Constructing a Winning Portfolio

1. Constructing a Winning Portfolio Lessons in Stock Analysis from Master Investors

2. Some Key Questions • Out of all the possible stocks in the world, how do you decide which ones merit a closer look? • Stock “screening” • What is your comparative advantage? • Invest in what you know! • What is your universe?? • Can’t just ask, would Warren Buffett invest in this stock; need to ask, would Warren Buffett invest in this stock if he were you?? • How will you know when you are wrong about a stock? • How will you know when you are right about a stock?

3. Growth + Value 4 Legendary Investors: • Benjamin Graham • The Father of Security Analysis • Developed the field of “value investing” • Philip Fisher • Started in 1928, still investing today • “It’s quality that counts” • Warren Buffett • Berkshire Hathaway • Investing from a “business perspective” • Peter Lynch • Fidelity Magellan (1977 – 1990) • Invest in “understandable” stocks

4. Benjamin Graham: the Father of Security Analysis • Lived from 1894 – 1976 • Founded Graham-Newman partnership • Taught at Columbia Business School • Wrote: • “Security Analysis,” with David Dodd • “The Intelligent Investor” • Defined the “intelligent investor” as one who viewed investing in a stock as buying a part ownership of a business • Focused on “value investing”

5. General Advice to Investors • Be an investor, not a speculator • Don’t expect to profit from market movements • Know the asking price • Rake the market for bargains • NCAV rule is useful, but rules out most stocks • Only buy when there is a “margin of safety” • What’s the stock worth? • IV = E*(2R+8.5)*4.4 / Y • Regard corporate figures with suspicion • Don’t stress out • Don’t sweat the math

6. General Advice to Investors • First rule of diversification • Asset allocation at least 25% bonds, at least 25% stocks • Increase bond allocation if the earnings yield on stocks is less than the yield on high-quality bonds • Second rule of diversification • Try to hold at least 30 different stocks • When in doubt, stick to quality • Dividends provide a clue • Defend your shareholder rights • Be patient • Be prepared (financially and mentally) for prolonged market downturns • Think for yourself!

7. Specific Advice to Investors: Ten Attributes of an Undervalued Stock • An earnings yield (inverse of P/E) at least double the AAA bond yield • A P/E ratio no more than 40% of the highest average P/E ratio achieved by the stock over the previous 5 years • A dividend yield at least 2/3 the AAA bond yield • A stock price no more than 2/3 the tangible book value per share • A stock price that no more than 2/3 the “net current asset value” or the net quick liquidation value • These five attributes assess the amount of risk (in terms of margin of undervaluation) involved in buying a given stock

8. Specific Advice to Investors: 10 Attributes of an Undervalued Stock • Total debt that is no more than tangible book value. • A current ratio of at least 2.0 • Total debt no more than net quick liquidation value • (6), (7), & (8) relate to financial soundness • Earnings that have doubled in the most recent 10 years • No more than two declines in earnings of 5% or more in the past 10 years • (9) & (10) show a history of stable earnings Very few stocks make it through this screen, and many potentially valuable stocks are excluded!

9. It’s Quality that Counts: the Philip Fisher Approach • Wrote “Common Stocks and Uncommon Profits” • investing as a mix between science and art • investment decisions often boil down to a judgment call about the relative importance of relevant qualitative factors • wanted companies that could generate and sustain long-term growth

10. Philosophy Investment in “outstanding” companies that, over the years, can grow in sales and profits more than the industry as a whole. Key features of “outstanding” companies: • strong management with a disciplined approach designed to achieve dramatic long-term growth in profits • products or services that have the potential for sizable sales long term • other inherent qualities that would make it difficult for competitors and newcomers to share in that potential growth

11. Universe of Stocks • No restrictions on universe of stocks to select from; OTC stocks shouldn’t be overlooked, but “outstanding” companies not necessarily young & small Criterion for initial consideration: • 15 points, divided into 3 categories: • Functional factors • Excellence in management • Business characteristics

12. Functional Factors • Products or services w/ sufficient market potential for sizable increase in sales for several years; major sales growth, judged over series of years • superiority in production - lowest cost provider of goods or services • strong marketing organization - efficiency of sales, advertising, and distribution • outstanding R&D - amount expended relative to its size; effectiveness as indicated by ability to bring research ideas to market • effective cost analysis and acctg. controls; choice of capital investments that bring highest return • financial strength or cash position - sufficient capital to exploit prospects w/o needing to sell additional equity

13. Excellence in Management • Entrepreneurial attitude among management - keep innovating w/ new products or services to keep sales growing • Development of good in-house management & teamwork • Management depth • Good labor and personnel relations; labor turnover relative to competitors • Long-range outlook by mgmt., even at the expense of short-term profits • Good investor relations & willingness to talk freely about problems • Mgmt. of unquestionable integrity; salaries & perks in line w/ those of other managers

14. Business Characteristics • Above average profitability • compare profit margins w/in industry and over several years • older & larger firms usually best in industry • younger firm can have narrower profit margins if spending (investing) a lot in research and/or marketing • Ability to maintain good profit margins; good position relative to competition due to: • skill in a particular line of business • patent protection

15. Secondary Factors Once “outstanding” company is found, purchase stock when it is out of favor due to: • market has temporarily misjudged true value of company, or • general market conditions • outstanding companies can be purchased at fair value, but investors should expect a lower (though still respectable) return

16. Monitoring / When to Sell • 3-year rule for judging results if stock is underperforming but no fundamental changes have occurred • hold stock until there is a fundamental change in its nature or it has grown to a point where it will no longer be growing faster than the overall economy • don’t sell for short-term reasons • sell mistakes quickly once they are recognized • don’t overdiversify - hold 10 - 12 companies in a variety of industries having different characteristics

17. “The Warren Buffett Way” • “An Unreasonable Man” • Influenced by Benjamin Graham and Philip Fisher • “The reasonable man adapts himself to the world. The unreasonable man persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.” – George Bernard Shaw • General Philosophy of Warren Buffett • Invest in stocks based on their intrinsic value, where value is measured by the ability to generate earnings and dividends over the years. • Target successful businesses – those with expanding intrinsic values – and seek to buy at a price that makes economic sense, defined as earning an annual rate of return of at least 15% for at least 5 – 10 years.

18. “The Warren Buffett Way” • Step One: Turn off the stock market. • Mr. Market and the Lemmings – the market as manic-depressive • “After we buy a stock, consequently we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100 percent position in See’s or H.H. Brown to validate our well being. Why, then, should we need a quote on our 7 percent interest in Coke?”

19. “The Warren Buffett Way” • Step Two: Don’t worry about the economy. • “If Fed chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, it wouldn’t change one thing I do.” • Buy businesses that have the opportunity to profit regardless of the economy.

20. “The Warren Buffett Way” • Step Three: Buy a business, not a stock. • Four categories of tenets companies must satisfy to be considered as potential investments: • Business tenets • Management tenets • Financial tenets • Market tenets • Will be described in more detail later …

21. “The Warren Buffett Way” • Step Four: Manage a portfolio of businesses. • “Know-nothing” investors should own a large number of equities and space out their purchases over time • Use an index fund and dollar cost average purchases. • Will enable investor to outperform a majority of investment professionals • “Know-something” investors • “if you are … able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense to you.” • If the best stocks you own present the least financial risk and have the most favorable long-term prospects, why would you put money into your twentieth favorite choices rather than add to your top choices?

22. Back to Step Three:Buy a Business; Not a Stock • Business Tenets: • Is the business simple and understandable? How does it make money? • Does the business have a consistent operating history? Do earnings exhibit a stable upward trend? • Does the business have favorable long-term prospects? Is the business a “consumer monopoly” or a commodity-type business?

23. Monopoly vs. Commodity • Consumer monopoly: • Repeat business, plus one or more of following: • Strong brand or other barrier (Nike, McDonald’s, Amgen (patent), rock quarries) • Necessary gateway for mfrs. to reach customers (worldwide advertising agencies, newspapers) • Provide necessary services (tax preparers, insurance) • Commodity-based business: • Low profit margins, low ROE, absence of brand loyalty, presence of multiple producers, existence of substantial excess capacity, erratic profits that depend on management’s ability to optimize the use of tangible assets

24. Buy a Business; Not a Stock • Management Tenets: • Is management rational? Do they invest the company’s cash profitably? • Is management candid with its shareholders? • Does management resist the institutional imperative?

25. Buy a Business; Not a Stock • Financial Tenets: • Focus on return on equity, not earnings per share. • Calculate “owner earnings.” • NI + (D + A) – (capital expenditures necessary to maintain economic position) • Look for companies with high profit margins. • Want company’s management to view earnings as belonging to the shareholders. • For every dollar retained, make sure the company has created at least one dollar of market value. • What is the value of the business? • Can the business be purchased at a significant discount to its value? • “Margin of safety” to protect against mistakes • Focus of Benjamin Graham

26. Investing in a Business: the Warren Buffett Approach • Advantage of stocks over bonds • Stocks have opportunity for growth in yields • “Margin of safety” vs. “margin of protection” • “Margin of protection” comes from investing in successful companies • Get good growth opportunities even if stock never moves all the way up to its intrinsic value • Contribution to Warren Buffett’s thought from Philip Fisher

27. Universe of stocks • No limitation on stock size, but analysis requires some operating history Criterion for initial consideration: • Consumer monopoly, not “commodity-based” business • Strong management • Business that is easy to understand & analyze • also must have ability to adjust prices for inflation

28. Indications of capable management: • Strong upward trend in earnings • Conservative financing • Consistently high return on S/H’s equity • High level of retained earnings • Low level of spending needed to maintain current operations • Profitable use of retained earnings

29. Valuing the Stock • You’ve found a promising company, now how much should you pay for it?? • Buffett uses several approaches, incl: • Compare investment in bonds: • relative value = EPS / LT T-bond yield • Project value forward using historical data: • estimate growth rate in EPS using past 10 years’ worth of earnings data • future EPS = current EPS * (1 + est. g) • multiply by high & low P/E’s over past 10 years to get estimated future price range for stock • Q: will this future price allow 15% return?

30. Monitoring / When to Sell • Prefer investment in small no. of companies that investor can know & understand extensively • Diversification not favored • hold for long term • hold as long as company remains “excellent” • consistently growing • quality management operating for S/H’s benefit • Sell if: • these circumstances change, or • alternative investment offers a better return

31. “Invest in What You Know”: the Peter Lynch Approach • Wrote “Beating the Street” • Bottom-up approach, selection from among companies with which investor is familiar, then through fundamental analysis that emphasizes a thorough understanding of the company, its prospects, its competitive environment, and whether the stock can be purchased at a reasonable price

32. Philosophy • Investment in companies in which there is a well-grounded expectation concerning the firm’s growth prospects and in which the stock can be bought at a reasonable price • A thorough understanding of the company and its competitive advantage is the only “edge” that investors have over other investors in finding reasonably valued stocks • Find a “story” for the stock: • slow growers, stalwarts, fast-growers, cyclicals, turnarounds, asset opportunities

33. Universe of Stocks • All listed and OTC stocks, but ... • Size DOES matter! • Other than that, specific criteria depend on company’s story, but factors to examine include: • earnings - stability & consistency w/ an upward trend • P/E in lower range of historical average • P/E below industry average • (P/E) < (g + D/P) / 2 • low levels of debt financing relative to equity financing • high levels of net cash per share • if co. pays a dividend, look for low payout ratio but long records of regularly increasing dividends • esp. for cycicals, want inventory growth < sales growth

34. Other Favorable Characterisitics • Boring name, product, or service; or company does something disagreeable or depressing; or rumors of something bad about the company • spin-off • fast-growing company in a no-growth industry • niche firm controlling a market segment • repeat-purchase product that customers must keep buying even in bad times • not a technology producer, but can take advantage of technological advances • low % of shares held by institutions; little analyst coverage • insiders buying shares • company buying back shares

35. Unfavorable Characteristics • Hot stock in hot industry • Companies (particularly small firms) with big plans that are yet to be proven • Profitable companies involved in diversifying acquisitions (“di-worse-ifications”) • Companies in which one customer accounts for 25% - 50% of sales

36. Monitoring / When to Sell • As with Fisher & Buffett, • don’t diversify simply for the sake of diversification, esp. if it means less familiarity w/ firm • for diversification, invest in several categories of stocks, but invest in few enough firms that you can still fully research & understand each firm • don’t put all your eggs in one basket, but don’t use so many different baskets that you can’t watch them all!

37. Monitoring / When to Sell • Review holdings every few months, rechecking the company’s “story” to see if anything has changed - sell if: • the story has played out as expected or • either something in the story fails to unfold as expected or fundamentals deteriorate • Price drops should be viewed as opportunities to buy more of a good prospect at cheaper prices • Consider “rotation” - selling played-out stocks with stocks w/ a similar story but better prospects • Maintain a long-term commitment to the stock market & focus on relative fundamental values

38. A sampling of other approaches: • Growth (less emphasis on value per se) • The Motley Fool –Rule Breaker / Rule Maker • Geoffrey Moore –The Gorilla Game • George Gilder –Telecosm Paradigm • Quantitative • Robert A. Haugen – The Inefficient Stock Market • Technical Analysis • Martin J. Pring and John J. Murphy