The problem with buying bargain basement investments

When i first started in the stock market i focused on purely buying securities which were trading at low P/E, P/B, P/CF and so on, and if lucky, buying at a discount to book value (That's what i got for trying to enter the stock market at 20 with zero experience and I'm sure this will continue for a while. I do believe I'm continually learning even though this was only 6 months ago since i started.) However, the issue i have with this approach is that if a security is trading at a discount to book value, the business may actually have good reason to be doing so. When Warren Buffet returned home after working with his mentor Ben Graham, he reflected and discovered some interesting things about Grahams approach. Buffett, with the assistance of his partner, Charlie Munger, discovered that it's great to buy businesses that are cheap, but it's much better to buy good businesses selling for a miniscule price compared to underlying worth. Businesses with low P/Es and high returns on capital are ideal. When a company has proved itself, and it becomes available for a good price, it's important to assess the future of the business.You must analyse the company as if you owned it. You need to understand the future prospects because that's what will matter. Therefore, obtaining a formidable understanding of where the business will be in about 5+ years is crucial. The results you obtain from forecasts are only as good as the numbers you put in as one of my lecturers always said. Therefore, you need to study and be obsessed  with the business in order to generate more reliable forecast figures (if this is your approach.) If it's prospects are bleak or cannot be determined with a sufficient degree of certainty, it's probably not a business worth owning. There are no called strikes in this game, you can let as many pitches go by you and it wont matter.

Therefore, it's of paramount importance venturing forward to seek outstanding businesses with superior economics selling cheaply. That's the revised game plan. While I've had these sort of ideas since early on, it's becoming more apparent what needs to be sought out and what needs to be discarded. I'm weeding the garden one step at a time.

 My intention isn't to discount Ben Graham, but rather to claim his strategy rarely works anymore. How could you discount a man who put a logical consideration on a mess prior to the 1920s which the finance community was engulfed in. Prior to his scientific approach to the market, it was encapsulated by excessive speculation and disorderly conduct. It's also a shame that Ben Graham didn't get any credit for being one of the first if not the first hedge fund managers . He was actually engaging in long/short positions in the 1920s well before the middle of the 20th century which is when it has been credited to be born.  

The value investing ideology is an interesting one because from what I've heard and also from what I've tried to explain to some of my friends is that the notions followed under the discipline either immediately resonate with you or they don't. Seth Klarman even goes onto saying that this type of investing is genetic. While i personally wouldn't take it to such extremities, i do believe that it clicks on the spot or it doesn't. For me, when i read about the ideas, it just made so much sense to me. Luckily enough, the process works. All you need to do to justify this is to take a look at some value investors long-term track records if in doubt. (As a side note, I'd like to mention that this isn't the only form of investing. It's far from it, most people don't follow this discipline at all. So please, don't just listen to this and think it's the be all and end all. There are plenty of other successful investors who follow different perspectives. It's more a matter of finding one that works for you assuming it works in the first place.)

A review of some mistakes I've made so far

It's been about 6 months since i started personally investing my funds in the Australian equities market. I went in with some of my savings and my aim was to get a more practical understanding of the stock market.  My first purchase, Aveo Group (ASX: AOG) was a mistake to say the least. I applied a Graham and Dodd approach and bought mainly because it was (and still is) trading at a discount to NTA. However, what i didn't account for was a possible depletion of the asset values to lower fair values if, at liquidation value, (or replacement cost using Bruce Greenwald's words) might have been much lower. On the other hand, the group has weak fundamentals and if looked at again, i wouldn't bother buying into it. Therefore, I've decided to sell at a small loss (about 5% after transaction costs.) As they transition into a pure-play retirement this may provide sharp inclinations in revenues and profits (helped by the aging population) but to me, that's not something I'd like to partake in.

As we enter reporting season, we might see some value pop up. Buffett has once said that value basically "needs to be screaming at you" in order to purchase it. It will be interesting to see if the market offers us anything this time round.

My winter break to do list

Upon completion of my most recent semester, i embarked on a quest to utilize my 'free time' more efficiently than former breaks. My to do list mainly constituted of reading more books and annual reports. The books on my to do list are:

1. Finish Phil Fisher - Common Stocks and Uncommon Profits
2.Ben Graham's - Security Analysis
3. Applied value investing books/ financial statement analysis books.

1 has been done, 2 has been started (although quite a tough read, indeed) and 3 is in the mail as i write this. I'm pleased to see my time allocated to building upon myself and developing a stronger character. My biggest regret is not reading more during my teenage years. I believe reading is one of the fastest ways to obtain knowledge.

With Annual reports, Nick Scali (ASX:NCK) is a company I'm beginning to read up on. It's a company I've had interest in for a while and on face value, meets a substantial portion of my investing criteria. However, i will spend at least another 2 months before making a decision.

I'm also pleased to see my investing acumen developing at a fair pace. However, i believe it will never be fully developed. This is because the learning process should never end. If you think you know everything, the game is over and you've lost. The keen individual will never sleep.

Bubbles, Schurbbles and Dubbles

I've been hearing a lot of talk about a financial bubble in the ASX. Bubbles to me, mean there should be a correction and that prices will contract. In its simplest form, I believe a bubble implies prices above worth.

I think investors need to be aware markets contract all the time. You'd be a fool to think that the market can continually grind up indefinitely. When the bubbles burst, most people lose substantial amounts of money. 1987, 2000 and 2008 are some recent examples of bubbles. What we need to do is stick to facts. Yes, bubbles come, but in between all of these bubbles the Dow Jones Industrial Average has risen from about 1,300 in 1985 to just over 17,000 in 2014, but yet, people have lost a lot of money. This is because people try to dance in and out of stocks. People, get too obsessed with trying to find the stock that's going to be green tomorrow and avoid the red one. But, that's not how one should approach the stock market. The stock market should be approached with a business mind frame. When buying a stock you are buying part ownership of a business. A simple example will illustrate this point. Let’s assume you own a shoe store and its generating $1,000 a year in profit and today someone came to you and offered you $5,000 for it and you decline. Let’s say you decline because you think that business is doing really well and its worth more. The next day, someone else comes in and offers you $2,000 you decide to sell because you think something is wrong.

Funnily enough, this is the approach people take to the market. They buy stocks based on opinion, fads, friends, or if they had a good lunch that day and decided to buy based on that, who knows. It’s crucial to pivot away from this philosophy and stick to facts. In the above example, I mentioned nothing about a change in the operating components of the company, the only variable that changed (apart from the day) was that someone is offering a different price and that you somehow translate that to imply a drastic action needs to be taken. If I told you to jump off a cliff would you do it? Then why, would you let me tell you when to buy/sell something based on opinion in isolation of fundamental fact. This diametrically opposed view of the stock market, that is, that we are buying fractional ownership in a real business lies at the heart of what we need to be doing, not speculation and substantial guesswork. One thing that always baffles me is that many investors spend more time trying to find a better discount on a loaf of bread or a refrigerator than where to allocate their invest-able funds. 

To get back to the bubble topic, we need to focus on what the business is doing. If a company’s stock price has pulled back from $10 to $6 because of a “bubble” but the business is doing well (all things being equal), then I’d buy more. Take advantage of volatility, it’s one of our good friends. But hey, never listen to anyone. Warren Buffett will tell you that. The best and only good investment ideas should come from independent thinking and not crowd psychology.

The type of security i like best

In light of turning 21 soon, I'd like to detail a post of the type of companies which attract me. The reason why i pointed out 21, was because Buffett also wrote a post at 21 which has become well known ("the security i like best"). I hope you enjoy it.

The types of companies I tend to gravitate to are high quality businesses, which in the long-run are going to make a notable difference to our net worth (in the positive direction of course!). With the primary goal of capital preservation, sticking to what I know and can understand thoroughly, adopting a long-term focus and buying at the right price are all crucial factors which I put considerable emphasis on when studying a company.

In this post I’d like to emphasize exactly what I mean by a high quality company. I’ll start from the Profit and Loss to Balance Sheet and finishing off on the Cash Flow Statement. All three statements are very important and neither can be ignored. While there are other aspects I look at i.e. a company’s accounting policies or management remuneration, we’ll leave these peripherals for another time.

“Some men read Playboy. I read Annual reports”- Warren Buffett.

Financial statements tell us how a company is functioning. It allows us to delineate between terrible, mediocre, good and great companies which are going to make us immensely wealthy over the long term.

The Profit and Loss is an important statement because it informs us about the operating components of a company.  At the most basic, it tells us how much money has come in and how much money has gone out in terms of expenses (for a set interval of time) arriving at a net profit (if the company  has made one).  

My goal is to identify a fantastic business with good economics selling at a discount to intrinsic value. Once we've identified this sort of business we want this intrinsic value to consistently rise. 

A firms operating revenue is a good indication of what the business is like. A high number is of course good, but the revenue alone won’t tell us much, we need to subtract expenses to see the bottom line and see whether the company is earning a profit.  

The cost of goods sold (COGS) is a number we don’t want to see in the sky, the lower the better. When COGS is subtracted from the revenue we get the gross profit. This leads me to one of the first informative ratios when studying whether or not a company is investment worthy; the gross margin. A high gross margin may indicate we are dealing with a superior business (and one we might like to own). If you look at the gross margin of companies which are superior you see that they are consistently high and or growing not over a two year period but a ten year period. The key thing here to keep in the back of our mind is that we're looking for a business who sells a product/service with a durable competitive advantage. If the businesses is operating profitably, it will attract competition. The company must have something that can stop or keep to a minimum this competition. This can be done through a variety of ways. Being the lowest cost producer is one way, another is by a patent. One thing i keep in mind if i identify a company that is superior and their source of competitive advantage is a cost-leader strategy is that if times are tough i.e. high inflation, and if the company for some reason cannot pass the higher costs onto the customers, because their margins are so low, it could wipe the company out. For example, a profit margin of say, 2% with the change in inflation from say, 2% to 6% might cripple the company financially. This problem is compounded when a company is selling relatively elastic products/services. That last sentence was a trick, we wouldn't have shares in a business that sells elastic products :)

To derive an astute picture of a company we need to put close attention to the operating expenses of a company. This is because it’s very important to understand the source of a company’s earnings.  We want companies that have substantial earnings power. Let's take a closer look at them.

Selling, General, and Administrative expenses is an expense that can vary drastically between industries with or without economic moats. Some superior businesses will have a high SG&A exp to sales ratio but other operating expenses are low. The key is that it a consistent expense, as opposed to sharp vicissitudes in this ratio.  

 TO BE CONTINUED…

Few potentials

FSA group (FSA:ASX) and Credit Corp (ASX:CCP) are two companies I’ve been watching (stock price) for about 6 months. They tick some of my boxes and seem to be good investments.  However, since I’ve only just gotten around to reading their annual reports I’ve decided not pursue interest at this point in time. The sole reason is because I don’t understand the businesses well enough.  

FSA group seems to operate a diverse earnings model in an extremely profitable industry with economic moats and is trading on a P/E of 7.8. The company does however have a debt/equity ratio of about 430%. While, I haven’t looked in depth into this company I will need to update my knowledge on the insurance business and its products in order to better understand this company before returning to this businesses. To be blunt, it’s out of my circle of competence at the moment. One thing that did come to my mind was the extremely high remuneration senior management are being paid.

Credit Corp attracts me because it appears to be cheap and seems to have good management. They are buying into the US debt market however, as I’m unsure of the regulatory requirements over there among other things, I’ll leave this one alone.

Although these companies may rise 1% over the next year or 300% it won’t bother me because I’ve stuck to my rules which are of paramount importance (to me). As Buffett says, the best thing about this industry is that you can get paid to sit on your hands. He often compares it to Baseball, but you don’t have any strikes. If you let 1 pitch or 50 pitches go without swinging it won’t matter. He also says, you only need to have very few (about 5) good ideas to become successful. So, for now, I’ll let these go. I’ll still read into them because if I obtain the right knowledge circumstances may change.

On the other hand, I’ve been doing some more reading on Vita Life Sciences (ASX:VSC) which is a company I understand much better. I’ve identified this as a buy opportunity despite its steep price (P/E and P/B based). This company ticks so many of my boxes and is the most exciting company I've discovered (that isn't an REA type stock). Phisher's Scuttlebutt proves worthy here as I've visited many health food stores and spoken to customers and store owners, but yet to speak with its competitors. I’m going to have cash reserves so that if this stock pulls back further, I’ll buy more. This is one of Warren Buffetts most underrated traits; to have cash handy in order to swoop in when Mr.Market presents a good opportunity one day.