There is a swathe of books on long-term investing. The most popular among these are about the value investing approach which remains rather undefined. One of the classical versions of the approach is to buy stocks available at a throwaway price (deep value investing). This has turned out to be a graveyard even for many accomplished investors, as they waited years for the elusive turnaround as the stock went lower and lower. Value investing now, often, means buying good-quality stocks at low prices, and, therefore, as an approach, is indistinguishable from any other sensible approach to buying stocks. After all, nobody would like to invest in buying expensive stocks of mediocre companies. There are many books which tell you how to picks stocks well. So, can another book add much value? Invest Like a Guru is, indeed, an important addition to the art and craft of stock-picking because it is evidence-based. Charlie Tian’s approach rests on two simple strategies.
1. Buy Quality…
One of the first steps in value investing is identifying good companies to invest in because they reduce your worries about timing and are unlikely to inflict permanent loss of capital. How does one identify such companies? Warren Buffett said, “Time is a friend of the good business and an enemy of the mediocre.” Tian says “We should look at the financial statements of companies for at least one business cycle to see how the business has done during good times and bad. Of course, the requirement of at least one business cycle will exclude many companies that have short histories, or making new issues. Investors should avoid new companies that haven’t yet proven themselves.” This also means the Next New Thing. “Avoiding mistakes is more important for long-term investment performance.” To see if a company qualifies as a good company, investors need to ask themselves three fundamental questions while consulting the historical financial statements of companies:
1. Is the company consistently profitable at good and stable profit margins, through good times and bad?
2. Is this an asset-light business that has a high return on investment capital?
3. Is the company continuously growing its revenue and earnings?
Is this just another of those opinions that seems intuitively correct or are there hard facts to justify this? To show how relevant the hypothesis is, Tian identified the stocks (3,577) traded continuously over the past 10 years. “Among these 3,577 stocks, 1,045 or 29% were able to make money every year. Collectively, they averaged an annualised gain of 8.5% a year, doubling the gain of 4.2% generated by the second group, which were profitable in 9 out of 10 years. For the companies that were profitable six or fewer years over the past 10, the average gain is negative, even if held for 10 years.” Clearly, the possibility of losing money with any stock is greatly diminished for a company that is consistently profitable.
Of course, this study only records companies that were traded 10 years ago and are still traded today. This approach is statistically flawed because it is biased in favour of survivors which would be unknown at the start of the 10 years. But, in this case, the bias is in favour of companies that have been losing money. If those that continued to lose money and went bankrupt were included, the gains for the group companies that lost money would be even smaller and the percentage of the companies that lost money would be greater.
In short, by simply investing only in companies that are always profitable, investors can avoid losses and achieve above-average returns. But even if a company has always been profitable, that doesn’t mean it will continue to be so. How to guard against it? By focusing on a second metric: operating margin. “We want to invest in those that consistently have above-average profit margins. If a company can maintain a higher profit margin over the long term, it most likely has an economic moat that protects its pricing power from competition. A higher profit margin also leaves room for the business to stay profitable during bad times, when a low and unstable profit-margin business may fall into loss, which usually results in major punishment to its stock price,” writes Tian.
What kind of profit margin is high? Tian goes back to the database of 577 companies and shows the distribution of the operating margins. Many companies had an operating margin between 3%-8%. The median was 10%. Roughly 29% companies had an operating margin higher than 20%; 16% had a margin of 30% or higher; 12% had been profitable and had a 10-year median operating margin higher than 20% over the past 10 years. Applying the filter of consistent profitability with a 10-year operating margin of 20%, only 429, or 12%, companies in the US passed the filter. Interestingly, as long as a company was consistently profitable, the operating margin figure didn’t make much of a difference on its stock performance. “For the 1,045 companies that were consistently profitable over the past 10 years, there is no clear correlation between the average annualized gain of the stock and the median operating margin over the same 10-year period. But we still prefer those with higher margins because a lower profit margin leaves less room for error,” writes Tian.
2. …At Fair Prices
Wal-Mart stock gained more than 500% in three years, to around $70 a share by the end of 1999. It was a great company that easily met the criteria of being consistently profitable and with high margins. But had you bought Wal-Mart in late-1999, 12 years later, you would have still not made any money and 17 years later, barely enough. “Wal-Mart has quadrupled its earnings from 1999, but those who bought in 1999 have not benefited because they overpaid for the stock,” points out Tian. Wal-Mart had a P/E (price-to-earnings ratio) of 60 at the end of 1999. Today, the P/E ratio of the stock is 16. What the company gained in profit expansion, the market took away in value compression.
That brings us to the second part of Tian’s approach: find fair value for the stock. Tian, following the classical approach first elaborated by John Burr Williams in 1938, points out that the value of a company is the present worth of its stream of future earnings, called discounted cash flow (DCF). Unfortunately, this is elegant in theory but useless in practice. It asks us to estimate how much the company will make over the next, say, 10 years, the number of years of the business’s remaining life, and the appropriate discount rate. These are all shots in the dark. If it were not so, we would come across how the DCF calculated for this company or that has turned out to be stunningly accurate. These are, at best, estimates and may help brokerages to construct a future scenario that institutional investors can use to justify the purchase of a particular stock. The second approach of Tian is to calculate a fair P/E which was used by Peter Lynch and expressed as a rate that is below the growth rate. In other words, if a company is growing at 20%, the fair P/E of the stock is 20. Strangely, Tian tucks in a lot of very useful tips of how to use different valuation ratios (price to earnings, price to book value, price to sales and price to cash flows) as part of a chapter called “How to Evaluate Companies”.
This is an excellent book, with clear advice on how to pick stocks. It also has a lot to say on failures, errors and traps. Unfortunately, as happens with every investment book barring just one or two, there is nothing on when to sell. Nevertheless, a good book to read.