Stock Picking Framework

BY

LAABSQUARE CONSULTING

December 2012
Has the company consistently performed well?

We will always looks at Return on Equity ROE to see

whether or not a company has consistently performed
well in comparison to other companies in the same
industry.

NPAT / Shareholders funds

Has the company avoided excess debt?

We prefer to see a small amount of debt so that

earnings growth is being generated from shareholders'
equity as opposed to borrowed money.

Long term debt / Share holders

funds
Are the profit margins high? Are they increasing?

To get a good indication of historical profit margins,

investors should look back at least five years. A high
profit margin indicates the company is executing its
business well, but increasing margins means
management has been extremely efficient and
successful at controlling expenses.

Net profit / Sales

How long has the company been public?

Buffett typically considers only companies that have

been around for at least 10 years. Value investing
means looking at companies that have stood the test
of time but are currently undervalued. Never
underestimate the value of historical performance,
which demonstrates the company's ability (or
inability) to increase shareholder value. Do keep in
mind, however, that the past performance of a stock
does not guarantee future performance - the job of
the value investor is to determine how well the
company can perform as well as it did in the past.
Determining this is inherently tricky, but evidently
Buffett is very good at it.
Is the company in a commodity business?

Buffet tends to shy away (but not always) from

companies whose products are indistinguishable
from those of competitors, and those that rely solely
on a commodity (like oil and gas).If the company
does not offer anything different than another firm
within the same industry, Buffett sees little that sets
the company apart. Any characteristic that is hard to
replicate is what Buffett calls a company's economic
moat or competitive advantage. The wider the moat,
the tougher it is for a competitor to gain market
share.
Moat Examples - Absolute advantage

The ability of a country, individual, company, or region

to produce a good or service at a lower cost per
unit than the cost at which any other entity produces
that good or service.
Moat Examples – First mover advantage

A form of competitive advantage that a company

earns by being the first to enter a specific market or
industry. Being the first allows a company to acquire
superior brand recognition and customer loyalty. The
company also has more time to perfect its product or
service. First movers are often followed by
competitors that try to capitalize on the original
company's success. By this time, however, the first
mover has usually accumulated enough market share,
expertise and customer loyalty to remain on top.
Moat Examples – Soft economic moat

A type of economic moat (or competitive advantage)

that is based on intangible qualities such as
exceptional management or a unique corporate
culture that breeds success.
Does the company have economic moat?

The wider the moat, the larger and more sustainable

the competitive advantage. By having a well-known
brand name, pricing power and a large portion of
market demand, a company with a wide
moat possesses characteristics that act as
barriers against other companies wanting to enter
into the industry.
Test of good management

If a company has excess funds than what it needs for

operations, it can either buy new businesses or
return the funds to the shareholders.
Retained earnings should be distributed to
shareholders so that shareholders can decide
whether to spend on consumer items or on further
investments. Retained earnings should be retained by
the company only if every rupee of captial retained
creates one rupee of market value for the investors.
This would happen only if the capital retained would
earn incremental returns equal to or above the
returns available to the investors.
Test of good management

If a company has excess funds than what it needs for

operations, it can either buy new businesses or
return the funds to the shareholders.
Retained earnings should be distributed to
shareholders so that shareholders can decide
whether to spend on consumer items or on further
investments. Retained earnings should be retained by
the company only if every rupee of captial retained
creates one rupee of market value for the investors.
This would happen only if the capital retained would
earn incremental returns equal to or above the
returns available to the investors.
Test of good management

In case of X Ltd from 2007 to 2012 the total earning

per share is Rs. 40 Out of this Rs. 10 was distributed
as dividends. Rs. 30 per share (40-10) was retained by
the company. In this period EPS grew from 0.50 to
20.50 by Rs. 20.00. Hence 20 / 30 x 100 is 67% return
in 5 years. A return of 67% would be acceptable to
most investors but in the end it is the investors who
have to consider whether had they received the
entire amount as dividends, would they have put the
money to better use. It is the ability to use the
retained earnings of a company to increase earnings
at a higher rate than the market which attracts
investors like Mr. Warren Buffet.
Test of good management

This is really just an extension of Warren Buffett’s

investment principle that one should not invest in a
company whose business one does not understand. If
it applies to direct investment, it also applies to
indirect investment and an investor is better off
investing in a company that uses its capital in areas of
its own expertise.
Test of good management

An investor likes to see a company grow because, if

profits grow, so do returns to the investor. The
important thing for the investor, however, is that the
company increases the returns to shareholders. A
company that grows, at the expense of shareholder
returns, is not generally a good investment.
Test of good management

Earnings that are consistently increased are an

indication of a quality company, soundly managed,
with little or no reliance on commodity type products.
This leads to predictability of future earnings and cash
flows.
Test of good management

On the other hand, with a company whose earnings

fluctuate, future cash flows are less predictable. The
reasons may be poor management, poor quality or an
over reliance on products that are susceptible to price
reductions.
Test of good management

Debt financing can be used to increase the rate of

return on equity. This can be misleading and also
problematical if interest rates rise or fall. This is
probably one reason why Warren Buffett prefers
companies with little or no debt. The rate of return on
equity is a true one and future earnings are less
unpredictable. A careful investor like Buffett would
always take rates of return on total capital into
account.
Is the stock trading at a discount to its real value?

This is the kicker. Finding companies that meet the

other five criteria is one thing, but determining
whether they are undervalued is the most difficult
part of value investing, and Buffett's most important
skill. To check this, an investor must determine the
intrinsic value of a company by analyzing a number of
business fundamentals, including earnings, revenues
and assets.
Is the stock trading at a discount to its real value?

And a company's intrinsic value is usually higher (and

more complicated) than its liquidation value - what a
company would be worth if it were broken up and
sold today. The liquidation value doesn't include
intangibles such as the value of a brand name, which
is not directly stated on the financial statements.
Once Buffett determines the intrinsic value of the
company as a whole, he compares it to its current
market capitalization - the current total worth (price).
If his measurement of intrinsic value is at least 25%
higher than the company's market capitalization,
Buffett sees the company as one that has value.
Valuation of the business

1) Method - Discounted value of free cashflows

i.e. FCF1/ (1+r)^1+ FCF2/(1+r)^2…..+ FCFn/(1+r)^n
2) Discounting factor (r) - WACC
3) Free Cash flows (FCF) - This is a measure of how
much cash can be paid to the equity shareholders of
the company after all expenses, reinvestment and
debt repayment. (Net Income - Net Capital
Expenditure - Change in Net Working Capital + New
Debt - Debt Repayment)
Valuation of the business

4) WACC - A calculation of a firm's cost of capital in which

each category of capital is proportionately weighted. All
capital sources - common stock, preferred stock, bonds
and any other long-term debt - are included in a WACC
calculation. WACC is calculated by multiplying the cost of
each capital component by its proportional weight and
then summing.
Valuation of the business
Broadly speaking, a company’s assets are financed by
either debt or equity. WACC is the average of the
costs of these sources of financing, each of which is
weighted by its respective use in the given situation.
By taking a weighted average, we can see how much
interest the company has to pay for every Rupee it
finances.
A firm's WACC is the overall required return on the
firm as a whole and, as such, it is often used
internally by company directors to determine the
economic feasibility of expansionary opportunities
and mergers. It is the appropriate discount rate to
use for cash flows with risk that is similar to that of
the overall firm.
Valuation of the business

Cost of Equity - A model that describes the

relationship between risk and expected
return and that is used in the pricing of risky
securities.
Cost of equity = Risk free return + Beta x ( Expected
market return - Risk free return)
Beta is the tendency of a security's returns to
respond to swings in the market.
Mr. Buffet’s quote on “Company’s track record”

Here's what we're looking for...businesses earning

good returns on equity while employing little or no
debt." - Warren Buffett's letter to shareholders, 1987
Mr. Buffet’s quote on “Capital Allocation”

"Almost by definition, a really good business generates

far more money (at least after its early years) than it
can use internally." -Warren Buffett's letter to
shareholders, 1994
Mr. Buffet’s quote on “Employ Incremental Capital”

"The best business to own is one that over an

extended period can employ large amounts of
incremental capital at very high rates of return. The
worst business to own is one that must, or will, do the
opposite - that is, consistently employ ever-greater
amounts of capital at very low rates of return.
Unfortunately, the first type of business is very hard
to find." - Warren Buffett's letter to shareholders,
1992
Mr. Buffet’s quote on “Pay back to Shareholders”

"Most high-return businesses need relatively little

capital. Shareholders of such a business usually will
benefit if it pays out most of its earnings in dividends
or makes significant stock repurchases." - Warren
Buffett's letter to shareholders, 1992
Mr. Buffet’s quote on “Low Risk”

"...the might of their brand names, the attributes of

their products, and the strength of their distribution
systems give them an enormous competitive
advantage." - Warren Buffett's letter to shareholders,
1993
Mr. Buffet’s quote on “Pricing Power”

"Favored business must have two characteristics: (1)

an ability to increase prices rather easily (even when
product demand is flat and capacity is not fully
utilized) without fear of significant loss of either
market share or unit volume" - Warren Buffett's letter
to shareholders, 1981
Mr. Buffet’s quote on “Pricing Power”

"An economic franchise arises from a product or

service that: (1) is needed or desired; (2) is thought by
its customers to have no close substitute and; (3) is
not subject to price regulation. The existence of all
three conditions will be demonstrated by a company's
ability to regularly price its product or service
aggressively." - Warren Buffett's letter to
shareholders, 1991
Mr. Buffet’s quote on “Management”

The certainty with which management can be

evaluated, both as to its ability to realize the full
potential of the business and to wisely employ its
cash flows...The certainty with which management
can be counted on to channel the rewards from the
business to the shareholders rather than to itself..." -
Warren Buffett's letter to shareholders, 1993
Mr. Buffet’s quote on “Branding”
Severe change and exceptional returns usually don't
mix...Experience indicates that the best business
returns are usually achieved by companies that are
doing something quite similar today to what they
were doing five or ten years ago. Businesses always
have opportunities to improve service, product lines,
manufacturing techniques, and the like, and
obviously these opportunities should be seized. But a
business that constantly encounters major change
also encounters many chances for major error.
Furthermore, economic terrain that is forever shifting
violently is ground on which it is difficult to build a
fortress-like business franchise. Such a franchise is
usually the key to sustained high returns." - Warren
Buffett's letter to shareholders, 1987.
Mr. Buffet’s quote on “Stability in Market share”

A fast-changing industry environment may offer the

chance for huge wins, but it precludes the certainty we
seek." - Warren Buffett's letter to shareholders, 1996
Mr. Buffet’s quote on “Margin of Safety”

"An analyst can easily go wrong in estimating future

'coupons'. We insist on a margin of safety in our
purchase price. If we calculate the value of a common
stock to be only slightly higher than its price, we're
not interested in buying.- Warren Buffett's letter to
shareholders, 1992
Mr. Buffet’s quote on “Margin of Safety”

A too-high purchase price for the stock of an excellent

company can undo the effects of a subsequent decade
of favorable business developments." - Warren
Buffett’s letter to shareholders, 1982

It's far better to buy a wonderful company at a fair

price than a fair company at a wonderful price.
Mr. Buffet’s quote on “Utilities, energy companies
and railroads”

"We get decent returns on equity. You won't get rich,

but you won't go broke either." Berkshire Hathaway
Annual General Meeting, 2009.
Mr. Buffet’s quote on “Understanding of Business”

"Sometimes our own intellectual shortcomings would

stand in the way of understanding, and in other cases
the nature of the industry would be the roadblock.
For example, a business that must deal with fast-
moving technology is not going to lend itself to
reliable evaluations of its long-term economics...We'll
stick instead with the easy cases. Why search for a
needle buried in a haystack when one is sitting in
plain sight?" - Warren Buffett's letter to shareholders,
1993
Mr. Buffet’s quote on “Understanding of Business”

In investing, one should avoid businesses whose

futures one can’t evaluate, no matter how exciting
their products may be. Often the future includes
competitive dynamics that would decimate almost all
of the companies entering those industries.

It is not that we don't understand a technology

business or its product. The reason we don't invest is
because we can't understand the predictability of the
economics ten years hence."
Mr. Buffet’s quote on “Businesses immune to change”

"We favor businesses and industries unlikely to

experience major change...Fresh ideas, new products,
innovative processes and the like cause our country's
standard of living to rise, and that's clearly good. As
investors, however, our reaction to a fermenting
industry is much like our attitude toward space
exploration: We applaud the endeavor but prefer to
skip the ride." - Warren Buffett's letter to
shareholders, 1996
Mr. Buffet’s quote on “Scuttle butt research method”

"Now I did a lot of work in the earlier years just

getting familiar with businesses using the
"Scuttlebutt Approach." I would go out and talk to
customers, suppliers, and maybe ex-employees in
some cases. Everybody. Every time I was interested in
an industry, say it was coal, I would go around and
see every coal company. I would ask every CEO, "If
you could only buy stock in one coal company that
was not your own, which one would it be and why?
You piece those things together; you learn about the
business after awhile...I have done that in the past on
the business I felt I could understand so I don't have
to do that anymore." - Speech at University of
Florida, 1998.
Mr. Buffet’s quote on “Reading of Annual Reports”

If you get interested in a company and you read the

annual report, he said, you will have done more than
98% of the people on Wall Street. And if you read the
footnotes in the annual report you will have done
more than 100% of the people on Wall Street.
Mr. Buffet’s quote on “Long term investing”

Only buy something that you’d be perfectly happy to

hold if the market shut down for 10 years
The best period to hold shares is “forever”.
Happy Investing !!