Business-like investing

“Investing is most intelligent when it is most business-like” –Ben Graham.

Imagine a close friend who owns a restaurant and is thinking of opening up one in another city but requires additional capital to expand his operations. He gives you a call hoping you would join in as a silent partner. Would this be a wise investment?

Below are some questions that you may ask. Take a moment and think about what questions you would ask before looking at the list.

The questions you should ask yourself are:

“How trustworthy is my friend?”

“Is he any good at running a restaurant business?”

“What do I know about the restaurant business? (Do I understand it?)”

“How well is the restaurant doing currently?”

“How well has the company done in the past? (Does it have good financials?)”

“How well should the new restaurant perform?”

“What price should I pay to receive a good return on investment? (What should be my % of ownership based on my investment?)

“What’s my time horizon for cashing out of this business?”

These are just some of the relevant questions you should be asking yourself and if you were a serious investor, I’m sure you would do a lot more research such as going to the restaurant periodically, eating the food, verifying the financials with an accountant, and visiting the competition. These are the traits of a good business analyst and if you can take that same mentality and apply it to stocks, you are on your way, to becoming a better investor. That is lesson number one.

Understanding the Business

“Invest in your circle of competence” – Warren Buffett

Your investing success will be determined by how well you understand the company. Always try to invest in easy to understand companies that have great long term future.

Newspaper stocks of are an example of a slowing business. It used to be a cash cow because of its monopoly (one or two newspapers that represent the town) and low cost (equipment doesn’t need to be updated). Now future prospects don’t look so bright because of the growing competition and ease of use of the Internet. So when studying companies, ask questions like:

“What’s the competition landscape in 5 years?”

“Will profit margins be lower because of competition?”

“Can the company raise prices?”

“Can technology or new innovations affect the company?”

Honest and Competent Management

“How trustworthy is my friend?”

“Is he any good at running a restaurant business?”

Imagine if you had a hockey team and you could pick any player from any era to be the team captain. Who would it be? Wayne Gretzky? Bobby Orr? Or what if you had a basketball team and you could pick anybody you wanted. How about choosing Michael Jordan in his prime? The point is, the team leader can have a dramatic effect to the performance of your team. The same goes with stocks. The CEO (chief executive officer) plays a vital role in the company’s success.

Examples of great CEO leadership:

In 1997 Steve Jobs became Apple's interim CEO after the directors lost confidence in and ousted then-CEO Gil Amelio. Under Jobs' guidance the company increased sales significantly with the introduction of the innovative products such as iMac, iPod, & iTunes. Apple stock has continued to go higher and higher! In Oct 1, 2001, it was $8.07 (stock split adjusted), and has gone to $74.08 in Oct 2, 2006. That’s a 55.80 % compounded rate of return for 5 years!

Mark Hurd replaced Carly Fiorina who left at the advice of Hewlett Packard’s board of directors after the difficult merger with Compaq and a struggle with the HP board after reports of disappointing earnings. Under Hurd’s leadership, the company’s earnings improved dramatically through cost cutting and market share gain. The stock has performed brilliantly! In Sept 30, 2002, HPQ was $11.45 (stock split adjusted), and has gone to $37.42 in Oct 2nd, 2006. That’s a 34.45% compounded rate of return for 4 years!

Eddie Lampert was able to emerge Kmart out of bankruptcy in 2003. Lampert sold 68 of the firm's stores to Home Depot (HD) and Sears for $850 million. He sold 68 stores -- less than 5% of Kmart's real estate assets -- for about the same price that he had paid for control of ALL of Kmart's 1,500 stores and 16 distribution centers during bankruptcy proceedings! Lampert also took measures to improve Kmart's operating results and cash flow, leading to a string of profitable quarters for the resurgent retailer. It has now merged with Sears and continues to blow away quarterly earning numbers.

The management is just as important as the business itself. Whenever you mention a stock, you should immediately be able to mention the CEO or chairman who runs the company. If not, then start practicing. Now the next question is how can you figure out the management is any good? Here are some signs:

Management’s history:

What’s the track record and biography of management? If they have been with the company for a long period of time, has the stock appreciated in value during their tenure?

Conference calls:

Listen to the quarterly earning conference calls. If they made a mistake, do they openly admit to it or place the blame somewhere else? Are they candid when answering questions or dodge the bullet? Do they under promise and over deliver (UPOD) by beating earning expectations each quarter? Are they humble or arrogant?

Annual reports:

Every company gives their annual reports. In addition to the positives, do they openly express the negatives that have happened during the year? Are the reports spent with glossy and colorful designs or are they just plain black and white and stick to the facts and figures?

Ownership:

Does management have a significant ownership in the company? Are they the founders of the company?

Compensation:

Is the management pay reasonable based on past stock performance?

Every great company you discover that has honest and competent management should be a part of your stocks to track list. It will give you the opportunity to buy the stock the moment you see the price drops to an attractive value. But how do you know determine if it’s the right price to buy? Read on.


Fundamentals

So the million-dollar question is “How can I get a 20% return on my money?”. The answer can be broken down into two parts. “What stock should I buy and what’s price that I should pay?” Ultimately here some of the possible results.

Investing in:

Bad company bought at an overpaid price
= negative return.

Bad company bought at a fair price
= poor return.

Bad company bought at a bargain price
= average return.

Good company bought at an overpaid price
= poor return.

Good company bought at a fair price
= average return.

Good company bought at a bargain price
= high return. (20%+)


Figuring out what to buy and at what price is crucial to getting a high return on investment over the long term. So let’s investigate on the first part, what makes a company good.


Return on Equity (ROE)


“Time is a friend to a wonderful business” – Warren Buffett

So if you want to find a 20% return on investment, doesn’t it make sense to start by looking at companies that can return 20% consistently year after year? This is called the return on equity (ROE), defined as: the rate of investment return a company earns on stockholders' equity. Return on equity is calculated by dividing net earnings by average stockholders' equity.

Below shows Coca Cola’s financial ROE over the last 10 years.

1996 60.5%
1997 61.3%
1998 45%
1999 27.1%
2000 23.1%
2001 38.5%
2002 34.3%
2003 33.6%
2004 32.3%
2005 30.2%


Compare this with Nortel’s yearly ROE.

1996 14.4%
1997 17.4%
1998 NM
1999 NM
2000 NM
2001 NM
2002 NM
2003 7.5%
2004 NM
2005 NM

NM means it was a negative figure because it lost money that year. Which one is the better company? It’s really a no-brainer.

For Coca-Cola, is ROE expanding or contracting? If the trend is expanding, it’s a sign the company is doing well and sign of good management. If the trend is contracting, it could mean poor management, saturation, or more fierce competition.

Again, ROE is just a good starting point to finding great investment opportunities. In addition to ROE, the following are also important measures in finding a good company.

Revenue and Earnings growth:

Revenue (Sales) and earnings (net income) are consistently growing year over year.

Profit margin:

Profit margins (% of Net Income of Revenue) are better compared to the competition. It’s even better if it’s growing year over year.


Debt ratio:

Preferably I like companies with little or no debt but there’s the exception if that type of industry requires a high level of debt. It’s good if the debt is decreasing year over year?


Capital Expenditures:

How much money does it have to spend to maintain its operations? It’s a good sign if it’s growing modestly because that means earnings are going to its bottom line rather than depreciating equipment.



Book value growth:

Book value is what the company is worth if it were to go bankrupt and liquidate itself. I like to see this grow consistently because every year, the earnings retained should add to its bottom line.


Common Equity:

Is the number of shares outstanding increasing or decreasing year over year? If it’s decreasing, then the company is buying back it’s stock to increases shareholder value.


To get this information, my TD Ameritrade account offers the S&P Report that shows the companies’ ten years history. I think many other discount brokerages also offer this service so please check with your account. It is an invaluable tool and I wouldn’t invest without it. To me, finding good fundamentals is like finding the next Picasso.