This book is a little different from most investment books because the investment principles are embedded in a story. The story centralises on the character named Sean, who was learning investing from an old man at a jetty. The old man was painted as Warren Buffett while ‘Sean’ should be the author himself.
I am not going to regurgitate the story in this post. Stories are meant to be enjoyed so go and read the book. I will highlight the main investment pointers in the book and add some of my thoughts.
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Warren Buffett learned value investing from Benjamin Graham and it was Charlie Munger who introduced Philip Fisher’s concept of growth investing to Buffett. The latter was what made Buffett one of the richest man in the world. As narrated in the book,
“With the old method of buying undervalued businesses, we made millions, but with the new method, we made… billions.”
The problem with growth investing is the many unknowns to consider and calculations are subjected to projections. We all know about the accuracy of projections – I wrote a post why it ain’t accurate. Yes, it can make you very rich with growth investing if you get it right. But the truth is, not many people are able to make a lot of money this way, for both skill and luck reasons. Buying undervalued businesses the Benjamin Graham way is recommended for most investors, and you will still make enough money this way. Nevertheless, let’s go through the growth investing principles mentioned in the book. It is useful to understand the concept and for those who are interested to apply to their own investing.
Durable competitive advantage
“Businesses with fishing nets are able to draw customers to them. And their customers come back to them over and over again. When you want that particular product or service, you will go to them instead of others. These businesses are able to monopolise the market through their unique services and product. Ask yourself these questions when you are analysing whether a business has a competitive advantage:
- What value (products/services) does this business provide?
- Is this value provided by anyone else?
- Will I choose to get this value from elsewhere instead of from this business?
- Why would we rather get this value from this business instead of from anywhere else?
- Is the reason(s) we identified in question 4 sustainable in the long run?”
Sean suggests to start looking at businesses at the malls or at your workplace. Identify the existence of competitive advantage before you go into the financial reports!
Consistent historical earnings per share
Earnings per share should be growing steadily per year to prove that the competitive advantage exists, and the company is capturing market share overtime.
Consistently high return on equity
“In this case, we want a business that has a consistent, average ROE of more than 15%; the higher the better, because it suggests higher growth and more efficient use of our equity.”
Consistently high return on assets
“In this case, we will cross check that the return on assets (ROA) is high as well. As a rule of thumb, the return on assets must be at least more than 7%. If the return on equity is consistently high, but the return on assets is not, it may not mean that the business is efficient.”
5 times net income > long-term debt
“A rule of thumb is to have a business that has long-term debt not more than five times its income. So if we have done our initial checks right, it means that the business should be able to generate consistent income and thus be able to pay its long-term debt within five years.”
Interest coverage ratio more than 3
“We want an interest coverage ratio of at least 3. This means that the amount of profits made by the business can easily allow it to pay three years of interest. It means that the business is able to survive three years of down time in its business and still be able to pay its interests. This is important because if a business is not able to pay its interest, the amount of debts is going to roll into a bigger amount. We do not want compounding to work against us. As such, having the ability to pay its interest suggests the business is able to weather and survive bad economic times.”
Check cash flow
While earnings can be faked, cash flow is harder to. It is important to check free cash flow and determine if the company is fraudulent.
“The Free Cash Flow of a business is what the business brings into the business through its operations after deducting expenditure to maintain or expand its assets, also known as capital expenditure. In simple terms, Free Cash Flow tells us how much money the business is actually collecting. Remember, as much as the earnings of a business can be creatively faked, the amount of cash reported is technically backed by the amount of real cash they are holding”
There can be periods of negative free cash flow but it does not mean the company is screwed.
“There are many reasons why a business reports negative Free Cash Flow. Sometimes a business uses the cash it makes to invest in other investments. This will result in an outflow of money and if the investment is a good one, this negative cashflow may be a good sign. Other times, the business takes its profits to pay off its debts. This will also result in an outflow of money which may be good for the business. These are examples of times where negative cashflow is due to proper strategic planning and investments by the business.”
Ability to raise prices
“If you can raise prices without losing business to a competitor, you have got a very good business. And if you have a prayer session before raising prices by 10%, then you have got a terrible business.”
“There are some industries where it is difficult for businesses to build up a competitive advantage. In these businesses, ‘price’ may be the only factor customers look at when making their buying decision. We want to avoid these industries.”
I totally agree to keep away from IPOs. The deals are stacked against retail investors.
“In an IPO, the investment banker has all the knowledge and information about the business and is offering the uninformed a price he sets. It is very unlikely that he will offer a bargain price. I’d rather wait for the stock to be trading for some time and confirm its performance. And when Mr Market misprices it, this is when I go in to get the bargain. But not at IPO, it does not make sense.”
Choose businesses not dependent on talented people or the management
“We want to avoid businesses whose performance will drop when a group of people leaves because they lose their competitive advantage. This kind of competitive advantage is not at all durable. Instead, we want to buy businesses that even a fool can run, because someday one will.”