Dummies" by Peter J. Sander and Janet Haley, I came across templates which the book advocated that value investors make use of, in order to enhance understanding of a company and also to have a more systematic approach to valuation. Thus far, I have been assessing companies based on many qualitative aspects as well as simple metrics such as margins, earnings growth and earnings per share. In order to constantly improve and grow as a value investor, one must incorporate new models or knowledge which will enhance his assessment of companies suitable for investment; and these templates and spreadsheets really do assist in giving me a better picture of various aspects of a company. I will just briefly list the key areas I wish to look into to give myself an added dimension, as I have yet to design my own customized template. Once I have the templates ready, I will proceed to use them in future posts to evaluate companies which I deem suitable and worth investigating.

First of all, the book talks about "running the numbers" in order to arrive at an intrinsic value computation. Essentially, this estimates the number of years of growth of the company at a certain rate, discounted using an appropriate discount rate. Suffice to say the worksheet is comprehensive enough to cover most aspects of the assumptions but the growth and discount rate assumptions are the most important in order to arrive at a conservative value. It is this conservative value which value investors seek to establish a margin of safety against. I will go into more detail in subsequent posts when I design the spreadsheet for this.

The next section talks about "Strategic Financials", which seeks to examine three aspects of a company - profitability, productivity and capital structure. Again, a template is provided for assessing these three key traits of a company using a 5-year comparison (to look for trends and to see if things are improving). It is a pretty rigorous exercise and it is not easy to fill in the numbers, but it definitely provides a lot of useful information about a company. Finally, an ROE figure is computed based on these three aspects, and I will again provide more details of the ROE equation in a subsequent post.

The final section is the one without numbers, as it focuses on Strategic Intangibles. This area is the most difficult to ascertain and may be "grey" in certain instances due to subjective assessments of a company's brand power and management effectiveness. The characteristics given in the book which are evaluated include brand power, market share (and leadership), special competencies (if any), management effectiveness in terms of candour and independence, ownership, asset productivity and credit rating (less important factor). It will be extremely tedious to go through each and every one of these to obtain a "holistic" view of the company, thus even the book recommends skipping the less important and focusing on what makes the company worthwhile to consider. This is also the most interesting part of the analysis as it can provide insights into many qualitative aspects of a company which I frequently discuss on my blog.

Ultimately, these three aspects of analysis are just based on numbers and ratios. It is up to the astute value investors to MAKE SENSE of all the information and churn it into something useful and insightful. In a way, I have to admit that is the most difficult part of value investing - applying common sense and logic to a bunch of numbers and facts. But this is where the challenge comes in: if we do our homework properly and adopt a disciplined approach to investing, there is very little chance for failure and very little reason for losing money.

Purchase of Phil Fisher's "Common Stocks and Uncommon Profits"

Today, at the Times' Warehouse Sale Book Fair at the Expo, I managed to purchase this classic book from Phil Fisher which I had been eyeing for very long. Warren Buffett's style had evolved from being almost 100% Graham to being part Graham and part Fisher, which signifies the start of Buffett looking at businesses for the quality and intangibles instead of just plainly numbers. My investing style has long incorporated aspects of Phil Fisher's style in that he also enjoys talking to Management and also the company's stakeholders to get a more balanced view of the company outside of simply the numbers.

I managed to purchase this book for S$29, which is great value as the original price was S$38.50 ! Haha I guess value investors always love to seek value ! I had seen this book and eyed it for a long time but refused to buy till it was offered at a bargain price.....and now I finally own it. I shall be reading it thoroughly and posting valuable tidbits from it over time.

14 comments:

Simon said...

u don't really have to wait and go to the expo to get the book at S$29.

berkshire book store has it. u can get it for S$30 with self collection from a kiosk near your home.

http://www.berkshirebusinessbooks.com/book_details.php?id=1052

Simon said...

so...not really a bargain price eh? =)

musicwhiz said...

Hi Simon,

Thanks for the link. Well, in the absence of such information, I have been comparing the prices to bookstores around Singapore. I guess I did not do enough research on buying this book as compared to the companies I own. I only have myself to blame for running down all the way to Expo when I could have bought it online. Hahaha !

Regards,
Musicwhiz

Anonymous said...

hi musicwhiz, thank you for sharing so much with us. am an ardent follower of your blog.

koori

H said...

Hi MW,

Its a book worth reading and re-reading. How wonderful to have ten-baggers in our portfolio :)

I just finished reading Ken Fisher's new book (at borders) and decided not to buy it.

Enjoy reading!

HH

la papillion said...

Hi,

Aww, mw, you should have asked me. I've always told people that berkshire business books sells books at a great discount to any bookstores, even with membership and special discounts :)

The link is also included in my links.

HH, oh I saw Ken fisher's book :) Haha, you just sat there and read all??

LP

PanzerGrenadier said...

Hi musicwhiz

I guess valuing a company is as much art as it is science.

If it were all down to numbers, then why are analysts all disagreeing with one another on target price and buy/sell/hold calls? ;-)

My own feel is that the numbers are the hygiene factor but the true test of the pudding is in the eating, i.e. one has to bite the bullet and invest according to one's convictions after taking into account the numbers.

Be well and prosper. :-)

Anonymous said...

Excellent book- added the extra investing dimension to the young Warren Buffett.

i think you are already doing a great job reading financial statements and commenting on them.

The intrinsic value calculations involve DCF- so if you can post in the future what your thoughts about the discount rate (or do you use the risk free and discount purchases to that) is in Singapore?

musicwhiz said...

Hi Koori,

It's my pleasure. I think we can all learn from one another when it comes to investing and financial freedom.

Regards,
Musicwhiz

musicwhiz said...

Hi HH,

Yeah I believe Phil Fisher's book will be worth reading and re-reading, even though his style is a little long-winded (people in the 1950's wrote like this ? Haha).

As for Ken Fisher, he himself admitted that his books could not add too much more value compared to what his father had written. So I guess it may be worth a read but not a buy.

Regards,
Musicwhiz

musicwhiz said...

Hi LP,

Haha no problem it's ok. I got it at a price I felt was good value and since I will be reading it a few times (I do that with all my investment books), the cost per read is very low liao !

Regards,
Musicwhiz

musicwhiz said...

Hey Panzer,

Congrats on the birth of your daughter ! Yes, I agree investing is also part art, part science. It's also based on gut feel and common sense as well. For investors, knowing what to avoid is as important as knowing what to buy. There's the added dimension of also seeking margin of safety, so price is important once you've established that it is a worthwhile company to invest in.

Regards,
Musicwhiz

musicwhiz said...

Hi Anonymous,

Thanks, yes it will be a continuous improvement and learning curve for me, as I digest more and more information to value companies. Hopefully, though, it does not become analysis paralysis !

Yep, I will mention about my views on discount rate and equity risk premium once I get the spreadsheet up.

Thanks,
Musicwhiz

la papillion said...

Hi mw,

Hmm, that will be very interesting when you post your views on the discount rate, perpetuity rate etc. I look forward to debating with you on those issues :)