Constructing a Winning Portfolio

Lessons in Stock Analysis from Master Investors

Key Questions for Investors

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?

Growth + Value

3 Legendary Investors: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

It’s Quality that Counts: the Philip Fisher Approach

Wrote “Common Stocks and Uncommon Profits”investing as a mix between science and artinvestment decisions often boil down to a judgment call about the relative importance of relevant qualitative factorswanted companies that could generate and sustain long-term growth

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 profitsproducts or services that have the potential for sizable sales long termother inherent qualities that would make it difficult for competitors and newcomers to share in that potential growth

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

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

Excellence in Management

Entrepreneurial attitude among management - keep innovating w/ new products or services to keep sales growingDevelopment of good in-house management & teamworkManagement depthGood labor and personnel relations; labor turnover relative to competitorsLong-range outlook by mgmt., even at the expense of short-term profitsGood investor relations & willingness to talk freely about problemsMgmt. of unquestionable integrity; salaries & perks in line w/ those of other managers

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

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, orgeneral market conditionsoutstanding companies can be purchased at fair value, but investors should expect a lower (though still respectable) return

Monitoring / When to Sell

3-year rule for judging results if stock is underperforming but no fundamental changes have occurredhold 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 economydon’t sell for short-term reasonssell mistakes quickly once they are recognizeddon’t overdiversify - hold 10 - 12 companies in a variety of industries having different characteristics

“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.

“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?”

“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.

“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 …

“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?

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?

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

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?

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

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

Universe of stocks

No limitation on stock size, but analysis requires some operating history

Criterion for initial consideration:Consumer monopoly, not “commodity-based” businessStrong managementBusiness that is easy to understand & analyze also must have ability to adjust prices for inflation

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

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?

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

“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

PhilosophyInvestment 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 priceA thorough understanding of the company and its competitive advantage is the only “edge” that investors have over other investors in finding reasonably valued stocksFind a “story” for the stock: slow growers, stalwarts, fast-growers, cyclicals,

turnarounds, asset opportunities

Universe of StocksAll 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

Other Favorable Characterisitics

Boring name, product, or service; or company does something disagreeable or depressing; or rumors of something bad about the companyspin-offfast-growing company in a no-growth industryniche firm controlling a market segmentrepeat-purchase product that customers must keep buying even in bad timesnot a technology producer, but can take advantage of technological advanceslow % of shares held by institutions; little analyst coverageinsiders buying sharescompany buying back shares

Unfavorable Characteristics

Hot stock in hot industryCompanies (particularly small firms) with big plans that are yet to be provenProfitable companies involved in diversifying acquisitions (“di-worse-ifications”)Companies in which one customer accounts for 25% - 50% of sales

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!

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 pricesConsider “rotation” - selling played-out stocks with stocks w/ a similar story but better prospectsMaintain a long-term commitment to the stock market & focus on relative fundamental values

A sampling of other approaches:

Value Benjamin Graham –The Intelligent Investor;

Security Analysis

Growth 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 Zweig; Martin J. Pring; John J. Murphy