"Make it your mission to understand & invest wisely. Everyone has the potential to succeed in their search for true wealth & happiness & everyone can be successful in their pursuit of financial freedom." Contrarian Invest

Tuesday, 11 December 2012

From Basic to Business

I’ve decided to start communicating some of my thoughts about the shares on the stock exchange to people that expressed interest in the subject. Being a Warren Buffett fan my newsletters will be based on the solid investment guidelines Buffett laid down. The newsletter is for forward-thinking individuals who plan their lives and work towards goals. Most newsletters will start or end with some tasty Buffett quote that should wake your appetite for yet more intelligent investing.

1. Newsletter one – for forward thinking individuals

PE’s and DY’s

Investors are investing for one purpose only: PROFIT.

The basic ideas of investing are to look at stocks as businesses, use the market fluctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us and a hundred year from now they will still be the cornerstones of investing.”

- Warren Buffett - 1994

How wise. I believe PE’s and DY’s are neglected in seeking our margins of safety and spotting fluctuations. Here’s the wrap from basics to business:

PE’s and DY’s are so commonly available in papers and magazines that we tend to skip over them without putting some thought into what they ought to be telling us. PE ratios (price:earnings ratios) tell us what we’ll pay for what your business is earning (based on the latest financial results).

Basics (If you know what PE’s and DY’s are skip to the “business” heading below!)
A PE of 10 means your would pay R10 for every R1 the company earns in net profit. Not all of these earnings come your way as dividends. The directors choose to allocate earnings either back to the business or as dividends to you. Take the calculation a bit further: Say you invested R10000 in a company with a PE of 10, then your company made R1000 profits for your shares. If you calculate earnings yield (earnings/investment = R1000/R10000 = 10%) you see that the company used your R10000 to add another 10% (R1000) of profit to it.

To me it makes sense not to pay too much for what your company currently earn and will earn – I try to stick around PE’s of under 12, but will go up to 16 if future earnings potential is great. The problems with anything “future” is that it is unsure. Therefore buying shares with PE’s of 20 or 30 doesn’t make sense to me: It obviously already discounts future earnings, so what will happen if a major disaster causes future earnings to me the same as current earnings? Earthquakes and tsunami’s do happen…

Dividend yield is a return-on-investment calculation that tells us what cash you could expect back from your business. What you get is tax free – the company already paid tax on it (called secondary tax). If you invest R10000 in a company, and the dividend yield is 4%, you should get a dividend of R400. Now getting only 4% back sounds silly if you could get 7.5% in the bank…? What happens to the other 6% of the 10% profit on your investment?

Theory goes that if a company re-invests that 6% into itself, they should have better profits next year (implying your dividend yield might rise to, say 5.25% on the original investment). Assume the company added an additional production plant with the extra earnings and settled some debt.

The company’s assets therefore increased (they have a new plant which is likely to grow in value). If they purchased the property as well, the property value would also increase. Settling debt means that there are less liabilities and less interest to pay. The effect this all has is that you now have ownership in a company that has more property, production capacity. Calculate the net worth of your company now by deducting liabilities from assets, and you have a considerably higher net worth – not just 6% more.

On the income statement the increased capacity delivers better output and hopefully sales. Subtract the company’s expenses (which included the reduced interest on debt) and you have an increase in cash flow – of surely not just 6% - but considerably more. Your reward is increase in asset value as well as an increase in profits. Share-hunters notice your company and price it at fair value, taking into consideration the increase in asset value and profits. And your share price rises with 30%. Well, that’s the theory.

It might sound as if I’m promulgating companies that pay very low dividends to ensure that earnings go towards re-investing and expansion of the business. I’m not. I like dividends and I like cash. For the only reason that if I get a cash dividend of 4%, I know that I have a few rands already in the bank. And there’s very little risk of loosing that 4% that sits safely in the bank earning interest.

Spot a company with low PE value, offering some dividend to keep aside as a margin of safety, and then further looking at GOOD companies trading close to or even less than their net asset value, you might have a real gem in hand. Do your research thoroughly and make sure the market hasn’t priced it cheap for a reason it might know and you are yet to discover.

Happy investing!

2. Newsletter two – Invest in what you understand

To me, investing is… sort of… say “chicken business.” Here’s why.

When I started investing I was tempted to make the quick buck. “Play warrants”, they said, so I opened a warrant trading account. “Buy Sanlam call warrants”, they said, “they annual results are out tomorrow and we think it’s going to be extremely good”.

Well, it was good. But investors already expected it. In fact, they expected better, so the share price fell a few percent, and my warrant’s all lost me quite an amount as stop losses triggered.

I took a conscious decision never again to buy into something I don’t understand, whether it’s a company or the use of an unknown financial instrument. I probably missed a few opportunities, but I sleep sound now, knowing that my finances are dependent on research, not luck.

How does an investor decide on where he puts his money amongst the hundreds of companies on the JSE? What companies are out there, that are easy to understand well in order to gauge their profit potential as an investor?

Warren Buffett “missed out” on the IT boom. He chose not to invest in things he didn’t understand. He might have missed on the miracles such as Google, but he also missed out on the .com bomb. He invests in what he understands, and he is one of the richest people in the world.

I do actually have shares in a chicken business – Astral (ARL). I believe trends are converging on chicken as primary source of protein: Rich people are eating more and more of it because it’s healthy. Poor people sharing in economic upliftment can now afford something better than just maize. Risks are things like Avian influenze, nbut they have strong control measures in place. And besides all that, I like a juicy chicken just as much as “braaivleis”.

Personally, I own only 5 shares at this moment. I understand all 5. I spent at least 8 hours of research on each of them before I actually invested in any one of them. I understand what the main drivers are for future demand of their products or services. I know how economic changes impact on them. Perhaps I share Buffett’s view he expressed when he said:

“All we want is to be in business that we understand, run by people whom we like, and priced attractively relative to their future prospects” (Buffett 1994)

I noticed today that Buffett is looking for an investment in South Africa. He makes specific mention that they’ll apply the same criteria here as anywhere else. Business is business, and South Africans have ample opportunities – even Buffett thinks so.

Happy investing!

3. Newsletter three – Go small or go home.

One of the first things academic investment managers would tell you is to diversify. Spread the risk. Diversify across sectors or companies within one sector.

Well well... How should I, having a rather full time job as well, do my homework well and keep up to date on latest news and developments in my portfolio of 50 companies? The fund manager that has nothing else to do might find time to do this. And he wants money for it.

If you want to diversify, give your cash to a fund manager who gets paid to do that for you. Or invest in Satrix 40 shares (which are a basket of underlying shares of the JSE top 40 shares). By owning Satrix shares you are in fact diversifying over all the top 40 shares.

And that, in itself, is not a bad thing to do if you are a beginner and want to learn how to trade. But, for the more advanced investor, let’s go back to our Buffett-roots. Let’s think about this - critically.

Firstly, as I mentioned, time constraints does not allow us modern working individuals to really spend days on analyzing shares. We have a Saturday or Sunday maybe. It takes me at least one full day to do initial research into a company. Information abounds, and working through everything on the internet that was recently published, takes a lot of time. If I had to analyse 400 businesses on the JSE I’d either spend 10 minutes on each, or spend a lifetime doing all of them.

But the second facet is more important – and that is the quality of your understanding of what the research tells you. I’d like to quote something here: It’s from the book “The Warren Buffett Way” by Robert G. Hagstrom. He explains Buffett’s peers and educators and makes the following mention about investor Philip Fisher:

“Fisher found a simple way to reduce his workload – he reduced the number of companies he owned. He always said he would rather own a few outstanding ones than a large number of average ones. Generally, his portfolios included fewer than ten companies, and often three to four companies represented 75% of his entire equity portfolio.”

When I came across this section in the book I felt relieved. The insurmountable amount of shares I planned to keep an eye on was suddenly reduced to a select few.

Two last comments on NOT diversifying: The more you diversify, the more you average out. Yes, you average out risk, but you also average out performance and time for quality research. If you want to out-perform the market (and you can) you have to be intelligent about it and find companies that would outperform the average. You also need more than average time to do your homework.

Secondly, if someone tells me there is less risk in a diversified portfolio than my own little portfolio of 4 to 7 shares, I’ll laugh out loud (Not really, I’ll be polite & courteously tell him or her I disagree).

I sleep more soundly with my few shares, chosen because I know them so well that I understand the risks and I can therefore manage them. I expect extraordinary performance from them over years to come. I am pretty sure that my few shares are more resistant to interest rate hikes than a group of shares. I know how they react to exchange rate changes, oil price hikes, demographic changes, etc. And with this I can deal decisively.

One comment on why I believe ownership in equities via managed funds is more dangerous than directly managing your own portfolio. Suppose the oil price suddenly drops because someone finds an alternate source of energy and is able to supply in quantities that reduce the demand for oil. Fund managers all over the world notice the trend and start selling out of companies like Sasol. Suppose you also own 200 Sasol shares, and your stop losses and alerts tell you to sell out.

Here’s my question: How quickly can you get rid of your shares in a market melt down? I’d say on a liquid share like Sasol you might be able to sell to bargain hunters within an hour or two. But the fund manager that sits with millions of shares just isn’t that lucky. He’d probably be selling the whole day long as prices slide. If there are no more buyers at the price you sold at, he has to reduce his price to attract more bargain hunters. And the next day, and the next he’ll be selling at even more reduced prices. In a downward market there just are more sellers than buyers. He’ll eventually get rid of all the shares he wanted to, but at a price far below the price you were still able to sell at.

I hope this helps you a little in forming a strategy around the number of shares you try to manage. Remember, this is for the advanced investor able to manage his risks with his understanding of all the potential impacts of economic and political change or disaster.

Happy investing!

4. Newsletter Four – Buffett’s “durably competitive advantage” revisited.

I can strongly suggest a book that’s been around now for a couple of years, and which probably meant most to me in my early days of investment. It’s called “The New Buffettology” – by Mary Buffett and David Clark.  (I can strongly advise you to try to get hold of this book.)

The cover quotes Business Week’s opinion of the book: “A probe inside the head of a financial genius.” The book explains how Buffett chose companies that had a durably competitive advantage. The advantage needs to be sustainable ensuring long term growth. And having the competitive advantage means having something competitors can’t copy.

The result of this is that these companies are able to grow profits and increase prices faster and more than competitor companies. Stay away from price-competitive companies, such as airlines: They battle each other with their own profits. Find a company that has no one to battle with except the challenges to expand their markets.

Let’s try to relate this back to our own stock exchange: What companies on the JSE has this durably competitive advantage? I’d like to name a few I think are worth a look at, and why.

Firstly, Telkom. Coming from an IT manager background, they’re my least favourite people. I can’t tell you how we battled for service. Yet I had to stay with them purely because there was no one else. They had the monopoly. And a monopoly is nothing else than a durably competitive advantage. They are operating in a licensed environment which only recently opened doors to a second network operator. In a big way Telkom still has a monopoly in various telecoms applications.

How about Sasol – a huge blue chip with the rare ability to produce liquid fuel from gas. They’re and absolute leader down the path of Gas-to-Liquid (GTL) technology and has a competitive edge over other oil & energy producing companies in this regard. Consider that oil is a limited resource and demand just keeps growing. I’ve heard stories of earth having only 40 years of oil supply left. Low supply, high demand = high prices.

I previously mentioned Astral Foods – the “chicken business” in my portfolio. If I understand the company correctly they own part of their supply chain (Food nutrition) and can therefore likely cut costs lower with inter-group discounts that competitor Rainbow chickens can?

I sometimes think a having a certain person on board can give companies a competitive edge. People like Jannie Mouton. Read up on the man. His history of unlocking value is impressive and frankly I am in PSG just because Jannie Mouton is there. The company is however well diversified and I have trust that when he leaves someday the share price won’t just tumble down.

Having a license to produce or provide something can tender company’s the competitive advantage. Kagiso media owns licenses to operate Jacaranda 94.7, OFM, Kaya FM, Heart 104.9, and iGagasi 99.5 amongst others. Primedia owns 94.7 Highveld Stereo, KFM and various other brands.

Most of these companies totally outperformed the JSE average over the last 5 years, and I believe they’ll continue to do so. Do your homework and look for other companies that have a durably competitive advantage, then wait for the right moment to get in. From the companies above, Sasol is the only company that underperformed the JSE all share average over the last 5 years. Perhaps it’s a good long term company to get into now?

No comments:

Post a Comment

Warren Buffett Quotes

Leadership Quote of the Day