My Investment process

The most important aspect of investing is discipline. Just think about Grocery shopping, would you rather just wander around every aisle and pickup whatever looks good or have a shopping list and only purchase if the stuff is reasonably priced??? . I am sure you will pick the latter choice My core principle is based on “Never losing money” . Thus I would rather be happy to pass on 100 good opportunities than to be stuck with a bad one.

Following is my investment process. 1. Building the watchlist : Through this step I scan through all the businesses for a particular sector and choose the businesses that I (i) Understand (ii) Have sound balance sheet and healthy cash flow (iii) Which are somewhat predictable. If the business matches these criteria then it becomes part of my watchlist. 2. Quick valuation : This is the 3 line valuation that you will find below every stock chart. This I develop after an initial quick analysis of the business’ 10-k report. 3. Regular monitoring of the stock : My goal is to browse through my watchlist at least once every week and spot the stocks that are trading way below my valuation. 4. Deep dive of Investment candidates : For stocks that are trading below my valuation I again look through its SEC reports. This time I look its latest 10-K and 10-Q reports. This second level analysis is done to gauge the factor of safety I will need to make sure I will not loose my money. 5. Investment decision : Let us assume that I figure out a factor of safety of 2. This means if my valuation of the stocks is $40 then I would only buy if its trading below $20 ($40 / 2). 6. Post Investment monitoring : Once I buy the stock I monitor its fundamentals every quarter and make sure the management is following a path that I had predicted, if not then sell the stock. 7. When to sell? If my valuation is $40 and the stock has reached $80 then I would sell the stock because its overvalued.

What is Value Investing

In the first few blog posts I have written about some basics of Investment valuation and about the thought process of a cautious investor. In this article I try to answer the question - What is Value Investing? Dialogue between a Newbie and a Value Investor Institutional Charecteristic of Stock Market Golden rule of estimation - Its always done for a range Investment vs Speculation

Dialogue between a Newbie and a Value Investor NEWBIE: “I am new to stock market and looking to make some money, can you please guide me”. VALUE INVESTOR: “You will need to search for stocks whose intrinsic value is greater than their price. For instance if the stock’s intrinsic value is around $35 to $45 range and its selling for $15 then just buy it and hold it tell it gets to $45.” NEWBIE: “What is intrinsic value?” VALUE INVESTOR: “It’s the net future discounted free cash flows of the business” NEWBIE: “OK, maybe you will need to explain me with an example. Let us say Walmart’s stock is selling at $75/ share. Should I buy it???” VALUE INVESTOR: “You can buy Walmart's stock at $75 if you feel Walmart’s intrinsic value range is way more than $75/ share. At least in the range of $120-$130 range” NEWBIE: “How Do I find out Walmart’s intrinsic value range???” VALUE INVESTOR: “Intrinsic value is the net discounted future free cash flow of a business. You will need to calculate that for Walmart. It’s very important to note that, the intrinsic value / share is always a range of numbers, it’s never a perfect value. The best way to start is by first analyzing how much free cash flow the business has generated in the past, based on that make your judgment if the business has capacity to repeat or improve the past. But remember , the investment analysis is not just about plucking numbers from the financial statement and putting into a formula and get an output. The main part of Investment analysis is using your business acumen to decide what to input. Thus if you want to be successful in investment you will first need to develop business acumen. NEWBIE: “OK Got it, so how do I develop my business acumen???” VALUE INVESTOR: “I can certainly guide you how to develop your business acumen. But a lot will depend on how you adapt yourself in the development process. It’s like learning to play Tennis. You can get coaching on how to hit different shots, but you will need to do the heavy lifting of developing you’re playing style.” VALUE INVESTOR: OK , so your first lesson is to learn about the institutional Charecteristic nature of stock market. INSTITUTIONAL CHARECTERISTIC OF STOCK MARKET Any person who has worked in the Information Tech (IT) department of any large enterprise might be familiar with the notorious “Estimation template” . This is basically a long list of questions and multiple choice answers. In order to estimate the cost of the project the Project manager asks his Tech lead to use the template to come-up with the total number of development hours that will be needed for the project. The rationale for this process is that it gives the top management an input to figure out the feasibility of the project. On an average the estimation process does a decent job. The final cost of the project is always within 20% range. But for certain projects, the estimate is way off. Why is it that this process does not work for certain project? Let us assume that one of the main drivers of the final estimate is the number of lines of legacy code that the developers need to analyze to arrive at their Integration solution. Basically this is the solution that integrates the new system to the present legacy system. The legacy code is designed in such a way that certain programs have large data structures (called copybooks) embedded in them. Even though this technically increases the total lines of code of the program , but the developers spend very less time analyzing them because the core business logic is very small. Thus whenever a project involves such modules, the estimate gets bloated. Let us imagine that there are a set of Vendor managers who bid for the projects. One of the Vendor manager is called “Value Vendor manager” . The “Value Vendor manager” just bids at selective projects where he has enough information about the loophole of the estimation process. In this case he knows the loophole to do with lines of code. He undercuts his competitors by pricing the project at 10% less cost than what they bid for and hence wins the project. Other Vendor managers think he is a big fool in making a money loosing deal. But in fact he has played an almost risk less game. Following figures explain his perspective. Estimation as per template: 10,000 hrs. Cost of Developer time: $80 / hr. Vendor offer = 10,000 x $80 = $800,000 x 0.9 (10 % discount) = $720,000. Actual development hours : 6,000 hrs. Actual cost = 6,000 x $80 = $480,000. Gross profit = $720,000 - $480,000 = $240,000.p> Project overheads = 10% of Gross margin = $24,000. Net profit from the project = $240,000 - $24,000 = $216,000 Net margin = $216,000 / $720,000 = 30%. Thus the “Value Vendor manager’s” factor of safety was $216,000. As he was confident that this cushion was good enough to avoid any loss, thus he could offer the 10% discount.On the flip side there might be some programs that seem somewhat small, but involve large nested IF statements. These programs take a lot higher time to analyze than what actually they are estimated for. The “Value Vendor manager” would judiciously avoid any projects that involve such programs and will let other vendors fight for the tiny profit that comes with large risk. The above scenario gives a very simple example as to how one can benefit from a process that is institutionalized. Just like the IT department, stock market is also institutionalized to its core. Overall the process works for the market, but there are odd balls when its process fails miserably. This is where Value investors jump in and benefit from those odd balls. Important thing to remember is that these are “Odd balls”. In other words Value investing candidates are very rare. If you analyze 10 stocks and find 8 of them worth investing , then you can assume that you are not investing but speculating. This is very important to understand, because it will set our expectations from beginning that what we are hunting for is a very rare species, thus we are well aware of the efforts and patience needed to discover them. Golden rule of estimation - Its always done for a range : Following can be a fun exercise that explains the point. 1. Visit your nearest Starbucks coffee shop and predict the number of customers that will be buying coffee in next 15 minutes. 2. Sit near the counter and count how many folks actually walk in the store and buy coffee in the next 15 minutes. It’s very likely that your prediction will not be correct. 3. Repeat this step a couple of more times and the chances are you will still get your prediction wrong. 4. Let us say that the first 15 minutes 22 people bought coffee, the next 15 minutes 27 people bought coffee and the next 15 minutes 19 people bought coffee. Thus we are getting a range of numbers here that range from 19 to 27. The fourth time, change your approach. Instead of predicting an exact number , TRY PREDICTING A RANGE.Conceptualize your puzzle by answering Yes / No to the following questions (i) Do you think that the number of customers buying coffee can be less than 5 in next 15 minutes? (ii) Do you think that the number of customers buying coffee can be greater than 75? One can fairly answer both the above questions as (i) No (ii) No. It’s very likely that you will be correct in your prediction. CONGRATULATIONS!!! You just cracked your first puzzle. The point here is that in the fourth instance, instead of picking an exact number, you predicted if a range of outcome was possible. In other words you were very comfortable in predicting the range that the number of customers will be very likely between 5 and 75 for the next 15 minutes. Estimation for a Value investor is all about playing around the ranges. The more cretain we are about a business' future prospects, narrower is the range and vice-versa Investment vs Speculation Let us assume that each employee working in the job market is considered as a stock whose value is the net earnings that employee is going to earn in his life. Its quite well known that the highest earners in the corporate world are the CEOs of the blue chip companies. Most of them have a MBA degree from an Ivy league college like Harvard or Stanford. Even though a fresh Ivy league MBA might just earn around $150,000 per year, one can be tempted to value him as if he earns $10 million per year assuming that in near future he would become CEO of a large blue-chip company. If we look carefully, a fresh MBA has just basic knowledge of management. Most of the knowledge needed for the CEO’s job is obtained in the course of his work experience. Thus when one is betting on a fresh MBA graduate to become a CEO, one is betting that he will obtain that knowledge in the course of his experience and thus will become CEO. In other words one is betting on something that is not present today. Hence this bet can be termed as speculation , because we are betting on something that's not present. Instead of betting on fresh MBA graduates, let us assume a scenario where we bet on workers with salary over $100,000 , but who right now are on a short term disability and earning just $30,000. The market is valuing them as if they will just continue earning $30,000 for the rest of their working career. Over here if we are able to analyze the short term disability’s reason and feel assured that they will return to work and earn their “present full potential” , this bet can be termed as Investment. Because we are betting on something that’s already present , which is the ability to earn $100,000. Its just that because of a temporary situation the complete intrinsic value of the asset is not evident. If we buy the stock for this employee at a price equivalent to him earning $30,000 / year, it can be termed as Investment , because there is high probability that the employee will return to full time work and start earning $100,000. This gives us the margin of safety. Over here the core competence of the value investor is his ability to forecast whether an individual who is in short term disability will return to work or will go towards long term disability.

Why does a Common investor always second guesses?

If we ask 100 common investors as to what is their process of selecting an Investment candidate, more than 90 would answer that they don’t have any set process. Whenever they feel like investing they just browse some web site or watch CNBC and just pluck an investment idea from there. So why does this happen???...to get answer to this question , let us analyze a basic characteristic of human psychology.

Let us assume that we are playing a game of estimating commute time for a set of 200 commuters , each having a different route. The details of the commute, traffic pattern and weather are available in a report. But we don’t want to spend time going through it, so we just listen to some “so called traffic experts” and deduce our answer. As the traffic experts change their opinion so do we, it’s because we don’t have any of our own opinion. Instead if we spend time understanding all the routes and traffic pattern in detail then we can have a better judgment of ours. In this case we won’t have any hesitation of going against the crowd because we know that we have done our homework and can trust ourselves. The same principle is applied to the Investment landscape. The first step for any common investor is to build knowledge about the businesses that comprise the Investment world. Once he has built that acumen then he will be in a better position to stick to his judgment.

Getting Rich one dollar at a time

Why to follow this Blog?It's been about five days since I have started this blog. Its main goal is to teach investors about Investment valuation. To be honest Investment valuation involves a lot of drudgery. If you are OK with picking up 200 tennis balls from the ground (one ball at a time) and putting in the basket , then you qualify for learning Investment valuation. The other aspect is patience, you needs a lot of it to impliment this knowledge. Well by now you must be thinking why bother so much , when we can just throw money around somewhere and expect to be lucky. In other words , why to follow this blog???. This blog post titled "Getting Rich one dollar at a time" will give you the answer.

It’s Sep-1998. Dan has just finished his Masters and has majored in Computer Science. The dot com craze is picking up steam. He lands a job in Silicon Valley. He is having a time of his life, working in new technology and earning six figures. In June-1999 his company goes public. He instantly becomes a millionaire and gets a feel as to how easy it is to get rich. In six months his stock is worth $4mn, he in on a roll and becomes more greedy. His high flying broker advises him to get into margin trading where he could borrow money against his company’s shares .By March-2000 he is worth $10mn. This is when his fairytale starts taking a turn. His company misses the next quarter’s targets, the stock drops more than 40% in 1 week. Because of the steep fall he gets a margin call so he has to sell his shares to cover the call, his net worth is still $2mn. Next few quarters are bumpy, by end of Sep-2001 his stock’s worth is $236,120. Even though he is no more a millionaire he still has hopes he would get back. In Mar-2002 Dan gets a rude shock. Not only is his stock worthless, his company lays-off 90% of its work force. Dan is un-employed with all his credit cards maxed out. After few months he lands another job and starts all over again. Its Mar-2006, Dan is now married and somewhat settled in his life. His friend Josh shows how he is flipping homes and making a killing doing it. He convinces Dan that real estate never comes down and thus the strategy is safe. Dan and his wife put a chunk of their savings and buy an expensive house. In one year they make 30% return. In June-2007 Dan and his wife buy their second home and are fully invested in Real estate. They are also expecting their first child. His wife takes a break from her career and decides to focus in raising their child. By Mar-2008 the subprime crisis is heating up, they have to sell their second house and take a hit in their investment. By Oct-2008, it’s De-ja-vu again. Dan loses his job, but this time he is in a bigger hole. He is also behind in his mortgage payment and his bank decides to foreclose his property. This affects his credit score badly. He and his family are forced to adopt a very hard life style. He does get a temporary consulting job, but had to take a 40% steep pay cut with no benefits. It’s Jan-2013. Dan has just turned 40. He sees the first grey hair sliding down his forehead. After two bitter experiences Dan is convinced that there is no shortcut to financial freedom. It’s a long and tough journey. Dan decides to be a Value Investor: In his quest for financial freedom, Dan reads all about people who have been financially successful. He is most impressed by Warren Buffett’s advice on Value investing and buys the books “SECURITY ANALYSIS” and "INTELLIGENT INVESTOR" But within a few weeks he is lost. The books have a very abstract tone. On top of it Dan has no accounting knowledge and has hard time figuring out even the basic concept like the difference between Net income and comprehensive income. But Dan is determined, he sticks to his plan. After trying intermittently for a year, he finally succeeds in understanding the Value investing principles laid down in the books. Are there other folks who are in Dan’s shoes? There are millions of Gen-X Americans who like Dan have been doubled down by dot com bubble and housing collapse. With no safety-net of any pension, they have no option, but to fight their way back. Their only option is to live below their means and invest their savings wisely using Value investing methodology.