3 Timeless Investment Principles

In his well known investment book "The Intelligent Investor", Benjamin Graham has explained several investment principles that have withstood the test of time.

If you haven't heard of Graham, he is considered the 'guru' of value investing and was a teacher of Warren Buffett. Graham's book is recommended reading for all small investors.

To appreciate and understand Graham's value investing principles, here are three time-tested ones:

1) Margin of Safety

It means buying a stock  at a price below its intrinsic value. What is intrinsic value? Investopedia.com defines it as the true value of a company's stock based on all aspects of the company's business, including qualitative and quantitative factors. That means putting a value to the company's reputation, business model, competitive advantage, as well as calculating its financial ratios to assess profitability, sustainability, financial prudence.

A DCF (Discounted Cash Flow) method that takes into account a company's free cash flow and weighted average cost of capital is often used to calculate intrinsic value. But even such a calculation is subjective, as it requires certain assumptions to be made about future earnings that may or may not turn out to be accurate.

Is there an easy way to figure out 'Margin of Safety'? One way is to compare the average 'earnings yield' of a company (inverse of the P/E ratio) over a period of 5 to 10 years with the fixed deposit rates of banks. If the average E/P is more than the current FD rate, you have some 'Margin of Safety'. (Otherwise, you may be better off investing in a bank FD.)

Note that higher E/P means lower P/E, which usually happens in bear markets or when a company is not performing well. A company with strong fundamentals in a bull market is likely to have a high P/E ratio and hence low E/P - not leaving much 'Margin of Safety'.

'Margin of Safety' can also be thought of as 'buy low and sell high'.

2) Profit from Volatility

A young investor had once asked John Pierpont Morgan, the famous American financier, banker and art collector, what the stock market will do on that particular day. Morgan had responded: It will fluctuate.

Warren Buffett had said: Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

Volatility is an integral part of stock market movements. Sometimes a market fluctuates so rapidly and wildly that it scares off most investors. But irrational market movements can be your friend, because it allows you to avail of sudden extremes of low or high prices.

If you are a long-term investor and not a day trader, there can be a couple of ways you can benefit from market fluctuations. First is 'Rupee Cost Averaging' (or, SIP), where you invest a fixed amount of money at regular intervals, which smooths out day-to-day fluctuations. Second is investing in a balanced fund, which has a mix of stocks and fixed income instruments; stock price fluctuations are 'balanced' by steady returns of fixed income instruments.

For novice investors, or, for those who don't have the time or inclination for detailed fundamental and technical analysis before buying a stock, regular investment of monthly savings in a good balanced fund is an excellent way to build wealth for the long-term without much effort.

3) Know Thyself

You know yourself better than anyone else. At least, you definitely should. Your investment style and strategy should depend on your personality. Otherwise your market returns will not be up to the mark.

Are you an active and enterprising investor, who loves nothing better than to dig out less-known small-cap or mid-cap companies and then do detailed analysis of their annual reports for selecting future multibaggers? Or, do you prefer to be a passive and defensive investor, who hates bothering about the economy, inflation rate, currency fluctuations, price chart patterns?

Do you enjoy the adrenaline rush of picking an unknown stock based on a friend's recommendation and seeing it rise into the stratosphere, or, would you rather make a detailed financial plan and asset allocation plan and then regularly invest according to your plans to achieve your investment goals?

Only you have answers to such questions. And there are no right or wrong answers. The bottomline is that your personality should match your investment strategy. 

However, remember that wealth can not be built by constant activity of buying and selling. It is built by buying with a 'Margin of Safety', using volatility to book part profits and re-entering at lower levels, and holding on for the long-term to get the benefit of dividends, rights issues, bonus issues and stock splits. 

Read more about the three timeless principles.

Related Post

What exactly is the Margin of Safety?

How to value Companies with Negative Earnings

Negative earnings means losses. Most small investors should stay far away from companies with negative earnings. However, there are instances of even well-managed companies running into problems and making losses. If the problems are temporary in nature, then a turnaround may be just a few quarters away, and the stocks of such companies can give phenomenal returns.

But how does one know whether negative earnings have been caused by temporary problems, or whether the problems are more deep-rooted? Traditional valuation metrics, like P/E (or E/P) or RoE won’t work because the ratios will be negative. In a recent article at investopedia.com, three methods of valuing companies with negative earnings have been discussed.

Here is an excerpt:

“Investing in unprofitable companies is generally a high-risk, high-reward proposition, but one that many investors seem willing to make. For them, the possibility of stumbling upon a small biotech with a potential blockbuster drug, or a junior miner that makes a major mineral discovery, makes the risk well worth taking.

While hundreds of publicly traded companies report losses quarter after quarter, a handful of them may go on to attain great success and become household names. The trick, of course, is identifying which of these firms will succeed in making the leap to profitability and blue-chip status.”

You can read the full article at the link below:

http://www.investopedia.com/articles/investing/121013/how-value-companies-negative-earnings.asp?

Some strategies about buying stocks

In a post last week, I had discussed strategies for selling stocks. Most small investors know how to buy stocks, but they rarely have proper strategies for selling. So why am I writing about buying strategies?

From the spate of questions I have recently received about when and how much to buy, it seems that discussing some buying strategies may be useful after all. I had mentioned about using the ‘Margin of Safety’ concept and P/E bands to decide entry points in last week’s post.

The importance of those two concepts can’t be over-emphasised. Too many young investors follow the wild west policy of ‘Shoot first, and ask questions later’. Just switch on any business TV channel (just for entertainment) during the day when they take reader queries. 99% of the questions are: ‘I have bought thus and such stock at this price; should I hold or sell.’

It is apparent from the questions that the stock was bought near a top, and the investor is already sitting on a loss. The question – or rather, a plea – is to find out if the TV expert knows some magical formula by which the loss can be quickly turned into a profit, or, at worst, break-even with no loss.

All one has to do before placing a buy order, is to first check whether the current E/P (i.e. inverse of the P/E ratio) is higher than the long-term bank fixed deposit rate, leaving a ‘Margin of Safety’ . Also check that the debt/equity ratio is less than 1, and that the cash flow from operating activities is positive for 4 of the last 5 years.

If E/P is lower than the bank FD rate, then check the P/E band within which the stock normally trades, and buy only if it is available near the middle of the P/E band or lower. These are basic precautions, and will help prevent losses – even if you don’t have the time or inclination to do a detailed fundamental analysis.

If you are like most small investors, the stock price will fall just after you’ve bought it (and, it rises soon after you sell)!! What should you do? Do not, repeat, do not average down. That is the single cause for turning a small loss into a much bigger one. Instead, keep a stop-loss – and sell if the stop-loss is hit on a closing basis (i.e. take intra-day movements out of the equation).

You will make much more money by averaging up. When should you do that? Buy 20-25% of your intended quantity at the beginning. Add more every time the stock dips or corrects on the way up. Follow a ‘pyramid’ strategy – i.e. buy less and less quantity on the dips as a stock keeps moving up in price – till you acquire your intended quantity.

Such a strategy will prevent impulsive buying of 2000 or 5000 shares in one go, in the hope of becoming a Warren Buffett within a month. Talking of Buffett, I love his quote: ‘You can’t make a baby in one month by getting nine women pregnant!’

Wealth-building takes time. If you hone your buying and selling strategies, you have a chance of becoming wealthy in 15-20 years – but not in 15-20 months.

Using Earnings Yield (E/P) to time your investments – a guest post

In last Thursday’s post, I had taken a look at the historical P/E ratios of the Nifty 50 index and suggested an investment strategy. In this month’s guest post, Nishit takes a slightly different view. He compares Nifty’s earnings yield with the 10 years G-Sec yield to time stock market investments.

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Subhankar had written about Nifty’s P/E multiple or Price to Earnings Multiple last week. Let us delve deeper into it. He had written “Nifty’s P/E ratio has varied between 11 and 27 during the past 12 years - with peaks of 27.35 on Mar 1, 2000 and 27.64 on Jan 1 2008, and troughs of 11.62 on Jan 1, 1999; 10.86 on May 2, 2003 and 11.76 on Dec 1, 2008. The average P/E ratio over the past 12 years is 18.24.”

Price/Earnings ratio is nothing but the Market Price divided by the Profits per share of a company in rupee terms. Assume the share price of a company is Rs 100 and it makes a profit of Rs 10. So its P/E ratio is 100/10 = 10. It is a very fundamental ratio of finding out the valuation of a stock (or index). Now, P/E by itself has no significance. How do we know if P/E of 10 is stretched or P/E of 50 is stretched?

We look at the growth prospects of a company and sector. The derived ratio is PEG Ratio (Price to Earnings Growth ratio). Now if the company is going to grow at an annualized growth rate of 100% for the next 3 years, a P/E of 100 may be acceptable. This is especially true of the IT companies in the glory days of 1998-2001 when Infosys used to come out with 100% growth figures every quarter.

The inverse of P/E (i.e. E/P) is the earnings yield. It is the amount per annum you are going to earn by investing in a company. This ratio is very important in the sense that you can use it to find if a stock (or the Nifty) is over-valued or not. What will we compare against? Let us take the 10 years Government Treasury Bill return. This is the safest investment in the country. Whenever 10 years G-Sec yield is more than equity earnings yield that is the time to go long big time.

Let us take an example. During Oct ’08 – Mar ’09, the Nifty P/E ratio dropped below 15; the earnings yield was 6.66% and below. The G-Sec Yield was 7.83% in Nov ’08.That was the time when the long term portfolio of stocks should have been built up.

For the past 1 year, the Earnings Yield of the Nifty has been around 5%. The G-Sec yield is around 8%. At such times, exposure to equity has to be limited. That is, keep trailing stop losses and don’t add fresh equities.

The Earnings Yield is a simple extension of the P/E concept and comparing it to the Bond Yield gives us a perspective on finding whether the equity markets are overvalued as compared to the Bonds Market or not.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)