Wealth management session 3

Welcome to the Wealth management course S G Raja Sekharan

. World’s wealthiest five - Forbes Feb 2010 Carlos Slim Helu –Mexico -$ 53.3 B – Mobile companies William Henry Gates –US - $ 53 B –Microsoft Warren Buffet – US - $ 47 B –Berkshire Hathway MukeshAmbani –India $ 29 B – Reliance Industries LakshmiMittal –UK -$ 28.7 B – ArcelorMittal

. Warren Buffet –The sage of Omaha One of the most successful investors in the world Noted for his adherence to “Value Investing” Also known for his personal frugality Born in 1930, second of three children, father was a stock broker and politician Early in school age, he started earning by selling soft drinks and delivering paper At 14 years, with his earning, he bought 40 acres of land –which he rented out He went to Columbia for graduation - studied under Benjamin Graham –father of Value investing

. Warren Buffet –The sage of Omaha Benjamin Graham refused to hire him –saying Stock broking and Wall street was not for him Warren Buffet came back –got married and stayed in Omaha with his father’s brokerage Benjamin Graham changed his mind and gave him a job in his NY office Value investing means seeking stocks selling at extraordinary discounts to the value of it’s underlying assets –defined as “Intrinsic value” Buffet went a step beyond Value investing – he looked at the value of a good management team, product’s competitive advantage in marketplace

. Warren Buffet –The sage of Omaha In 1956, he came back to Omaha and launched Buffet Associates Ltd In 1962, already a 30 year old millionaire –he joined forces with Charlie Munger This collaboration eventually resulted in the investment philosophy of Value investing that helped Buffet to get where he is today Along they way, they purchased a dying textile mill called Berkshire Hathaway - as a long term investment Cash flows from this mill were used to fund other investments – eventually other investments overshadowed the textile business In 1985, Buffet shut down the textile business – but continued with the company as a holding company

. Warren Buffet –The sage of Omaha Buffet pick up stocks in what he believes are well managed under valued companies When he purchases any stock – his intention is to hold the stocks for infinite period of time Coke, Amex, Gillette etc are such stocks held by him for many decades He also purchases companies outright and let’s their management teams handle their day to day business

. Warren Buffet –The sage of Omaha An investor and a businessperson should look at a company in the same way. The businessperson wants to buy the entire company while an investor wants a part The first question any businessperson will ask is, ‘‘What is the cash generating potential of this company?’’ Over time, there will always be a direct correlation between the value of a company and its cash generating capacity. The investor would benefit by using the same business purchase criteria as the businessperson

. Warren Buffet –his investment philosophy The basic idea of investing are to look at stocks as business, use the market’s fluctuations to your advantage, and seek a margin of safety. Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right Once a good company is identified and purchased at an attractive price, it is held for the long-term until the business loses its attractiveness or until a more attractive alternative investment becomes available.

. Warren Buffet –his investment philosophy Buffett seeks businesses whose product or service will be in constant and growing demand. In his view, businesses can be divided into two basic types: Commodity-based firms, selling products where price is the single most important factor determining purchase. Buffett avoids commodity-based firms. They are characterized with high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is key for the long-term success of these types of firms.

. Warren Buffet –his investment philosophy Buffett seeks businesses whose product or service will be in constant and growing demand. In his view, businesses can be divided into two basic types: Consumer monopolies, selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.

. Warren Buffet – there are three types of consumer monopolies Businesses that make products that wear out fast or are used up quickly and have brand-name appeal that merchants must carry to attract customers. Nike, McDonalds, Drug companies with patents are good examples Communications firms that provide a repetitive service that manufacturers must use to persuade the public to buy the manufacturer's products. Advertising agencies, magazine publishers, newspapers, and telecommunications networks are good examples Businesses that provide repetitive consumer services that people and businesses are in constant need of. Tax preparers, insurance companies, investment firms are good examples

. Warren Buffet – how does he spot a commodity based business The firm has low profit margins (net income divided by sales) The firm has low return on equity (earnings per share divided by book value per share) Absence of any brand-name loyalty for its products The presence of multiple producers The existence of substantial excess capacity Profits tend to be erratic The firm's profitability depends upon management's ability to optimize the use of tangible assets.

. Warren Buffet – how does he spot a consumer monopoly The firm has managed to create a product or service that is somehow unique and difficult to reproduce by competitors due to Brand name loyalty A particular niche that only a limited number of companies can enter An unregulated but legal monopoly like patents A strong upward trend in earnings Conservative financing A consistently high return on shareholder's equity A high level of retained earnings Low level of spending needed to maintain current operations Profitable use of retained earnings

. Warren Buffet –his investment philosophy While Buffett is considered a value investor, he passes up the stocks of commodity-based firms even if they can be purchased at a price below the intrinsic value of the firm. An enterprise with poor inherent economics often remains that way.

. Warren Buffet –his investment philosophy Investment in stocks based on their intrinsic value, where value is measured by the ability to generate earnings and dividends over the years. Buffett targets successful businesses--those with expanding intrinsic values, which he seeks to buy at a price that makes economic sense, defined as earning an annual rate of return of at least 15% for at least five or 10 years.

We will now get into specifics There are 14 questions that we need to answer We will take one corporate example –CRISIL to understand the overall flow of thoughts

. Questions to determine the attractiveness of business – Q1 Is it a consumer monopoly or commodity business –does it have an identifiable durable competitive advantage? Consumer monopolies typically have high profit margins because of their unique niche Beyond high profit margins, look for companies with operating margins and net profit margins above their industry norms Also look for strong earnings and high return on equity will also help to identify consumer monopolies. Look at a detailed study of the firm's position in the industry and how it might change over time. CRISIL – Yes –it is a pioneer, market leader and an well known brand in India

. Questions to determine the attractiveness of business – Q2 Do you understand how the product /service/business model works? Only invest in industries that you understand – for example Buffet refused to invest in ecommerce companies during the dot com boom because he did not understand their business CRISIL – Yes – corporates want their financial instruments rated –Crisil rates them and corporates use this rating to advertise their credibility.

. Questions to determine the attractiveness of business – Q3 What is the chance that the product /service/business model would be obsolete in the next 20 years? Will there be a market for this product 20 years from now If there is going to be technological changes envisaged, then will this company have an upper hand still? CRISIL –rating is an expert’s job that cannot be automated. There will always be need for rating and corporates will need this service

. Questions to determine the attractiveness of business – Q4 Does the company allocate capital exclusively in the realm of expertise? Where have been their investments in the past 5-10 years? Does the company stick with what it knows? CRISIL – Yes it does not seem to be spending outside it’s area of expertise

. Questions to determine the attractiveness of business – Q5 What has been the company’s EPS history and growth rate The company must show a consistent growth in EPS over the past 10 years Erratic growth and dips in EPS would mostly make the company unattractive for investment unless there is a clear enough reason visible as to why it happened.

CRISIL’s EPS growth rate ( last 10 years) CAGR of EPS adjusted for shares issued for the period is - 27.8%

. Questions to determine the attractiveness of business – Q6 Is the company consistently earning high Return on equity The company must show a consistently high ROE over the past 10 years – ROE = reported net profit /Net worth CRISIL – has an ROE ranging from 13.5% to 39.5% with an average ROE of 23%

. Questions to determine the attractiveness of business – Q7 Is the company consistently earning high Return on total capital? The company must show a consistently high Return on total capital employed over the past 10 years ROCE = Reported net profit /Total liabilities in BS CRISIL – as they have no loans – the ROE and ROCE are the same and the average ROCE is 23%

. Questions to determine the attractiveness of business – Q8 Is the company conservatively financed? Consumer monopolies tend to have strong cash flows, with little need for long-term debt Screen for companies with no debt or low debt – look at the interest coverage ratio –compare with industry peers CRISIL – has no loans in it’s balance sheet – it is very conservatively financed

. Questions to determine the attractiveness of business – Q9 Has the company been buying back its shares? Buffett prefers that firms reinvest their earnings within the company, provided that profitable opportunities exist. When companies have excess cash flow, Buffett favours shareholder- enhancing manoeuvres such as share buybacks CRISIL – No -it has not yet bought back shares – in fact it has issued small amount of shares in the period 2003 to 2007

. Questions to determine the attractiveness of business – Q10 Is the company free to adjust prices to inflation? True consumer monopolies are able to adjust prices to inflation without the risk of losing significant unit sales. CRISIL – Yes – it can increase it’s prices as it is in a near monopoly market

. Questions to determine the attractiveness of business – Q11 Does company need to constantly reinvest in capital? Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better. CRISIL –Really no - it’s business model depends on it’s credibility and quality of manpower employed and the knowledge retention – these do not need large amount of investments

. Questions to determine the attractiveness of business – Q12 What is the initial rate of return (IRR) and relative value to a Govt bond? EPS for the year divided by the long-term government bond interest rate. The resulting figure is the relative value - the price that would result in an initial return equal to the return paid on government bonds. We then have to look at the CAGR of the EPS as well. CRISIL – assuming a 8% govt bond rate – and based on the current EPS of 212.43 – the relative value of govt bond would be –Rs 2655.37. With the current share price of Rs. 6132 – the Crisil share gives a pretax return of 3.46% with the returns growing at 27.8% pa

. Questions to determine the attractiveness of business – Q13 What is the projected share value and return on investment using historical earnings growth rate: Calculate the CAGR of EPS for the past 10 years Calculate the average dividend payout ratio (DPS/EPS) for the past 10 years Calculate the average PE for the last 10 years CRISIL – CAGR of EPS is 27.8% Average Dividend payout ratio is 33.95% Average PE for the last 10 years has been – 20.55

. Questions to determine the attractiveness of business – Q13 What is the projected share value and return on investment using historical earnings growth rate: Calculate the EPS for the next 10 years as follows: EPS of year 2 = EPS of year 1 * CAGR of EPS Calculate the dividend payout for the next 10 years as follows: Dividend payout for year 2 =EPS for year 2 * average DP ratio Calculate the sum of all the dividends paid for the next 10 years

Crisil –Historical earnings growth rate method

. Questions to determine the attractiveness of business – Q13 What is the projected share value and return on investment using historical earnings growth rate: Projected share price at 10th year = EPS at 10th year * Average PE ratio Total estimated gain at the end of 10th year = Projected share price at 10th year + Sum of all dividends for 10 years Calculate the CAGR of your investment in 10 years – FOR CRISIL THIS IS 24.37%

. Questions to determine the attractiveness of business – Q14 What is the projected share value and return on investment using sustainable growth rate: Calculate the average PE ratio for the past 10 years -20.545 Calculate the average ROE for the past 10 years -23% Calculate the average dividend payout ratio for the past 10 years – 33.95%

. Questions to determine the attractiveness of business – Q14 What is the projected share value and return on investment using sustainable growth rate: Calculate the Book value of the share for the next 10 years using the formula: BV for year 2 = BV for year 0 + Retained earnings for year 1 Retained earnings for year 1 = Projected EPS for year 1– Projected Dividend Payout for year 1 Projected EPS for Year 1 = average ROE * BV for Year 0 Projected dividend payout for year 1 = EPS for year 1* average Dividend payout ratio for past 10 years

. Questions to determine the attractiveness of business – Q14 What is the projected share value and return on investment using sustainable growth rate: Calculate the EPS for year 10 Calculate the expected Share Price for year 10 = EPS (FY10)* Average PE To this share price estimate, add the estimated dividends paid for the next 10 years Calculate the expected CAGR of your investment today

Wealth management session 3

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