Book Summary of “The Five Rules for Successful Stock Investing”

Note – This summary is till chapter 6 only.

Chapter 1: The Five Rules for Successful Stock Investing

Investors should have a investing framework i.e. investment philosophy. One should stick to his philosophy. Even Warren Buffet in Berkshire Hathaway’s AGM tells same thing every year of being invested for longer time. If you have done your homework well then you can do well in markets.

Five rules recommended by author are –

1. Do your homework – Many investors don’t have knowledge about the company they are investing in. It is good if homework is done because at the end it is your money which is at risk. Here homework means reading company’s annual reports, going through past financial statements in short doing research on company. Doing this can help you uncover facts about companies and you can make your investment decision.
2. Find economic moats – Economic moat refers a firm’s competitive advantage. In a competitive economy there are always people who eat away the profits of big businesses. If a firm has an economic moat, it can keep earning higher profits for a longer time and thus making a superior investment for longer tenure.
3. Have a margin of safety – Margin of safety means having a difference between the price the market is asking and the price you want to pay. It plays as a cushion if there are losses in future. Size of margin depends upon firm i.e. volatile firms require higher margin and vice versa. Valuation plays an important role.
4. Hold for the long haul – Buying a stock should be considered as an asset. You hold your asset for a long tenure so should be your stock – hold for a long tenure. Frequently trading stock will lead to higher expenses such as commission, taxes etc.
5. Know when to sell – In short term many factors drive stock’s price. It can be attractive or less attractive due to share performance in short term. There are some questions which can help you TO decide whether to sell the stock or not. These questions are – have the fundamentals deteriorated?  Do you make a mistake? Has the stock risen too far above its intrinsic value? Is there something better you can do with the money? Do you have too much in one stock?

So these five steps are just a summary of what an investor need to do and further will be discussed later.

Chapter – 2 Seven Mistakes to Avoid

While investing, the investor must know how to avoid the common mistakes, otherwise these portfolios returns wouldn’t be something that cheer him up. The Seven Mistakes which usually the investors make and which must be avoided are:

1. Swinging for the fences
2. Believing that it’s different this time
3. Falling in love with products
4. Panicking when the market is down
5. Trying to time the market
6. Ignoring Valuation
7. Relying on earnings for the whole story

• Swinging for the fences – One of the mistakes which investors often make is to load their portfolio with risky stocks. Such stocks may prove to be a disaster for any investor. It’s a very difficult job to assess the Startups and predict which startup is going to be the next big thing in Stock Markets. This is because it is difficult to foresee the future of the firm which is just starting out. Numbers prove that small growth stocks are the worst returning equity category over the long term. In fact between 1997 and 2002, 8% (Nearly 2200) firms on the NASDAQ were delisted each year.
• Believing that it’s different this time – It is foolishness in a market to think that “It’s Different this time”. An investor has to be a student of markets history to understand how the future events would pan out. For example, in 2001 the energy stocks were booming and many analysts had high hopes for these stocks until the economy slowed hurting demand and new plants coming in and thus driving up the supply as a result the energy stocks tanked 50% to 60% followed by the Enron Debacle which sealed their fate.
• Falling in love with products – It is not just a product which drives the stock price of a company it’s the entire business of the company which controls the stock price. Thus even if the product of the company is attractive, it is equally important for factors like profit margin, competition and the company’s moat to support the product to drive the stock up.
• Panicking when the market is down – It is generally being seen that assets are cheap when everyone is avoiding them. Stocks are generally attractive when no one really wants to buy them. For example, a study by morning star revealed that those fund categories which attracted the most money were the ones which were outperformed by those funds which experienced the strongest outflows. You will do better as an investor if you seek out bargain in parts of the market that everyone else had forsaken, rather than buying the popular stocks.
• Trying to time the market – Market timing is one of the myths of investing. There is no strategy that can consistently tell you when to be in the market and when to be out of it. A study by Financial Analyst Journal compared the buy and holds and market timing strategy between 1926 and 1999. It concluded that the market timing strategies produced a greater return than simply buying and holding. However there are limitations to these studies:
  • The benefit of compounding has been ignored as each year has been seen as a discrete period.
  • The market in and out strategy has a high risk of not being in the market for anyone looking to build wealth over a long period of time.
  • There are no funds which have been consistently able to time the market based on the signals generated by a quantitative model.
• Ignoring Valuation – The only reason you should buy a stock is that you think the business is worth more than it’s selling for and because you think another person will pay you more for the shares a few months down the line.  The best way to mitigate your investment risk is to pay careful attention to valuation. Buying a stock on the expectation of positive news is asking for trouble.
• Relying on earnings for the whole story – The importance of cash flow is more than that of earnings. The Cash Flow Statement is very helpful in providing insights into the true health of a business and a lot of blowups can be predicted through this statement. For example, if operating cash flow is stagnating even if earnings grow it’s likely that something is rotten.

Chapter 3: Economic Moats

Businesses which earn good profits attract a lot of competition in future. Economic moat is a characteristic by which companies can remain the same profitable or they can safeguard their profit.

Four steps to analyze company’s economic moat:

1. Check historical profitability of firm.
2. Assess the sources of firm’s profit.
3. Estimate company’s competitive advantage period
4. Analyze industry’s competitive structure

1. Checking historical profitability – we look for companies which are earning in excess of its cost of capital. To analyze this, there are few questions which can be helpful
   • Analyzing free cash flow of the company – Free cash flow is CFO minus capital expenditure. It essentially tells that how much cash is left after doing capex. Then free cash flow should be divided with revenue (sales) which will tell the proportion of each dollar which is converted in excess profit. Strong free cash flow is good sign of a company having economic moat.
   • Analyzing firm’s net margin – Net profit margin is how much profit the firm is earning on per dollar sale. Higher the margin better is the company doing.
   • Analyzing return on equity (ROE) – ROE is how much profit the firm is earning per dollar of shareholder’s equity. Posting consistent ROE for a longer period of time can be a sign of company having economic moat.
   • Analyzing return on asset (ROA) – ROA shows how a company is translating its assets into profits.  

These factors, if studied for longer time horizon, can be helpful in finding a company with good economic moat.

2. Building an economic moat – We should check why company is earning higher profits than peers. In every business there are competitors who are ready to eat away the profit. Company can build competitive advantage in five ways :
   • Real product differentiation – If a firm has a product which customers prefer over all peer brands then this can be a economic moat. Good knowledge of inner working of industries can help gain competitive advantage.
   • Perceived product differentiation – A firm with better products create a brand for itself. For a good brand consumers are ready to pay more. This helps in separating valuable brands. If a brand is actually making money then only it can be considered as economic moat because there are some brands which were unable to generate returns.
   • Driving costs down – If a product is offered at a low price then consumers are attracted towards this product. For this the firm has to drive down their costs. It can become a strong source of competitive advantage.
   • Locking in customers – If customers are locked in by putting higher switching costs then it can be a wide economic moat. Switching costs is not in terms of money but is time. A customer will least prefer to buy a brand and then learn how to use it.
   • Locking out competitors – If firms are able to lock out competitors it can result in years of strong profits. If licenses or other government exclusivity is obtained then competitors can be locked out easily. A strong network of customers can be more effective tool of locking out competitor.
3. How long will economic moat last – Estimating how long will an economic moat will be there for company is difficult but even if you come to an estimate it will be helpful because some firms post good profits in short term but their economic moat doesn’t last longer.
4. Industry Analysis – By analyzing firm’s sales and earnings growth rate, we can come out with a conclusion that whether the industry is growing or shrinking. It needs to be done on few companies and not one or two.

Chapter 4: The Language of Investing

• The Basics

An investor is always interested in three statements namely, the Balance Sheet, the Income Statement and the Cash Flow Statement.

The Annual Report, 10-k and 10-Q are the detailed set of financial information that the companies file with SEC. These are the sources to extract the three statements.

The Balance Sheet tells you how the company owns relative to what it owes at a specific point in time.

The Income Statement tells how much the company made or lost in accounting profits during a financial year.

The Statement of Cash Flows records all the cash coming in and going out of the company.

• The Income Statement and the Cash Flow Statement tell different stories about a business as they are constructed using different set of rules.
•  The Income Statement strives to match revenues and expenses whereas cash flow statement, regardless of the timing of the action, cares only about the cash that goes in and out of the door.

Chapter 5: Financial Statements Explained

Financial statements are the foundation for analyzing companies.

Balance Sheet –

This statement shows the equity and liability i.e. what company owns and what company owes. The asset side consist of current assets and non-current assets.

Current assets consist of assets which will be used in current fiscal year like Cash and cash equivalents (very short term investments like money market funds etc.), inventories, account receivables etc. Some useful information which can be found from this side is whether the inventory is increasing or decreasing, whether company is aggressively selling goods on credit etc.

Non-current assets consist of PP&E (Property, Plant and Equipment), Non-tangible assets like goodwill, investments (done in shares of other companies or purchased bond of other companies).

Liability side consists of current liabilities and non-current liabilities.

Current liabilities are those which the company has to pay within a period of 1-year. It includes account payables, short term borrowings etc. If the firm has huge amount of debt which needs to be paid in one year and it is huge as compared to asset then this can be a red flag.

Non-current liabilities are those which need to be paid after 1-year or from next fiscal year. Long term debt and retained earnings are the important things that can convey some message for investors.

Income Statement –

This statement shows how much company is making or losing. It consists of revenue, cost of goods sold (from these two we calculate gross profit), operating expenses (such as marketing, salaries, research and development etc.). Operating expenses or SG&A (Selling, General and Administrative Expenses) when is taken as a percentage of revenue can depict how a company is on cost basis (cost effective or efficient). Other components are depreciation, one-time (non-recurring) charges/gains, operating income, interest income/expenses, taxes and finally net income. One time charges and taxes need to be analyzed properly as they may convict some useful information.

While analyzing EPS more focus should be given on diluted shares because it can affect shareholder’s stake in the company.

Cash Flow Statement –

This is the most important statement. It tells the net cash earned by business either through operating activity, financing activity or through investing activity.

Cash flow from operating activity is the most important because it shows how much cash has the business generated through its core business. Changes in working capital can cause huge difference in net income and operating cash flow.

Cash flow from investing activity involves the income/expenses done by business either on the company itself (which is known as Capex) or is invested in bonds or shares of other companies. Money left after doing capex is free cash flow.

Cash flow from financing activities deals with transactions done with company’s owners or creditors like paying dividends, issuing/buying back shares, and issuing/repaying debt. This numbers are important to analyze because they show from where is the cash coming (either through issuing shares or bonds) or where the cash is going (buyback or repayment of debt).

Thus analyzing these three statements will guide investor to analyze the whole company.

Chapter – 6 Analyzing a Company — The Basics

The process of analyzing a company can be broken down into five areas:

1. Growth

Strong growth more often tempts investors than anything else. However, it has been seen that strong earnings growth is not very persistent over a series of years i.e. high earnings growth in the past doesn’t necessarily leads to high earnings growth in the future. It is always critical to investigate the sources of the company’s growth rate along with the quality of the growth. High quality growth means selling more goods and entering into new markets whereas low quality is generated by cost cutting or accounting tricks.

• The Four Sources:

Sales growth arises from one of the four areas:

• Selling more goods & services – The easiest way to grow is to sell more products than your competitors and steal market share from them.
• Raising prices – Raising prices can also be a great way to boost top lines, although it takes a strong brand or a captive market to be able to do it successfully for long period of time.
• Selling new goods & services – If there is not much more market share to be taken or your customers are very price sensitive, you can expand your market by selling products that you hadn’t sold before.
• Buying another company – Another source of sales growth is acquisitions of other companies. The historical track record for acquisitions is mixed. The reason for this can be that the firms have to acquire bigger and bigger firms to keep growing at the same rate or simply that buying other companies takes time and money. The goal of this type of analysis is simply to know why a company is growing; it will help in predicting the source of growth in the future and the opportunities that the company can tap.

2. Profitability

The real key to separating break companies from average one is to ascertain the amount of profits which the company is generating relative to the amount of money invested in business. By measuring the return that the company has achieved through its investment process, we know how good they are at efficiently transforming capital into profits. Higher the return, the more attractive the business will be.

• Return on Assets – The two components of return on assets are net margin and asset turnover.

Net margin is equal to net income divide by sales and asset turnover is equal to sales upon assets.

Net margin * Asset turnover = Return on Assets

ROA helps us understand that there are two routes to excellent operational profitability:

• High prices for your products
• Turning over your assets quickly – ROA isn’t enough because many firms are at least partially financed with debt which needs to be taken into accounting.

• Return on Equity – Return on Equity is an efficient measure of company’s profitability because it measures how good the company is at earning a decent return on the shareholders money.

Return on Equity = return on assets * financial leverage = net margin *asset turnover *financial leverage

Financial Leverage is a measure of how much debt a company carries, relative to its shareholders equity.

There are two caveats while using ROE to evaluate firms:

• Banks always have enormous financial leverage ratios that look high relative to a non bank.
• The second caveat concerns firms with ROE that are too good to be true. It may occur due to buyback of a company’s share, companies that have spun off from parent firms, etc because their equity base is depressed.

• Return on Invested Capital – Return on invested capital adjusts some peculiarities of ROA and ROE. It puts debt and equity financing on an equal putting. It removes all the debt related distortion that can make highly leverage companies look profitable when using ROE. It uses operating profit after taxes but before interest expenses.

3. Financial Health

After figuring out a company’s growth and profitability, we need to look at the financial health. The bottom line above financial health is that company increases its debt; it increases its fixed cost as a percentage of total cost.

The key matrixes when assessing a company’s financial health are:

• Debt to equity Ratio
• Times Interest earned
• Current and Quick Ratios

4. The Bear Case

Constructing a bear case involves listing of all the potential negatives, from the most obvious to the least likely. It acts as a great reference point when you decide to buy the stock. It will help you know in advance what kinds of trouble to watch for so that better decisions can be made.

Having investigated the negatives you will have the confidence to hang on to the stock even during rough patches.