– 19 Jan 2006

In an investment classic “5 Key Lessons from Top Money Managers”, the author, Scott Kays, writes on the need to develop an investment philosophy.

“Webster’s defines philosophy as “the critical study of the basic princi­ples and concepts of a particular branch of knowledge… a system of principles for guidance in practical affairs.” Stated simply, a philosophy is a belief system, a way of thinking.

When you filter out companies based on objective standards, you will likely exclude firms that turn out to be good investments. That is not a problem. You are not trying to develop a philosophy that iden­tifies every good investment; rather, you want to build a philosophy such that every investment it identifies is good. For example, assume the universe of superior investments consists of one hundred busi­nesses. Your selection criteria filter out eighty of those companies, along with thousands of bad ones. As long as the twenty firms that pass muster are quality selections, you have accomplished your goal of constructing a portfolio of winners.

Some money managers only invest in companies below a certain size as part of their philosophy. That is not to say they believe larger businesses never make good investments. They have just decided to limit their purchases to the small-cap market, perhaps because they believe the best growth opportunities reside there, or possibly they feel this area offers exceptional valuations. By excluding large firms from their consideration, they hope to develop greater expertise in the small-cap sector and spot opportunities missed by others.

Some managers exclude firms that have not grown their earnings by at least some minimum rate over a number of years. By doing so, those professionals don’t even look at high-quality, slower-growing corporations selling for half their value. Even though those firms might produce excellent returns, their characteristics do not match the philosophies of the growth-oriented managers, so the companies get rejected.

Investors often needlessly suffer losses from failing to develop and abide by strict buy and sell guidelines. In an effort to chase short-­term performance numbers, even professionals can fall into this trap. During the great technology bubble, I periodically read statements by analysts similar to this: “You can’t justify the price for this secu­rity, but you just have to own it.” In other words, “This security is overvalued and no longer meets my criteria, but its price continues to rise for some inexplicable reason and I’ll look bad if I don’t urge investors to buy it. So I am ignoring my philosophy and recommend­ing it anyway.”

If you purchase a stock that doesn’t meet your buy criteria, how will you know when to sell it? When everyone else decides to sell it? When its price drops a certain percent? A lower price might ac­tually make the security more appealing instead of turning it into a sell candidate. You leave the realm of investing to speculate when you violate your investment philosophy.

Rather than base their decisions on objective criteria, individuals often buy and sell solely because of the opinions of others, again moving them from investing to speculating. Accepting someone else’s analysis is fine if you understand and agree with his or her philoso­phy. However, most people don’t know the reasoning behind a rec­ommendation when they embrace it.

An investment philosophy anchors your decision making and sta­bilizes your portfolio during turbulent times. It acts as both a map and a compass that provide direction and guide you through stormy in­vestment markets. Great investors do not change what they believe to match whatever is popular. They are willing to risk missing a good investment to avoid bad ones.

Developing a Repeatable Process

Once you have developed your philosophy and determined what types of companies you want to own, you must develop a repeatable process, or set of procedures, designed to search for and identify firms that match your investment criteria. You should also include proce­dures for identifying holdings you need to sell because they no longer meet your requirements. Your process implements your philosophy and moves you from the idea phase into the action phase.

Specific data must be gathered, organized, and analyzed, and par­ticular calculations must be made every time you examine a company.

As I emphasize throughout this book, no single correct way to in­vest exists. The process I develop over the next several chapters is not the correct process; it is simply a process that employs many sound investing principles. The important thing is that you establish a set of procedures that puts your philosophy into action and you follow those procedures faithfully.

Bill Nygren, Lead Manager of the Oakmark and Oakmark Select funds, stated the last two principles succinctly during a conference call in which I participated: “I buy businesses that are growing their in­trinsic values when they are selling at sizable discounts to their intrin­sic values.” His statement makes two things clear about his strategy. First, he buys firms that are growing their values, implying he looks for quality companies. Second, he waits to purchase them until they sell for significantly less than they are worth. Those two standards exemplify businesslike investing.

Ask yourself these two questions each time you consider invest­ing in a company: (1) Does this firm qualify as a quality business? (2) Can 1 buy it at a price that will allow me to earn a strong return over time? Do not purchase shares of the business unless you can answer both questions affirmatively.

Defining a Quality Business. A cheap price alone does not justify buy­ing a company. A corporation may sell at a bargain price for good rea­sons, such as incompetent management or waning demand for the company’s products. You should disqualify the firm as an investment candidate if company-specific factors that are structural in nature drive its depressed price.

Superior businesses possess certain common characteristics, in­cluding robust profit margins, strong earnings and revenue growth, a clean balance sheet, and competent management.

Profit Margins. High profit margins help a business weather nega­tive circumstances. Such circumstances may be economy-wide, such as a recession; industry-wide, such as airlines after 9/11; or company specific. Poor margins have forced many corporations to fold or sell to competitors during business downturns, as low-margin firms can easily generate bottom-line losses when their revenues take a hit.

The larger a firm’s net profit relative to its revenues, the greater the probability it will generate positive earnings for the foreseeable future, offering investors a higher margin of safety. While there are excep­tions, companies with large, ongoing capital requirements and firms that produce commodity items with little pricing flexibility tend to op­erate at relatively low margins. Service-oriented businesses and those with pricing power, due to either strong demand for their products or a lack of competition, frequently operate at higher margins.

Historical Earnings Growth. Look for businesses that exhibit histor­ically strong and consistent earnings growth. Strong previous growth adds credibility to the notion that the firm has a product line and man­agement team capable of generating future earnings increases. Be wary of any business projecting a sizable income expansion that has never attained such growth in the past.

Consistent earnings growth allows you to project a company’s fu­ture cash flow with greater confidence. Since a firm’s worth depends on its projected income, you can more accurately value a business with a reliable earnings stream.

Does this eliminate cyclical firms, whose earnings rise and fall pe­riodically based on external factors such as interest rate cycles? Not at all. However, understand that investing in those businesses adds an­other factor that you have to get right-timing! If you feel confident that a company is coming out of a cyclical downturn and entering a period of rapid growth, the principles I discuss apply.

There are a few ways to determine the consistency of a company’s historical earnings growth. The first involves running a regression analysis on a firm’s previous earnings per share. The formulas can get quite complex, so I recommend using another method.

Second, the Value Line Investment Survey computes an earnings predictability factor for businesses it covers. This measure, which runs between 1 and 100, indicates how reliable and therefore predictable a firm’s earnings stream is. I recommend looking for businesses with factors of 75 and higher.

Third, you can eyeball a company’s prior years’ earnings figures and make an informed judgment about how consistently a firm has grown its earnings. For example, compare the five-year earnings his­tory for O’Reilly Automotive and General Motors.

O’Reilly Automotive General Motors
1999 $0.92 $8.52
2000 $1.00 $8.58
2001 $1.26 $3.23
2002 $1.53 $6.81
2003 $1.84 $5.68

Quite obviously, O’Reilly has generated more consistent growth. Investors would likely place a higher degree of confidence in their forecasts for O’Reilly’s future earnings than GM’s.

Projected Earnings Growth. Strong historical growth does not guar­antee a healthy expansion in a firm’s future income. New technologies make older products obsolete, demographic changes alter consumers’ purchasing habits, and buyers’ preferences shift over time. Before investing, make sure you understand a company’s products well enough to develop confidence in its future demand. Ask yourself if the firm’s products are trendy, or if they exhibit growing demand regardless of changing fads. You want businesses that can sustain their earnings growth.

You cannot simply extrapolate prior earnings trends indefinitely into the future when projecting a firm’s growth-another mistake technology investors made in the late nineties. Then corporations up­graded equipment early and expanded their IT spending dramatically in 1998 and 1999 to avoid potential Y2K problems, resulting in huge earnings growth for tech firms. A drop in business spending occurred after the turn of the millennium. Investors, however, had projected years of unsustainable earnings growth to justify prices for technology companies.

Historical and Projected Revenue Growth. Top-line growth is just as critical to a company’s long-term success as increasing its bottom line. Firms can temporarily cut costs to expand their net profits without growing sales. At some point, however, businesses must grow their revenues to achieve long-term earnings growth.

Balance Sheet. Producing a unique product with a strong demand will not ensure a company’s success. A weak financial situation can prevent a firm’s management team from executing its business plan effectively. Two factors dominate when determining the health of a company’s balance sheet: liquidity and debt level. A strong balance sheet with plenty of liquidity and low debt gives a company flexibil­ity and fortifies it against business downturns.

Liquidity refers to the amount of assets a business can convert to cash in a relatively short period of time. A company may have lots of assets, but if they cannot be converted to cash, the firm may not be able to pay its bills. Liquid assets are referred to as current assets. Bills that come due within a year are known as current liabilities. The ab­solute amount of liquid assets a business has on hand does not matter as much as its current assets relative to its current liabilities. There­fore, you compute a key measure of a company’s liquidity, known as its current ratio, as current assets/current liabilities.

Excessive debt has plunged many corporations into bankruptcy because steep payments strangled the firms’ cash flows. High fixed expenses also reduce a company’s ability to adjust to changes in its operating environment.

Analysts refer to a firm’s debt as borrowings with at least a year before they must be paid back. Again, a company’s absolute debt level is not as important as its debt level relative to the company’s size, often measured by its equity. Therefore, investors often look at a company’s debt/equity ratio as the most relevant measure of the firm’s debt.

Competent Management. The future success of a company hinges on the quality of its leadership team. A corporation with a great prod­uct line will never fulfill its potential without a management team ca­pable of developing and executing a well-designed business plan. Qualities to look for in management include experience, integrity, shareholder orientation, honest and forthright communication, and the ability to consistently allocate the firm’s resources into high-return projects.

Although this area is somewhat subjective, measuring the return the business has earned on its capital can help determine the compe­tency of a firm’s leaders and how effectively they have allocated the company’s resources. Understanding a firm’s return on capital also helps you project how fast the company is likely to grow its future earnings. The most common figure used in this regard, the return on equity (ROE), divides the net income of a business by its equity.

Buying Reasonably Valued Companies

Great businesses do not necessarily make great investments. For ex­ample, a firm may possess an accomplished management team, claim the leading shares of the markets in which it competes, and manu­facture products for which strong demand is projected several years out. Yet all these positive factors may be built into the stock’s current price, leaving little room for shareholders of the fully valued corpo­ration to experience above average returns. In fact, enthusiastic in­vestors often overprice outstanding businesses.

To quote Andy Stephens, “Statistically there is a correct price to pay for a company.” Christopher Davis says, “No business is worth buying at any price.”

Valuing a business plays such an important role in successful in­vesting that I devote two chapters to it. I not only discuss the factors that influence a firm’s worth, but I also build a simple model to calcu­late that figure. As you will learn, however, a couple of issues make it difficult, if not impossible, to determine one precise value for a company.

First, investment experts do not agree on one correct methodology to calculate a firm’s fair market value. Money managers have experi­enced great success using a variety of techniques.

With little dispute, a corporation’s worth depends primarily on the size of its future cash flows. However, professional investors and analysts disagree on what measure of cash flow should be used. Some formulas focus on operating earnings, whereas others consider div­idends most pertinent. Still other methods emphasize some varia­tion of a firm’s free cash flow (net income + depreciation – capital expenditures).

Second, a company’s future income stream is uncertain. Even if they use the same methodology, investors will likely calculate numer­ous fair market values for a firm because they anticipate different lev­els of earnings. Only time will tell whose numbers were correct.

You can solve this dilemma a couple of ways. First, you can de­termine a range of possible values for a business instead of trying to calculate one exact figure. You might utilize multiple earnings growth rates, such as for best- and worst-case scenarios, or you could use more than one method of computing a firm’s worth to develop this range. Instead of stating that XYZ Corporation is worth $75 a share, you might determine the company’s value lies somewhere between $70 and $85, then buy the stock when its price is at or below the lower end of that range.

Second, you might look at a number of factors in determining a corporation’s fair value, as already discussed, and synthesize the in­formation into one intrinsic value figure. You then only buy the firm’s stock when the market prices it at a significant discount to that figure in order to give yourself a large margin of safety.”


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