Book Notes: Christopher Browne's "The Little Book of Value Investing"


WHY IS VALUE INVESTING STILL SO UNCONVENTIONAL? IT IS TEMPERAMENT.

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

MANY PEOPLE DO NOT HAVE THE PATIENCE; They are eager for instant gratification, or for validation from their peers. Most people seek immediate gratification in almost everything they do including Investing.

Value investors are most like Farmers. They plant seeds and wait for the crops to grow. If the corn is a little late in starting because of cold weather, they don't tear up the fields and plant something else. No, they just sit back and wait patiently for the corn to pop out of the ground, confident it will eventually sprout.

BUY STOCKS LIKE STEAKS ... ON SALE

Most people tend to look at pretty much everything they buy with an eye on the value they get for the price they pay. When prices drop, they buy more of the things they want and need. EXCEPT IN THE STOCK MARKET.

In the stock market, there is the irresistible excitement and lure of the Hot Stocks everyone is talking about. People believe that they'll miss a terrific opportunity if they don't own these super exciting stocks. Everyone seems to think that they should buy stocks that are rising and sell those that are falling. There are reasons for this pattern of behavior: First investors are afraid of being left behind.

WHAT'S IT WORTH?

The consequences of the stock market revaluing overpriced stocks is often call "Permanent Capital Loss". If a stock is grossly overvalued and its stock price crashes, history shows that it is unlikely it will regain its former inflated value.

There are 2 broad approaches to determining Intrinsic Value.

(1) The first is highly statistical and involves a set of financial ratios that are good indicators of value

(2) The other called the Appraisal method, involves making a company-specific estimate of what the stock would be worth if the company were sold to a knowledgeable buyer in an Open Auction.

Most investors are driven by Emotions that run the gamut from Extreme Pessimism to Jubilant Optimism. These Emotions can drive stock prices to the extremes of overvaluation and undervaluation.

The job for the Smart Investor is to recognize When this is happening and to take advantage of the Emotional Swings of the market.

This is what Rational Value Investors do. They SIT BACK and WAIT for the market to Offer stock for Less than they are worth and to buy the same stocks back for more than they are worth.

BUY EARNINGS ON THE CHEAP - THE LOWER THE PRICE, THE HIGHER THE RETURN

The best part of following a Low P/E strategy is that it forces you to buy stocks when they are cheap while Fear of stocks is running high.

Low P/E stocks are usually Low Expectations companies. Study shows that when a Low P/E, Low Expectations stock reports disappointing news, the effect is usually minimal. The market anticipated bad news, and there was no need to knock the price down much further. Conversely, when a Low Expectation stock surprises the market with good news, the price can pop.

WHEN IS A BARGAIN NOT A BARGAIN?

We have to determine why a company's shares are cheap and which ones have little chance of recovery. The first and most toxic reason that stocks become cheap is too much debt. A company should own twice as much as it owes.

Analysts seem to be more focused on short-term earnings gains than future long-term success. Missing Earnings is Not Fatal, and it tends to create Opportunity for the Value Buyer; if the Trend continues, however, the shares will likely to fall.

- Some cyclical stocks may show up on our list of potential bargains. They are highly dependent on how the economy is doing.

- Increased competition is yet another reason for falling share prices. - Obsolescence is another potentially fatal cause for falling prices.

I like to stick to businesses we Understand and for which there is an Ongoing Need i.e. Banking, F&B, Consumer Staples...

I approach my list of investment candidates with a healthy dose of Skepticism. My best friend in the whole world when it comes to building my inventory of value investing opportunities is the No-Thank-You pile.

GIVE THE COMPANY A PHYSICAL - A THOROUGH CHECKUP WILL HELP AVOID INVESTING MISTAKES

One of the most important aspects of the Balance Sheet is Liquidity - the amount of Cash the company can lay its hands on in the short-term.

Current Ratio: reveals a company's ability to pay its short-term obligations. It is also important to look at the ratio over the past several years. A Current Ratio that is steadily declining year over year may indicate that a serious liquidity problem is developing.

Working Capital: The More the Better.

Acid Test Ratio: a clear view of a company's cash position vs. its bills.

Inventory: It is a good idea to track Inventory Levels over the past several years to see if they have been steadily rising in relationship to the company's sales. Rising inventories may indicate a product that has decreased in popularity and will be difficult to sell at a profit.

Intangible Assets: I tend to take these assets out of my calculations as their value may be difficult to determine.

Long-term Debt: A situation where LT Debt is declining year over year while assets are rising indicates that the company is generating excess cash and using it to pay down debt, a healthy indication for the years ahead. The less debt on the balance sheet, the greater the Margin of Safety.

Debt-to-Equity ratio: gives us a good idea of a company's solvency and ability to survive.

Evaluating not only the levels of Debt, Assets, and Working Capital but the Trends in each can give you valuable information about the company's health and future prospects.

Annual Income Statement: is more useful because some companies experience seasonal sales fluctuations.

Revenues/Sales: are the lifeblood of the company. Without them, a company can't earn a profit. Revenues growing over time are good.

Cost of Goods Sold: It it is rising as a % of Revenues, it may indicate that rising costs that cannot be passed on to the customer are squeezing the LT potential for profits or that the company faces new competition that may also squeeze profits.

Gross Profit Margin: the steadier the better.

Operating Profit: this is the number that I like to use in valuing a company, as it is the figure most likely to be used by anyone interested in acquiring the entire company.

EPS: I like to use the EBIT to determine both regular and fully diluted EPS numbers as it is more accurate measure of corporate earning power.

Increasing Shares Outstanding can also indicate that the company is financing itself through stock offerings rather than earnings.

Return on Capital (ROC): a good measure of how much money a company can earn on the capital it employs. A company with a high ROC has a much greater chance of financing growth with self-generated cash than one with a low return.

Net Profit Margin: if a company can grow its profit margins over time, every new dollar of goods sold has a leveraged impact on sales. A falling margin could also indicate bloated overhead and careless management, or cutthroat competition, something we very much want to avoid as we stock the shelves of our store.

THOROUGH EXAMINATION

There is some art to identifying the best prospects and so you should analyze your list of companies in greater detail. You need to drill down farther to get a better sense of how these companies operate and compete.

1. What is the outlook for Pricing for the company's products? Can the company raise prices?

2. Can the company Sell More?

3. Can the company increase Profits on existing Sales? How much is the Gross Profit Margin expected to increase/decrease as a result of changes in Price, Mix of business, or the specific costs that make up the CoGS?

4. Can the company control Expenses?

5. If the company does raise Sales, how much of it will fall to the bottom line? If Sales can be grown at No additional Cost, every dollar goes right to bottom line profits.

6. Can the company be as profitable as it used to be or at least as profitable as its competitors?

7. Does the company have 1-time expenses that will not have to be paid in the future?

8. Does the company have unprofitable operations they can shed?

9. What would the company be worth if it were sold?

10. Does the company plan to buy back stock?

IT'S A MARATHON NOT A SPRINT

IT'S TIME IN THE MARKET NOT MARKET TIMING THAT COUNTS

Many people believe that the fastest way to the highest market returns is by short-term trades that are accurately timed.

It is simply better to BE IN the market, invested in the VALUE stocks that offer the highest potential return, than to play the timing game. If your portfolio is well constructed, a bit of market turbulence is no reason to bail.

The reality is that the biggest portions of investment returns come from short periods of time but trying to identify those periods and coordinate stock purchases to them is nearly impossible.

2 issues are at play here:

(1) Short-term Timing doesn't work.

(2) The highest returns are achieved by being fully invested in the market at nearly all times so you can capture the times when stock rise the most. You have to be in the game to win it.

One of the most difficult factors in maintaining a LT approach is that Prices are so widely available. We can check the value of all of our stock holdings day by day, minute by minute. We can see how they fluctuate around short term factors, and in many cases this information can make us a little nervous.

Overconfidence: is another significant psychological flaw of most investors and money managers. People make changes in their portfolios because they are confident that they are making a change for the better. Without that confidence, they would merely sit still.

Investors who are less confident in their ability to make profitable decisions are more likely to sit still. Investors who trade the most, tend to buy riskier stocks. They are looking for more action, confident that they can jump ship before it runs up on the rocks.

"Most of men's problems arise from their inability to sit quietly and alone", Blaise Pascal.


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