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Book summary the five rules of successful stock investing
1. Book Summarization:
The Five Rules of
Successful Stock
Investing
Pat Dorsey, CFA, Dircetor, Morningstar
Successful Investing is SIMPLE but it is
NOT EASY
2. Author’s Background
• CFA, Director of Equity Research at Morningstar, Inc.
• Played an integral part in the development of the Morningstar Rating for stocks, as
well as Morningstar's economic moat ratings.
• Also author of The Five Rules for Successful Stock Investing: Morningstar's Guide to
Building Wealth and Winning in the Market (Wiley).
• He holds a master's degree in political science from Northwestern University and a
bachelor's degree in government from Wesleyan University
3. Disclaimer
• Author proposes a structured method to analyze and invest in a proven and
process driven method to avoid mistakes, however, this is only one of the ways
of successful investing. This may not be a full proof solution but the probability of
success is good
• Contents presented are view of author and his firm Morningstar either directly
taken from book or their presentations (all credit to them) or it may be a self
interpretation of message author is trying to communicate (wherever necessary)
4. Book Content
• Investment Philosophy and Application
– Five Rules to follow
– Seven Mistakes to avoid
– Understanding of Economic Moats
– Basics of Finance
– Analyzing Company – Basics, Finance, Management
– Avoiding Financial Fakery
• Valuation Philosophy and Application
• Industry Philosophy and Application
– Healthcare
– Services
– BFSI
– Software
– Hardware
– Media
– Telcom
– Consumer Goods
– Industrial Materials
– Energy
– Utilities
6. Five Rules to Follow
1. Do your homework
― Unless you know the business inside and out, you should not buy the stock
― Read, Read, Read : AR, Transcripts, Competition AR, Industry Reports
2. Find economic moats
― Capital chases areas of growth and higher returns, firms with economic moat
survive and maintain profitability
― ECONOMIC MOAT is firm’s competitive advantage
3. Have margin of safety
― Goal of any investor should be to buy stocks for less than they are really worth
because future has a nasty way of turning out worst than expected
― Difference between market value and estimated value is MARGIN OF SAFETY
― Margin of safety should proportional to uncertainty of firm’s predictable earnings
7. Five Rules to Follow
4. Hold for long term
― Avoid taxes and brokerages else you need to work harder to compensate
5. Know when to sell
― Constantly monitor the companies you own, rather than stocks you own
― Has the stock dropped or skyrocketed?
― Have your assumptions changed?
― Did you make a mistake?
― Have fundamentals deteriorated?
― Has the stock risen too far above intrinsic value?
― Is there something better you can do with money?
9. Seven Mistakes to Avoid
1. Swinging the fences
― Don’t try to keep finding next Microsoft in every microcap. Behind
every successful Microsoft, 100s failed one
― Ties back to finding great companies with strong economic
moats
2. Believing that it is different this time
― IT Boom – its different this time. Cash flow doesn’t matter but
eyeballs
3. Falling in love with products
― Fall in love with good businesses with economic moats, not with
products, specially technology based as innovation disruption
cycle is fast
10. Seven Mistakes to Avoid
4. Panicking when the market is down
― Articles titled “Death of Equities”, “The long bull”
5. Trying to time the market
― Historical Analysis says BUY & HOLD has given better returns
― No one knows the immediate future
― Stock markets are skewed – Bulk of returns (+ve or –ve) comes in
few days
6. Ignoring valuations
― Buying a good business is half work done, buying at right valuation
is other half
7. Relying on earnings for the whole story
― Look for cash earning not accounting earning
12. What’s A Moat?
• Capital seeks the areas of highest potential return, so all firms face
competition that seeks to force down high returns on capital.
– But some firms generate high returns for a very long time.
– How? By creating economic moats around their businesses.
• An economic moat is a structural business characteristic that allows a
firm to generate excess economic returns for an extended period.
– Note that “structural” means “inherent to the business.”
– Smart managers and great execution are important, but they’re not structural
attributes.
13. What’s A Moat?
The key to having an economic moat is the sustainability of excess
returns, rather than the absolute level of return on capital.
A company with 40% returns on invested capital (ROIC) due to a hot product
has no moat. The returns cannot be forecasted with any level of confidence.
Fashion stocks (Crocs, Heelys), Motorola Razr
A company with 12% ROIC – and a low cost of capital – that is structurally
protected from the competition may have a wide economic moat, because
we can forecast those returns with a high degree of confidence.
Pipelines, Railroads
15. 15
• Intangible assets
– Brands: Does it increase the consumer’s willingness to pay, or reduce
search costs?
– Sony vs. Tiffany
– Doublemint & Juicy Fruit
– Patents: Valuable, but subject to expiration & challenge.
– Big pharma vs specialty pharma
– Licenses & Government Approvals.
– Waste haulers, aggregate companies
Sources of Economic Moats
16. 16
×Switching Costs: Do the costs – in time or money – of switching to
a competing product/service outweigh the benefits?
– Monetary/Labor Costs
– -Oracle
– -Autodesk
– -Data processors
– Low or uncertain benefits from switching
– -Amazon
– -Asset managers
Sources of Economic Moats
17. 17
• The Network Effect – One of the most powerful types of competitive
advantage, which occurs when the value of a good or service increases
with the number of users.
• Examples of the Network Effect
– eBay
– Western Union
– MasterCard, American Express, Discover, Visa
– Microsoft
– Financial Exchanges
Sources of Economic Moats
18. 18
• Cost Advantages – Not necessarily tied to size
– Process – Invent a cheaper way of delivering a good or service that rivals
cannot (or will not) replicate. Dell, Nucor, Steel Dynamics, Southwest/other
LCCs.
– Low-cost resource base – Ultra Petroleum, Compass Minerals.
– Scale
– -Distribution – Stericycle, Cintas, Sysco, UPS
– -Manufacturing – Intel
– -Niche Markets/Single-Scale Efficiency – Graco, Blackbaud
Sources of Economic Moats
19. 19
What’s Not An Economic Moat
• Size / Dominant Market Share: High market share does not give a firm a
moat. (Ask Compaq – or GM.) In fact, market share may be irrelevant –
bigger is not necessarily better.
• Technology: What one smart engineer can invent, another can improve
upon. (Exception: Creating a standard that’s widely adopted.)
• Easily-replicable cost advantages (lean manufacturing, outsourcing.)
• Hot Products: Krispy Kreme, Tommy Hilfiger, Crocs, Iomega, etc.
– Can generate high returns on capital for a short period of time, but sustainable
returns are what make a moat.
20. 20
What’s Not An Economic Moat
• Management: Smart managers may create a moat over time, but
great management is not a moat by itself.
× "Go for a business that any idiot can run – because sooner or later, any idiot
probably is going to run it." – Peter Lynch
× “When management with a reputation for brilliance tackles a business with a
reputation for poor economics, it is the reputation of the business that
remains intact.” – Buffett
– Management matters, but moats matter more.
21. 21
Where Morningstar Finds Economic
Moats
• Three groups: Wide, Narrow, and None.
• Wide moats are tough to find. Less than 10% of the 2100 companies
that we follow have wide economic moats. (169, to be precise.)
• Moats vary by sector & industry.
– Fewer moats in highly commoditized or competitive sectors like computer
hardware, consumer services (retail/restaurants), or industrial materials. Only
1/3 of the companies in these three sectors are wide/narrow moat.
– More moats in areas with high switching costs (data processors) and durable
brands (consumer products),
22. 22
Why Moats Matter
• When comparing two companies with similar growth rates, returns
on capital, and reinvestment needs, the company with the moat
has a higher intrinsic value.
• Underestimating a moat results in opportunity cost, while
overestimating a moat can cause you to pay for value creation
which never materializes.
• Some fast-growing companies are worth the premium, because
the excess returns are more likely to persist. If a firm has a wide
moat that will allow it to reinvest cash flow at a high rate of return
for many years, what looks expensive may actually be quite a
bargain.
23. 23
Why Moats Matter
“Time is the friend of the wonderful business, affording it the
opportunity to reinvest incremental capital at favorable rates and
increase the value of the enterprise. Over time, the price you paid
for a terrific company looks cheaper and cheaper. For the inferior
business at the cheap price, time may turn out to be the fell
destroyer.“
– Bob Goldfarb, Sequoia Fund
• Moats enforce investment discipline.
– High returns on capital will always be competed away – eventually.
– For most companies (and their investors), the regression to the mean is fast and painful.
– But a few generate excess returns for many years, and moats give us an analytical framework for
selecting them.
24. 24
Why Moats Matter
• Companies with moats have greater resilience.
– If a firm can fall back on a structural competitive advantage, it’s more likely to
recover from temporary troubles.
– This is a great psychological backstop for the investor who’s buying when
everyone else is screaming “sell!”
– If you’re confident in the moat, it’s easier to average down if you initiate a
position too early.
YTD
Trailing
1-Year
Trailing
3-Year*
Trailing
5-Year*
Morningstar Wide Moat
Focus Index (ETN Ticker:
WMW)
41.6% 9.3% 6.0% 9.0%
S&P 500 Index 20.5% -9.1% -4.8% 1.0%
30. Analyzing Company : Basics
1. Growth
2. Profitability
3. Financial Health
4. Risk/Bear Case
5. Management
31. Analyzing Company : Growth
• Analyze levers of growth:
– Selling more goods and services
– Raising Prices
– Selling new goods and services
– Buying another company
• Analyze quality and sustainability of growth
• Questioning quality : accounting and cash growth mismatches
– Receivables
– Taxes
– One time gains and losses
• Skeptics to acquisitions
32. Analyzing Company : Profitability
• Operating Profit and PAT margins : Value and
Stability
• Return on Equity : 10% for normal business and
12% of banks (due to leverage)
• Return on Capital Employed
• Return on Assets
• DuPont Analysis
• Free Cash Flow
• FCF to Sales Ratio : More than 5% is worth looking
• Profitability Matrix
Reinvesting and
generating high
returns
Not generating
enough returns and
reinvesting
High returns and no
need for
reinvestment
33. Analyzing Company : Financial Health
• Financial Ratios : Liquidity
• Financial Leverage: Asset by Equity. More than 4 is risky
• Debt to Equity: Long term debt per dollar of equity
• Time Interest Earned : EBIT/Interest
• Current Ratio: Current Asset/Current Liability. Liquidity status. Approx. 1.5 is good
• Quick ratio: Current Assets minus Inventories divided by current liabilities. More stringent
34. Analyzing Company : Risk
• Understand business and key risks
• Read, Read, Read
• Track, Track, Track
35. Analyzing Company : Management
• Compensation, Character and Operations
Compensation Character Operations
• Subjective topic
• Salary as a % of PAT ~ 2%
• Prefer big bonus to big base
• Prefer restricted stock to
generous options : Neck in
performance
• Competitive firm scenario
• Quality of compensation policy
• Any rewards for acquisition
• Forgiven loans
• Excessive Perks
• Frequent use of stock options
• Additional stocks despite big
shareholding
• Skin in the game
• Subjective topic
• Related party transaction
• Board composition and
independence
• Ability to accept mistakes
• Over Commitment-Under
delivery/tone of management
• Talent retention
• Ability to make tough decisions
• Performance
• Promises and Follow Through
• Candor
• Self-Confidence
• Flexibility to operate
37. Avoiding Financial Fakery
• Six Red Flags:
– Declining cash flows : Rising income and declining cash flows is a warning sign
– Serial Chargers : Be wary of frequent one time gains and one time write downs
– Top Level Exits : Timing of exit sometimes are signals
– Serial Acquirers : Need to have extra lens as it can hide lot of things in one go
– Bills are not being paid
– Change in credit terms and accounts receivables
• Some Other Pitfalls:
– Gains from Investments
– Pension Pitfalls
– Pension Padding
– Inventory Pileup
– Frequently changing accounting policies like depreciation accounting
– To expense or not to expense
39. Valuations : The Basics
• Stock returns have 2 components:
– Investment Return: Due to dividend and growth in profitability
– Speculative Return: Change in PE
• Over a long period of time, impact of investment return triumphs impact of speculative return
• If you find great companies, value them carefully, and purchase them only at a discount to a reasonable
valuation estimate to stay fairly well insulated against the vicissitudes of market emotions
• Being picky about valuations is not fun. It means letting many pitches go by and watching many stocks
run but disciplined valuation greatly increases your batting average – and also limits the odd of a real
blow up damaging your portfolio
• Using Price Multiples:
– Price to Sales
– Price to Book
– Price to Earnings
– Earnings Yield
– PEG
40. Valuations : The Basics
• P/S can good as sales numbers are little difficult to fudge, however, it does not reflect profitability,
leverage and capital allocation skills
• Be highly skeptic of firms having sizable goodwill to their order book
• A firm with low P/B and a high ROE could be a bargain
• Good things about financial firms and P/B value is as book value are marked-to-market, they are
reasonable current
• Comparing current PE with historical PE for stable firms can be useful
• High growing firms are less comparable to their historical PE
• A P/E is a relative evaluation concept. Also, check the following:
– Has the firm sold a business or asset recently?
– Has the firm taken a big charge/one time charge recently?
– Is the business cyclic?
– Do the firm capitalize or expense its cash flow generating asset?
– Is the E real or imagined?
41. Valuations : The Basics
• Risk and Growth often go hand in glove. This conflation of risk and growth is why PEG is frequently
misused. Don’t assume all growth as equal with same amount of capital requirement and risk exposure
• Yields can be compared to alternate investments like bonds
• The best yield valuation is cash return which FCF/Enterprise Value, better than P/E.
• The goal of cash yield is to measure efficiency of business while using equity and debt capital
• Be highly skeptic of firms having sizable goodwill to their order book
• A firm with low P/B and a high ROE could be a bargain
• Good things about financial firms and P/B value is as book value are marked-to-market, they are
reasonable current
• Ratios do not tell value of stock, the actual worth
42. Valuations : Intrinsic Value
• The value of a stock is equal to the PRESENT
value of its FUTURE cash flows. No more and
no less – Irving Fisher and John Burr Williams
• FCF – Dividends, Reinvestment, Buybacks
• Intrinsic Value is impacted by:
– Amount of FCF – Understanding of growth,
profitability, operations and CAPEX
– Time Value of Money : When the cash flows are being
generated
– Risk Premium : What is discount rate to be paid
43. Valuations : Intrinsic Value
• Discount Rate
– No precise way to find exact discount rate
– Discount Rate = Long term average of treasury rates + Risk Premium
– According to financial theory, risk is same as volatility and can be measured by beta
– Risk should be accessed by looking at company and not stock, and that a firm’s riskiness is determined
by the likelihood that it will or it won’t generate the cash flows we are forecasting
– Hence, risk is a chance of permanent capital impairment driven by multiple factors like size, financial
leverage, cyclacity, management, governance, economic moat and accounting complexity
– Difficult to find riskiness, so, categorize as Low (3% risk premium) , Medium (6%) and High (9%)
– Don’t try to find accurate discount rate but right discount rate
• Margin of Safety
– Any valuation or analysis is subjected to error due to future uncertainty and to minimize the effect of
these errors, stocks should be purchased at a discount to estimated intrinsic value and this discount is
called the margin of safety
– 20% - 40% margin of safety based on stability and strength of economic moat of the firm