Stock Investment – The Business-Like Way

conbributed by Mr Charlie Soh, author of "Profit From Online Stock Investment". published by McGraw-Hill, 2001

The Singapore stock market has been in a bullish mode since the end of the SARS crisis in 2003. In May 2003, the Straits Times Index (STI) was 1281. By January 2004, the STI was 1848, up about 44 percent. In July 2005, the STI was 2352, up another 504 points or 27 percent. On 27 July 2007, the STI was 3,492, up about 48 percent (1140 points) from the STI level of July 2005.

In the last few weeks, the Singapore stock market has been very jittery. When the Singapore government decision to raise development charges on 18 July 2007, the STI fell 68 points to 3583. Last Thursday (26 July 2007), the Dow Jones Industrial Average (DJIA) fell by 311 points on concern about the U.S. subprime mortgage issues, widening credit-market worries and disappointing results from home builders. The strenghtening of the yen against USD caused some worry about the unwinding of Yen carry trades and a repeat of the sell-down in Feb 2007.

As an investor, what should you do? Are you confused by the large amount of news and expert commentaries about where the market is heading? Should you be buying or selling? My answer is that one should acquire the right investment knowledge and use it to guide you in your stock investment. Based on my ten years of working experience in the stock-broking industry, I agree with the observation and advice of Warren Buffett, one of America richest man and an investment guru. By following Warren Buffett’s advice and experience, you will be able to invest in the stock market with confidence and knowledge rather than worries and confusion. In the next few sections, I will share with you the advice and investment strategy of Warren Buffett.

Advice From Warren Buffett

Warren Buffett advised investors to ignore the stock market as it is behaving like a schizophrenia. Every day, the stock market value the stock with a different price. Depending on her mood (market sentiment), the market is willing to buy from you at a higher price or sell to you at a lower price even though the sales and profit of the company have not changed. Take the example of the stock Cosco. In January 2007, the market is willing to sell to you for $2.43. In early February 2007, the market is willing to buy back from you at a higher price of $2.88. In early March 2007, the market is willing to sell to you at $2.32. Today, the market is willing to buy back from you at $5, a hefty profit of 115 percent. Has the valuation of Cosco changed so much in less than six months? That’s why, Warren Buffett said that the market is schizophrenic!

According to Warren Buffett, the critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price. Buffett never invests in businesses he cannot understand or that are outside his circle of competence. He buys great businesses when they are having a temporary problem or when the stock market declines and creates bargain prices for outstanding franchises. He recognizes that over the long term, the stock price is highly correlated to the underlying economic value of the business and not the daily market quotation. He does not believe in market timing or judging the economic cycle. However, he is concerned with inflation as it affects the company’s returns on equity. A company can increase return on equity in five ways:

1. increase asset turnover (sales/assets);
2. increase operating margins;
3. pay less taxes;
4. increase leverage; and
5. use cheaper borrowings.

Knowing that inflation hurts the return on equity, Buffett avoids investing in businesses that will be hurt by inflation such as those that require large amount of fixed assets. Businesses that are less affected by inflation are those that possess economic goodwill and can command premium price for their products.

Warren Buffet 11 Characteristics of a Healthy Business

1. Offers a good return on capital.

2. Sees its profit in cash.

3. Is understandable.

4. Has a strong franchise and thus freedom to price.

5. Doesn’t require a genius to run it.

6. Delivers predictable earnings.

7. Should not be a natural target for regulation.

8. Should have owner-oriented management.

9. Offers a high rate of return on the total of inventories plus physical plant.

10. Is a royalty on the growth of others and requires little capital itself.

Source: Train, John. The Money Masters. Penguin Books (1981).

Buffett advised that one should look at return on equity, change in operating margins, debt levels, and capital expenditure needs, and the company’s cash generating ability to assess the value of the company instead of the stock’s market price. His investment strategy is to look for companies that he understands, has favorable long-term prospects, and are operated by honest and competent management.

Hagstrom’s Tenets of Warren Buffett’s Investment Strategy

Robert Hagstrom published “The Warren Buffett Way” in which he described Buffett’s remarkable beginnings from a small investment partnership to the acquisition of an ailing textile company, Berkshire Hathaway in the mid-1960s. Hagstrom describes Warren Buffett’s investment strategy using twelve tenets which is presented below:

Business Tenets

• Is the business simple and understandable?
• Does the business have a consistent operating history?
• Does the business have a favourable long-term prospects?

Management Tenets

• Is management rational?
• Is management candid with its shareholders?
• Does the management resist the institutional imperative?

Financial Tenets

• Focus on return on equity, not earnings per share.

• Calculate ”owner earnings”.
• Look for companies with high profit margins.
• For every dollar retained, make sure the company has created at least one dollar of market value.

Market Tenets

• What is the value of the business?
• Can the business be purchased at a significant discount to its value?

Source: Hagstrom, Robert G. Jr. The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor. John Wiley & Sons (1995).

Invest in Stock the Business-Like Way

According to Benjamin Graham, “investing is most intelligent when it is most business-like.” So, invest in a stock as if you are investing in a business. If someone wants you to invest in his business, what questions will you ask him before putting money in the venture? These very same questions can be repeated when you invest in a stock. The difference is that the capital for stock investment can be as low as a thousand dollars and you get to enjoy the privileges of a shareholder such as access to annual reports and invitation to annual general meetings.

Before you buy a stock, have a basic understanding of its core business, product, market, customers, profit and loss statement, and balance sheet. Ask the following questions before you put any serious money in a stock:

• What is the business model?
• What products and services are they selling?
• What is the market size of these products and services?
• Who are their top customers?
• Who are their competitors?
• How profitable is the business? Is profit growing?
• What is the profit margin? Is it high?
• Are they generating positive cash flow?
• What are their costs and expenses?
• What is the debt level of the business?
• How is the quality of top management?
• What is the return on my investment?
• How long will it take to get back my investment?

Convince yourself that the stock is doing a business that you want to be in. Like a business partner, continue to monitor the financial health of the stock:

• Is cost escalating or well managed.
• Are sales and earnings growing?
• Is the business getting more customers and market share?
• Is management delivering what they promise year after year?
• Is the business achieving earnings growth as promised?
• Is the business giving me the expected return on my investment?

Use Hagstrom’s tenets of Warren Buffett’s investment strategy to screen and pick stocks. As long as the fundamentals of the stock is intact (i.e. the company is making profit year after year, earnings growth is continuing strongly), stay invested. When the stock price fall because of bearish market sentiment, buy more of the stock as if you are buying more share of a good business. Always remember, invest in stocks the business-like way.