Summary of the book “The five rules for successful stock investing” (1/4)

Treat your investment in stocks as an investment in the business, you will find yourself focusing more on the things that matter – such as free cash flow – and less on the things that don’t – such as whether the stock will go up or down, after all, investing in stock is to become an owner in a business

Chapter – 1: The five rules for successful stock investing

Do your homework

The most common mistake investor make is failing to thoroughly investigate the stock they purchase; you should know what you are buying
Just to act on another’s words will not prove a good investment for you, digging into a company’s fundamentals is necessary

Find economic Moats

Economic moats mean competitive advantage which separates the bad company from the good and good company from great
Economic moats keep companies to stay profitable for a long time, which is the best investment

Have a margin of safety

After finding the great company, as an important stock-picking process, we have to get its actual worth; We shouldn’t pay what market demand
Buy the stock when it is at a lower price than your estimation, the difference between your buying price and the company’s true worth according to you called the margin of safety, it can be high or low according to the company’s predictability

Valuation is the term used for finding a stock true worth, one simply valuation is to look at the historical range of the P/E ratio, it is good to invest if today’s P/E ratio is on the lower end of that range

Hold for the Long Haul

The word “Investing” means not to touch your stocks for the long term, which will take you far much profitable than short term “Trading”
Basic factors by which investing stay more profitable than trading are, taxes, brokerage cost, compounding

Know when to sell

Knowing when to sell a stock is as important as knowing when to buy; The key is to constantly monitor the companies you own, instead of monitoring stock price 20 times a day
If the price of the stock has dropped, it is not useful news for us as the price can go in any direction in the short run, but in long run, it depends on future cash flows, almost nothing to do with past

Answer these questions when you look to sell a stock

1. Did you make mistake? (Intention due to which you had purchased stock is not fulfilled due to the company’s inability, sell it)
2. Have the fundamentals deteriorated? (Whether the company’s growth started slowing down and whether it is suffering from no investment opportunities and profits eaten away by competitors, then it is a time to sell)
3. Has the stock risen too far above its intrinsic value? (If the stock price rises much higher than your estimation, you should book the profit)
4. Is there something better you can do with the money? (It is not wrong to sell a fairly valued company to buy an undervalued one, even if with loss)
5. Do you have too much money in one stock? (Even if you have picked the winner, more allocation in one stock should be trimmed)

Chapter – 2: Seven Mistakes to Avoid

Avoiding common mistakes make our investment errorless, here are some mistake that should be avoided by you

Swinging for the fences

Building your portfolio with risky, all – or – nothing stock – is like swinging for the fences, makes your portfolio ineffective
By buying a share which is undervalued according to your valuation, you will be able to find a business which may change the world after some years

Believing that “it’s different this time”

If someone tells you it’s different this time at the time of any stock event, you should always stick to fundamentals that history always repeats itself

Falling in love with the product

Companies with new and innovative products not always perform well, the economy matters more
Consider that is this an attractive business? Are you ready to buy the entire company if you can? If the answer is no, you should leave the company

Panicking when the market is down

Selling stocks with a shrinking market is the wrong investment practice
If we go to the least basic things, we will find that a stock which is sold by everyone is available at a very cheap price, buying when market buys is to acquire stocks at a high price
The best time to buy is when everyone else is running away from a given asset

Trying to time the market

Market timing is a big myth and no strategy constantly tells you when to stay in the market and when not to
By timing market, we lose the benefit of compounding which is a big factor in wealth creation
Stock market returns are highly skewed – that is, the bulk of return sometimes come from a few days of a year

Ignoring valuation

We purchase a stock because according to us, the stock is selling of lower value than its actual worth – the stock is undervalued
Spending a significant time for the valuation of the stock is good practice to do

Relaying on earnings for the whole story

As stated earlier, cash flow matters more to the company than earnings
Comparing cash flow from operation relative to earnings will tell you the health of the business

Chapter – 3: Economic Moats

We often judge companies by its profit, and assuming the trend will persist for a long
But high profit attracts high competition and businesses usually started becoming less profitable
The company’s economic moat is like the bodyguard of the company’s profit against its competitors who constantly want to take it away

To analyze a company’s competitive moats, follow these steps

Evaluating profitability

What we want are firms who can earn profits more than their cost of capital

Here are some measures to consider

How much free cash flow a firm is generating, for this, look at the company’s cash flow from operation and deduct CAPEX (capital expenditure) from that to reach free cash flow; Then, divide that free cash flow by sales (it is like how much free cash is thereafter investing in a business as a % of sales), a strong percentage of this is an excellent sign that a firm has an economic moat

Net interest margin of a firm, which is how much profit the company is making from its revenue, net interest margin above 15% is considerable

Return on equity of a firm, which is net income divided by shareholders equity, shows that how much profit a firm is making as a % of invested equity (as a thumb rule, firms with ROE more than 15% are likely to have economic moats)

Return on asset of a firm, which is net income as a percentage of assets, shows that how efficient a firm is at translating its asset into profit (constantly above 6% or 7% proves that the company have a competitive advantage)

These measures are to be considered for a long time as the consistent performance of this measure for a long time is something called “hard work”
These benchmarks are like a rule of thumb and comparing a company with the industry average is always a good idea

Building an economic moat

Now we need to identify why the firm is constantly making such profits and keeping competitors at the doorstep only

Think about it from a customer perspective; Why customers are using the firm’s product instead of competitors and why customers are accepting yearly increases in product prices? If you can find out the answers, you have found the source of the company’s economic moat

Five ways by which firms can make such a competitive advantage

Product differentiation, that is to provide high-quality products with different characteristics and features to the customer, but it will only work if you constantly stay one step ahead of your peers, otherwise, your product will be served better by competitors

Perceived product differentiation, that is if a firm constantly beat its competitor’s product, it creates brand value for the firm; Strong brand value is a license for a firm to charge premium from customers, but it merely depends on the industry

Driving cost down, to provide similar thing at a lower price than the market is a powerful competitive advantage, it can be done by either investing in a better process or achieving a larger scale (which can spread your cost across a large scale base)

Locking in customers means to create high customer switching cost, it is difficult to figure out what makes it tougher for customers to switch one firm to another (the switching cost doesn’t have to be monetary), having done this is a ticket to charge premium from customers. These points will help you in identifying the moat

If the firm’s product requires client training, the firm will lose its customer and productivity during the training period
If a firm’s product is not an industry standard, the customer may feel the pressure to use well-known and respected brands only
If a firm is contracting for the long term with its client, it is a sign that the customer will not or cannot go elsewhere

Locking out competitors is the strategy to generate lasting competitive advantage and to keep competitors at bay; if the firm has done well, the result will be ‘strong profit’ for many years; the most obvious way to locking out competitors is to acquire some types of regulatory exclusives like licenses, patent, etc; moreover, apart from regulatory exclusives, another way is the network effect – if a firm start business with a new idea and it keep growing its network and it now has many users, competitors who want to enter will not get that success as a firm has attracted a big network which will stay with the firm only

How long will it last?

Now we want to know how long a firm will able to keep its competitors at bay
Assume economic moat in two dimensions
1. There is depth – how much money the firm makes
2. There is width – how long a firm can sustain above-average profit

Firms economic moat can last for – a few years, several years, or many years
Software firms with product differentiation may have profits for a very short time as there are fewer barriers to entry
Firms with a brand name, customer lock-in, and competitors lock-out may have a long period of competitive advantage

Industry analysis

It is easier to make a profit in some industry than it is in other

To get a feel for the industry to classify them, answer these questions
Are sales of firms in the industry increasing or shrinking?
Are firms staying constantly profitable or profits are cyclical?
Is the industry dominated by big firms or there are same sized firms?
How profitable are the average firms – are operating margins fairly high or fairly low?

Chapter – 4: The Language of Investing

While analyzing a company, we should start with the balance sheet (how much company owns – Assets – and what it owes – Liability), income statement (how much company made or lost during a year or quarter) and cash flow statement (company’s cash inflow and outflow), there are windows into corporate performance

We need an income statement and cash flow statement due to a concept called‘ accrual accounting’, i.e. company book revenue when it provides good or service to the customer, instead of when a customer pays

The income statement shows accounting profit and the cash flow statement shows cash profit, the difference between these two is the key to understand all about how business work, as well as to separate good businesses from a poor one

Where the money goes?

Chapter – 5: Financial Statement Explained

Here are financial statements’ important line items which are worth paying attention

Balance sheet

Current assets are those which used up or converted into cash within one business cycle

Account receivables:

Account receivables are bills that the company hasn’t yes collected of its sales and it expects to receive payment soon
If the company’s account receivable is increasing faster than its sales (in % terms), the company is not is good shape, comparing these 2 is a good way to judge whether the company is doing a good job at the payment collection part
We have to deduct allowance for a doubtful account from account receivables to reach net account receivable

Inventory:

Cash that’s been converted into inventories which are not useful anywhere called inventories soak up capital
The speed at which companies turns over its inventory into cash has a huge impact on profitability because if the company has no speed doing this, the company’s cash has stuck and can’t be used anywhere else

Accounts payable:

Companies who have a lot of leverage over their suppliers and can hold their payable for a long are in benefit
Retained earnings is the amount of capital generated by the company throughout times minus dividend distributed and stock buyback
Consider debt taken by the company as a fixed cost as a company has to pay it with interest no matter how it performs

Income statement

Gross profit margin:

We can’t see gross profit generally in the income statement, but it is useful to a number and should be analyzed
Gross profit margin is gross profit i.e. revenue – the cost of goods sold divided by revenue; generally, tells you how much the company can markup its goods
Selling, General and Administrative Expenses (SG&A)
These are operating expense which should be measured as a percentage of revenue
By comparing this number of close firms, you will be able to know that which one is creating revenue with lower expenses

Operating income:

It is revenue – the cost of goods sold – all the operating expense, describes income generated from operations; it doesn’t include income or expense which are occasionally or one-time expenses
It is fairly comparable across firms and industries

Cash flow statement

Net income may not be a good representation of the amount of cash the company has generated

The cash flow statement is the most important thing for corporate value creation because it shows how much cash a company is generating

To truly analyze a company, we should first look at the cash flow statement that how much cash a business is throwing out, then should go for the balance sheet to check the company’s financial health and at last go for the income statement and PAT

Operating cash flow minus capital expenditure (CAPEX) is free cash flow i.e. amount of cash the company has generated

Some firms grant many options to their employees at a lower price and repurchase their stock at a higher price, which is not the best use of capital

By understanding these 3 statements, you should be clear about how money flows through a company

Chapter – 6: Analyzing a Company – The Basics

We will break down the process of analyzing a company into 5 parts

Growth (how fast has the company grown, what is the reason behind it, and is the growth is sustainable?)

We all love the high growth of the company, but it is a fact that fast-growing companies attract competitors and they generally take out some piece of the company’s profit
Hence, accepting high growth companies will keep growing for years and year is the worst thing in investing as this generally proves wrong, we want quality growth (not growth which came from cost-cutting or accounting tricks)

Always look for a source of the company’s growth, it will tell you all about growth’s quality and its sustainability

Generally, quality growth comes from 4 sources

Selling more goods and service
Raising prices
Selling new goods or service
Buying another company

The simple way to grow is to do whatever you can do better than your competitors

Sell more products than they do, increase the price for better growth (only strong can do this), explore new markets as one business can have a roof of growth i.e. growth can be limited – come up with new products to have a limitless growth and acquisitions, which are a complex source of growth as it makes business complex, tougher to understand, and hugely depends on the correct investigation of target firm; though growth is never sure here, moreover there is very little probability that business will have success by doing acquisitions

If you can’t figure out how the firm is growing without acquisitions, don’t buy it; The goal of a successful investor is to buy great companies, not successful mergers and acquisitions
Growth comes from acquisitions is low-quality growth (Low-quality growth is less of cooking growth and more of unsustainable growth)

There are many ways to alter growth by accounting tricks

When you find profit-growth is more than sales, you should dig more into numbers (it can be an accounting trick)
A big difference between the growth rate of net income, operating income, and cash flow from operating activity can give a hint of what’s happening

Profitability (what kind of return a firm is making on invested capital)

First, analyze from where this profit is coming, whether it is from cost cut or price hike, another good way is to analyze cash flow from operations to see the firm’s profitability; because profitability is the most crucial part to analyze as to how much the business is making from capital invested in it

Capturing only profitability is not enough, we also have to look at capital invested in the business, which we will measure-out by some ratios

Return on Asset (ROA):

Return on the asset has two components
1. Net margin i.e. net income divided by sales, which tells you how much is your profit from every rupee of the sales; If it is 5%, the business is earning 5% from every rupee of the sales as profit
2. Asset turnover – Asset turnover is sales divided by assets, which tells you how much a firm is generating revenue from each rupee of the sales; If it is 5%, the business is generating 5% sales from every rupee invested as assets

Companies who have high ROA because of high asset turnover rather than profit margin are better

Return on equity (ROE):

ROE is a great measure as it describes how much a business is earning on shareholder’s equity – it measures a profit on every rupee of shareholder’s equity
Multiply ROA with financial leverage ratio i.e. Asset divided by Equity to calculate ROE

Financial leverage is how much debt a company is carrying relative to shareholder’s equity, unlike profit margin or asset turnover, the leverage ratio the lower the better because it means the company have low debt, a Leverage ratio of 5 means from company’s 5 Rs of asset, 1 Rs is funded by Equity, and other 4 Rs is from Debt

ROE can be affected by 3 components, increase or decrease in profit margin, asset turnover, and financial leverage

Two caveats when you are analyzing ROE

Banks generally tend to have high leverage as it is part of their business, hence set ROE cut-off some high for banks

Firms with too high ROE, like 40 or more are meaningless to analyze as these firms have lowered their equity by buyback or other ways, so we should have special attention at equity analyzing this kind of companies

Free cash flow

CFO is what the business has generated from its operations, but it doesn’t absorb cash spending for acquiring assets or capital for business

So, free cash flow = CFO – Capital Spending (CAPEX)

And free cash is exactly belonging to shareholders as this is excess cash business is generating after paying all cost and all expenses have to be paid for acquiring capital, and so it is called “owner earnings”

Firms with free cash flow don’t have to rely on capital markets for expansion and all, they can save it for future opportunities, can buy their shares back, can do CAPEX, and so forth and thus it gives the firm the financial flexibility
Generally, a firm who can generate 5% of its sales as free cash flow is doing a great job

Putting return on equity and free cash flow together

One way to think about the returns a company is generating is to use the profitability Metrix
Which shows return on equity relative to free cash flows, finding companies with a high number of this Metrix are less risky and

Return on invested capital (ROIC)

ROIC is a better and clearer version of profitability ratio and can tell you clearer about a business’s working
ROIC assumes liability as equity as it doesn’t take equity and debt as separate
Hence, by doing it, there will be no interest expense

Moreover, it also deducts assets which are not there for the business’s operations – like an investment in a mutual fund, usually called non-core assets – and so there will be no other income there

Finally, ROIC is (EBIT – other income) minus tax divided by total asset minus noncore assets

It shows how much a firm is earning from its core assets

Financial health (how solid is a firm’s financial footing)

After looking at the company’s growth and profitability, we need to check its financial health
Financial leverage ratio is best to test the company’s equity and debt proportion in assets

Here are some other key metrics to do so

Debt to equity ratio, i.e. long-term debt divided by shareholder’s equity, shows how much long-term debt a company have on every rupee of equity

Times interest earned, i.e. EBIT divided by interest expense, which will tell you how many times the company can pay interest, higher the ratio the safer a company is; Comparing ratio for 5 or more year for a company will tell you whether the company’s time interest earned is falling – it is becoming poor at interest-paying capability – and vice versa

Current ratio i.e. current assets divided by current liability, tells us whether the company have enough current asset to pay its short-term liability; current ratio above 1.5 is decent as the company can pay its short-term liability without any trouble

Quick ratio i.e. current asset minus inventories divided by current liability, here we exclude inventories as it stays in current asset head but it can’t be converted into cash immediately; quick ratio’s interpretation is how many current assets (excluding inventories) company have to pay for current liabilities

The bear case

The next task is to analyze the bear case of the company’s stock, what could be wrong with the stock, why someone is selling a stock, here you have to interpret all the negativities of the stock to find a winner

As you have all the negatives of stock, you can be much confident after invested in the stock, you are ready with what can happen to the stock and in which case you should sell it

We should construct a bear case before investing in a stock

Further Portion of the Book summary (Click)

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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