Monday, April 6, 2015

How to get started with Value investing - Step 2: Common sense check

On popular demand this section is a continuation of the articles in on getting stared with portfolio management:

“Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something. ”

- Charlie Munger

In order to avoid the “fake precision in math” problem I usually do a common sense check. Here is where you want to think about the investment thesis that you can do in your mind. Typically to simplify things I use only the following data points for this:

  • Current P/E
  • Debt as a multiple of Profit after tax
  • Expected earnings level in 5 years as a multiple of earnings today
  • Expected return on invested capital (ROIC) going forward

I typically assume that before the shareholders get any return the debt has to be paid down with the earnings. Think about how long that would take. So a company that will double its earnings in 5 years and has 4.5x of PAT as debt will probably take almost 4 years to pay down the debt. Essentially the price you pay for the business is (Current P/E + Debt as a multiple of Profit after tax) because the debt has to be paid back and is senior your claim as a shareholder in the business.

The astute portfolio manager knows that you cannot have the earnings growth more than the expected return on capital. The dividends that you can get despite the growth as a percentage of earnings are as follows:

Think of the stock like a bond with yield of:

Now the difference with this bond is that the yield grows over time. Now think about the yield in 5 years. Does that yield sound like something you can live with for a long time? Typically after 5 years if you can get a yield of at least >1.5x of the corporate bond yield you might have a winner. The intelligent investor always runs through the common sense approach so that in every investment thesis simplicity rules.