Monday, March 16, 2015

How to get started with Value investing - Step 1: Finding the first investment

If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety...” – Warren Buffet

Finding the first investment is always the hardest. This is primarily because there are over 55,000 listed companies globally and literally gigabytes of data available on and off the internet on each. These businesses directly employ millions of people and indirectly probably deal with a large part if not a hundred percent of the world’s population. Each one of these people can have perspectives on the businesses you are looking at. I hope by now I have convinced you that knowing everything there is to know about all the listed businesses and then making the first investment would never lead to that first investment!

The best place to typically start is to look at companies whose products you use – soaps, shaving cream, toothpaste, cleaning chemicals, food that you eat, your bank, restaurants you eat at and other companies who make your life easy or joyous. This is typically a good place to start because as a consumer of the products or services of a company it will be easy for you to understand why you buy soap of company A versus company B when you very well understand that significantly cheaper products are available through the cottage industry around your house or from a fairly unknown company C.

Another approach is to see what top investors like Rajiv Khanna (Dolly Khanna) or Rakesh Jhunjhunwala holds. You can find their portfolios each quarter on my blog as well at Of course these might be missing positions where they hold less than 1% of the company as those might not be reported. And some companies may be left out as the shareholding screeners online are not 100% accurate.

Once you have identified the company you need to use your favourite search engine to find the annual report of the company. I find getting the latest annual report from the official website the easiest and fastest method of doing so. The annual report for a simple small business could be around forty pages and for complex large business could be even two hundred pages. Read this report like a novel. While reading, keep searching the internet to find the things you don’t understand. When I read an annual report for the first time it did not make any sense to me. Trust me when I say that when you have read 10 you will be a lot more confident and will take one tenth the time to read it. Once you have read a hundred (very few amateur investors read a hundred annual reports in a lifetime) you can probably write a book about how to read them.
Now that you have read the annual report you need to search the internet to find the peers of this company. Any financial website will have this information. Visit their websites, read about them on Wikipedia, find online brand rankings, sales rankings and other rankings. This will give you a bit of the flavor for the industry. By now you should have a decent idea of how fast the competition is growing and how fast the industry is growing. If you can find estimates on how fast the industry is going to grow in the future that would be great. Investing in industries that have good tailwinds is always a good thing.
Now it’s time to value the security. Please don’t look at the share price or market capitalization of the company before you form your own opinion. Please read my article on Equity securities Valuation before proceeding. Find the EPS (Earnings per share) and determine (in your opinion) how fast this company can grow its earnings. Growth in earnings will decide the price to earnings ratio.
For the mathematically inclined you can use the following formula for a fair P/E:

Now you are probably wondering that Warren Buffet always says don’t trust the fake precision in math. That is correct but unfortunately I don’t know how to value companies without the Fair P/E formula mentioned above. This only works as a standalone formula if you can convince yourself of a growth number over a long number of years.

This Fair P/E multiplied by the earnings is the value of the company today. Any excess cash not required by the business or assets not required by the business should be added to this value and debt or other liabilities should be subtracted from this value to get a value for the firm.

This value should be well above the market capitalization of the company. Typically value investors will tell you a minimum number of anywhere between 15% and 25%. This is called the margin of safety. Of course a higher margin of safety is obviously better.

A simpler approach (but slightly less accurate) approach is to get a good sense of the growth that can be achieved over the next 5 years. Say you think the earnings can double over that period. And then assume a exit multiple of:

So if you think the discount rate is 7.5% then the exit P/E would be 13.33 . Then you calculate the exit price in 5 years and calculate the returns you make on it. If the return is greater than your expected return (say 15% or 20%) you should buy the stock.

Assuming this is your first investment I would only play with a small amount of your capital (less than 1% of your net worth). Before making such an investment it would be wise to have a few opportunities lined up (let’s say 3) after analyzing at least 10 opportunities. This will give you a sense of the alternative opportunities in the markets. It is important to start investing after a month or so of research else one might get de-motivated – it has happened to me several times until I resolved to continue this journey for a year before I got hooked.