Stock Market Investing - Looking in the trash

I wrote a post several months ago about an investment strategy that involved buying into shares that had crashed.


Warren Buffett's investing theory


Warren Buffett referred to this strategy as Cigar Butts. This was because he likened the strategy to searching on the ground for used cigars that have one remaining puff. If you need a nicotine fix and have no money for cigars or cigarettes then picking up a few remaining cigar butts throw away by other people may give you the fix that you need. It's not pretty, in fact it's extremely dirty work but it can be profitable. Likewise, hunting around for once great companies that have fallen on hard times could be equally, if not more profitable. Investing in these dirt cheap shares and selling after making a quick return was how Buffett made a portion of his fortune. 


Buffett's mentor Benjamin Graham


Mentor to Buffett, Benjamin Graham recommended that if you wanted to find cigar butt-like shares then you should look for those Companies whose current assets are greater than their total liabilities. Whatever this net figure is if it is equal to or slightly greater than the total market capitalisation of the Company then you've found a bargain. However, Graham caveats this by suggesting that these sorts of businesses will have a very depressed price for one or more particular reasons. As such he suggests that you should only buy into these sorts of Companies when there are a number of them available.

At this point I feel the need to provide some realism. These sorts of shares are rare particularly in a growing stock market such as ours. The time to buy into these sorts of shares are when the whole market is depressed, as it is at this time that bargains become available. Nonetheless, if you scan the business news every day you may be able to spot Companies that have fallen out of favour. It is these news articles that I take as an indicator that I should take a look at that Company.

Last summer Britvic plc was in the press for having produced faulty products. It had produced 12million faulty bottle tops for it's famous Fruit Shoot bottles. As a result the share price fell 15% in one day. Followed by further falls by a couple of percentage points. The large price falls brought the company to my attention. Britvic had a diversified range of drinks other than Fruit Shoot including it's successful Robinsons brand. The company produced plenty of cash and a healthy balance sheet. As a result, I invested and was quickly rewarded with a 30% growth in the share price only a few months later. Unfortunately, due to external forces I was forced to sell at a healthy profit. However, if I was still holding those shares today I would have virtually doubled my money. C'est la vie!

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Lessons from the "Intelligent Investor" (part 3)

This is the third post in a mini-series on one of the greatest investment books ever written by a world famous investor, Benjamin Graham. To read the first part of this mini-series follow the link to part one. To read part two.


The Intelligent Investor part 3


This post is part three in a series that outlines some of the key lessons that I took away from reading "The Intelligent Investor".  If you believe that this or any of my posts on this subject have a smidgen of use then you MUST read the "Intelligent Investor". The lessons are invaluable and I will not do them justice here. In this post I will try to outline what you can reasonably expect to earn as a return on your investment and why if you follow Benjamin Graham's value investing technique. I would also like to credit the work of Jason Zweig. His commentary on the "Intelligent Investor" is invaluable.



The Investment Returns Formula


Figuring out what you can expect to earn on your investment is a pretty intuitive formula. Primarily we make investments for a return. Dividends are the return we expect on or capital. The rest of investment return is the nominal growth in our capital. This is the real growth in earnings per share plus inflationary pressure pushing up share prices. So the investment formula is: Return on Investment (ROI) = Dividend return + Nominal growth in Share Price

Dividend Return


According to the Financial Times data files, the FTSE 350 (the top 350 firms by size, listed on the UK stockmarket) currently distributes an average dividend of about 3.35% per annum.

Real Growth


Graham suggested that the long-run average for real growth in the Western World for the last decade is about 1.5% to 2% per annum. To err on the side of caution I would suggest that the long-run average real growth is about 1.5%, a more accurate figure given the fact that we are still emerging from a period of stagnant growth.

Inflation


The most recent figures for inflation stated that it is currently about 2.9%. This means that for every £100 invested, 2.9% of the growth is purely the effect of price rises.

Return on Investment


If we put all of this data together the Current Return on Investment in the stockmarket is: 3.35% + 1.5% + 2.9%, which equals 7.75%. This is about equal to the generally accepted, long run, average rate of return for investing in the stockmarket (estimates vary between 6% - 8% depending on the level of dividends).

I must emphasise the fact that this is what can be reasonably expected over the long-run. This should mean that you should expect this sort of return over decades, and not necessarily over years! Since this is a long-run average based on the whole FTSE 350, the most effortless way to capture this growth would be with a FTSE 350 equity index tracker. This sort of passive fund tracks the whole market growth of the FTSE 350. More ambitious investors may try investing using some of the valuation techniques as explained in part 1.


For more on this series:

Lessons from the Intelligent Investor Part 1
Lessons from the Intelligent Investor Part 2

Do you like what you've read? Tell your friends by sharing it with one of the buttons below. Please post this to Facebook or Tweet it to help your friends and family. Feel free to send me an email (mrmoneybanks<at>multimillionaireroad<dot>com), find me on twitter @millionairer0ad or comment. Whether good or bad, I want to hear from you all.


Lessons from the "Intelligent Investor" (Part 2)

This is the second post in a mini-series on one of the greatest investment books ever written by a world famous investor, Benjamin Graham. To read the first part of this mini-series follow the link to part one.


The Intelligent Investor


This post is part two of a seriesthat outlines some of the key lessons that I took away from reading "The Intelligent Investor". Once again I must stress that anyone with an interest in investment MUST read this book. The lessons are invaluable and I will not do them justice here. However, I will try to outline some more of the key guidelines (although some might say "commandments") so as to share the wisdom if this great man with a wider audience.


Where to start your investment research?


I believe that almost everyone should be investing for the future. I regularly find myself discussing investments with my friends. I am always surprised that although people show an interest in the stock market, they complain that they wouldn't know where to start when investing. It is my belief that the best way to learn is to do! If you've never seen Niagra Falls before you don't gain much insight from someone describing it to you. Conclusively, won't fully understand the experience until you actually go. It's the same with investing. You have to have some money set aside, that you can afford to lose, and give it a go. That's the best way to learn how to invest. It forces you to constantly research and learn. It's the reason I write blog posts such as these; that I may learn about investing and share that knowledge with others.

The next step to investing is the two Rs: that's Research and Reading, and lots of it! You want to read market data, newspapers, company websites, Annual Reports, and company announcements. An investor should be asking themselves - where do the profits come from? Where is the future growth of the Company going to come from? What is the intrinsic value of the Company today? How does that intrinsic value compare the the current Market Capitalisation (Stock market price multiplied by the number of shares)?


Red Flags for investing


An investor should also be on the look out for red flag, warning signs. If an investor becomes aware of any of the following when researching then do not consider investment:

If the Company appears to be making lots of acquisitions each year then this should be a big red flag warning sign. Successful companies can put their capital to good use and grow their earnings internally. If a Company is regularly having to go to the market place to boost it's revenues you should be asking yourself why. Obviously, some acquisitions are a good thing. In the UK WM Morrisons, the supermarket, took a 10% stake in an American online grocer to give them experience in online grocery shopping before considering expansion onto the net. This was a relatively cheap way to test online shopping before diving straight in. Generally, more than 2 "large" acquisitions per year should be a signal of possible underlying problems.

If the Company regularly finds itself approaching its shareholders for extra financing, or borrowing from another financial institution, this could be a cause for concern. These sorts of cash inflows will be written under "cash from financing activities" on a Company's Statement of Cash Flows. Regularly borrowing money from external sources generally means that the Company does not produce enough cash flow from its operating activities. If the Company always needs to borrow to grow then this it is not a share in a Company that you are investing; it is debt.

If a Company has only a few customers, this should be a concern to the investor. Whilst those one or two customers may provide plenty of revenue, there may be limited scope for scaling the business. Furthermore, an investor would want more comfort than provided by only a few customers. For example, should one customer 'go bust' and close for whatever reason then there may be problems for your investment as your Company relied too heavily on the list business.


Gaining confidence in investing


Apart from having a market price below intrinsic value there are a couple of indicators that a Company is or will be a successful one. Here are a few ideas:

Graham also encouraged looking for businesses with a "wide moat". In economics we call it "barriers to entry". Essentially, we mean factors that would prevent competitors from entering the market place. A business is in a good position if it has something inherent in the business that deters/ prevents other businesses from competing for market share. Examples of factors that provide a wide moat: brands such as coca cola, legal factors such as patents in drug companies, and technological factors such as Microsoft creating an operating system whereby consumers would have to busy Microsoft products to be compatible.

A management who's interests are aligned with the shareholders is extremely desirable. Graham believed that you should have confidence in management who own a lot of the shares within a Company. Managers sell shares for many reasons e.g. kids are going to University, the manager is moving house, the manager is going through a divorce etc, however, if the management are buying shares in the Company that they manage then that is a hugely encouraging sign to invest within the Company. Essentially, management share buying is the person(s) that knows the business best is endorsing it. I apologise for not having the exact statistics but I recently read an article in City am that suggested that those Companies that have employee share ownership tend to perform better over the long run.

For more on this series:

Lessons from the Intelligent Investor Part 1
Lessons from the Intelligent Investor Part 3

Do you like what you've read? Tell your friends by sharing it with one of the buttons below. Please post this to Facebook or Tweet it to help your friends and family. Feel free to send me an email (mrmoneybanks<at>multimillionaireroad<dot>com), find me on twitter @millionairer0ad or comment. Whether good or bad, I want to hear from you all.

Lessons from the "Intelligent Investor" (Issue 1)

This is the first of what I hope will be a mini-series on one of the greatest investment books ever written by a world famous investor, Benjamin Graham.

The brilliant intelligent investor


Recently, while on vacation, I read the greatest investment book that was ever written - The Intelligent Investor. Benjamin Graham, one of Warren Buffett's investment tutors wrote this Bible after decades of investment experience and success. I read a 1970s edition of the book and thought that I would share what I consider to be the key aspects of this Investment Bible. I must stress that anyone with an interest in investment MUST read this book. The lessons are invaluable and I will not be able to do them justice here. However, I will try to outline some key guidelines (although some might say "commandments") so as to share the wisdom if this great man with a wider audience.

7 Principles of Valuation


Graham sites 7 key filters for ascertaining whether a particular company is a worthwhile consideration as an investment. I have tried to offer some explanation to assist the reader:

1. Size - the general suggestion seems to be that the company should be large. In today's terms in GBP this should equate to about £70million in annual sales for a company.

2. Financial Condition - There should be a 2:1 ratio of current assets to current liabilities. This is to ensure that if the company faces financial difficulties it has enough current assets to help it through difficult times. Furthermore, Graham specifies that long term debt should not exceed net current assets. Once again this should ensure liquidity of the company if it should hit rough times.

3. Earnings stability - there should be positive earnings for at least the last 10 years. Clearly, you only want to invest in a company that has a proven track record to generate earnings. Whilst, Graham is not denying that there will be companies out there that have made large profits after several years of losses, he requires a certain level of safety that can only be gained by specifying certain criteria. It is that "margin of safety" that Graham is trying to establish with these 7 investing principles.

4. Dividends - Graham requires that an investment should offer a tangible return. He isn't interested in company that doesn't yet pay a dividend but may do in future. A return in the form of a dividend allows Graham to reinvest as he sees fit. This allows compound interest to take effect. Graham recommends that investors should look for companies with a dividend record of at least 20 years.

5. Earnings growth - an investor should require at least a 33% increase in per share earnings over the last 10 years. You should use a three year moving average of the first and last year. This should help to smooth out any unusual spikes in per share earnings over these periods. Similar to the 3rd point, this is to ensure that you are only investing in a company with a track record of growth.

6. Moderate PE - Graham suggests that the current share price should not be more than 15 times the average earnings of past 3 years. However, this rule is flexible, as is explained in point 7, below. 

7. Moderate ratio of price to assets - the suggestion here is that you should look for companies whose current price is less than 1.5 times the book value (total assets). If we combine the ideas in points 6 and 7, if the product of the multiplier of 3 year average earnings and the ratio of price to book value is below 22.5 then this is acceptable. Of course, this means that there will be instances either the multiplier or the ratio of price to book value is greater than what Graham had specified earlier but this caveat adds flexibility to Graham's "rules".

Investing Principles Notes


Graham himself made a point of admitting that if you find a company that meeting all of these criteria, there is still risk in investment. The sort of numerical analysis adopted here does not account for the fact that there may be qualitative disasters that will affect the future price of the shares. For example, Graham makes no mention of the management of the company, nor even that you should know what the function of the company even is. Furthermore, it has been noted that there are extremely few companies that will meet all of these criteria that exists today.

Whilst, Buffett was one of Graham's greatest disciples, and is now worth on excess of $50billion, he learnt that Graham's method is a solid base of knowledge and should be considered in investment. It is not, however, the only points to be considered in investment.


For more on this series:

Lessons from the Intelligent Investor Part 2
Lessons from the Intelligent Investor Part 3

Do you like what you've read? Tell your friends by sharing it with one of the buttons below. Please post this to Facebook or Tweet it to help your friends and family. Feel free to send me an email (mrmoneybanks<at>multimillionaireroad<dot>com), find me on twitter @millionairer0ad or comment. Whether good or bad, I want to hear from you all.

Disclaimer

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Always seek advice of a competent financial advisor with any questions you may have regarding a financial matter