Tuesday, September 8, 2009

How to buy a Great Business at a fair price

Before learning how to buy a great business at a fair price, we must be able to distinguish a great business from a mediocre one. But I'm getting a little ahead of myself, so let's start with some preliminaries.

When we buy a company's stock, we are not buying a piece of paper called a 'share certificate'. Nor are we buying an 'entry' in a dematerialised (a.k.a. demat) account statement.

What we buy is a minority share in a business. That is why they are called 'shares'. This is not a course in semantics. It is important to understand the difference.

A piece of paper, or a card, or a plastic chip can be used for gambling. But you will probably not gamble with part ownership of a factory, or a brand, or an export-import business. You are making an investment for future growth.

Before you buy a car, you go for a test drive, find out the fuel economy, maintenance costs, seating comfort, and then put your money down. Even for buying a less expensive item like a fridge or a TV, you probably check the products at a couple of showrooms and read reviews on the Internet before buying.

The same research and diligence, if not more, should be followed before you buy a share in a business - not after.

What are some of the traits of a great business?

  • high net margin
  • low debt
  • positive cash flows from operation
  • proven management with integrity
  • high return on equity
  • products or services with predictable earnings

What are the signs of a mediocre business?

  • low net margins - which may be the result of creative accounting
  • high debt
  • negative or negligible cash flows from operations
  • questionable management pedigree
  • low return on equity
  • products or services that keep changing, making earnings projections difficult

Buying a great business at a fair price is not easy, because great businesses usually sell at great prices. Occasionally, the market goes a bit crazy and great businesses and mediocre businesses sell at low or fair prices.

Once you have identified some great businesses, don't jump in to buy immediately. Wait patiently for an opportunity to buy at a fair price. If that means waiting for 2 or 3 years, so be it. Till then, keep your money in a bank fixed deposit and earn interest on it.

The worst mistake that an investor can make is to buy on a hunch or an impulse. That usually means buying a mediocre business at a great price - a ticket to financial ruin. A mediocre business bought at a fair price may also cause losses.

It is your money. Make it grow by buying great businesses at fair prices. It means, growing rich slowly. Isn't that better than getting poor quickly?

Related post

What exactly is the Margin of Safety?


ambardekarsuchita@gmail.com said...

Hey, Wondeful shubhankar!!!
Especially packaging with a wonderful puch writing...simple and lucid style...is good.

Suchita Ambardekar.

SG Money Mind said...

While I use the RoE as the starting point, I also look at the RoIC (equity + debt) to figure out the returns.

Reason being, some companies have high RoE, dig deeper you will find the debt hidden in the consolidated balance sheet way away from the prying eyes. E.g. Havells India.

Bharath said...

Hi...Another amazing article...

Especially I liked "low net margins - which may be the result of creative accounting".
I used to wonder, why these companies are run their business even though there is very
less profitability wrt to their size of their top line.

If possible can you please list possible cranky works that could be done by Corporate
to make money from investors like "creative accounting", then like "promoters reducing their stake" etc etc ..

sunny said...

i like your blog thanks for sharing information with us


Subhankar said...

@Suchita: Appreciate your comments, Suchita.

@SGMM: Good point. For companies with negligible debt, RoE works pretty well.

Debt, if well managed, isn't a bad thing. If a company can use a Rupee of debt to earn two, I've no problems. Trouble starts when they borrow to pay off earlier debts.

@Bharath: Thanks, Bharath. Companies can run even if they make zero profits - as long as their earnings cover all costs.

Financial shenanigans by corporates are too numerous to list - it would fill a thick book! The most common is siphoning off cash into unlisted subsidiaries or 'payments' to fake suppliers.

@sunny: Thanks.

Jasi said...

Hey Subhankar,
Interesting post. I recall reading The Little Book That Beats The Market. However the book was although detailed but was pretty simplistic in approach.
Subhankar as you know retail investors like me burnt our fingers a lot during the market crash by not booking our profits timely. I personally am confused how to invest during bull and bear phases. Basically when we should we putting our money in and when we should be taking it out. It is this taking money out part or profit booking that most of us struggle with. So if you can post an article that covers this aspect. Im sure it would be a lot of value to small retail investors like me :)
Thanks and regards!

Subhankar said...

Appreciate your feedback, Jaspreet.

You may want to read "It's when you sell that counts" by Donald Cassidy, published in India by Vision Books.

I'll write a post on partial profit booking next week.

Jasi said...

And I'm already looking forward to it :)
Oh, and I'm a long term investor. So if you can write your article keeping a long term investor in mind than a trader.

There is something else I wanted to share. There are two schools of thought. On one hand people say, you should buy when market is going up such that you are maximum invested when market is at its peak. There is this other class that says, you should sell when markets rally so that you are least invested when market is at peak and mostly into cash. Thus if there is a crash you can cash in.
I'd be very grateful if you can cover profit booking keeping this aspect in mind.
Oh one more thing (you cant believe the amount of thoughts I have on this) so some ppl say if one of your stock has run up ... you shud book profits. However another school of thought says, since a run up stock is a winner in your portfolio ... you shud continue to invest in it to maximise your profits.
I mean, the aspects are so many and so is the confusion :) I have a feeling you are the right person to answer such dilemmas that retail investors like me have. :)

Subhankar said...

Hi Jaspreet

All my articles are from the viewpoint of a long term value investor. (I only do long-term trading on cyclical stocks.)

You may want to read my Aug 25 '09 post: "When should you 'Hold' and when should you 'Fold' a stock?"