Stock market ( Legalized Stock market ( Legalized gambling)gambling)

Does and Don’tsDoes and Don’ts(For private viewing only)(For private viewing only)

Based on Warren Buffet way ofBased on Warren Buffet way of

Interpretation of financial statementsInterpretation of financial statements

Stock investment facts 1Stock investment facts 1

1. Very few people can make decent living on this business

2. Most people follow heard mentality…every sheep blindly walks and falls in the ditch behind the 1st one.

3. Younger generation is easily attracted as soon as they start earning

4. Poorer class is tempted to quickly become rich

Stock investment facts 2Stock investment facts 2

1. Every one thinks, it is easy money with no or less work

2. Publicity adds to temptation. News channels, internet, news papers, finance magazines give every minute commentary and analysis on the markets and scripts.

3. Many investors tell success stories but very few tell you financial fiascos because they want your company

4. Lastly, this presentation will be long forgotten and many will continue without corrective action till they are hurt

Stock investment rules 1Stock investment rules 1

• Media publicity is meant to promote their cause of being a popular and not investors.

• Do not get in to it till you get trained in reading financial statements

• Playing on market sentiments is short term and may earn you short term profit but generally loss on a longer horizon

• It is “White collared gambling” – Gambling because you earn or lose based on your

fate.– Its up to you to reduce “fate” factor and increase

“predictability”

Stock investment rules 2Stock investment rules 2

• No one would have worked if it was so simple to earn money this way

• Warren Buffet is the richest man, but he is only “one” in the top billionaires of the world who made money through share market. Secondly, he made his own rules, most important are …– Invest long term and– Invest in durable company. What is then a durable

company? Read on.

It’s the game of greed and fearIt’s the game of greed and fear

• High returns but at high risk

• Greed– Waiting to sell at the highest price in the rising market – Waiting to buy at the lowest price in the falling market

• Fear– Selling frenzy when market starts to fall bring stock prices lower than

their intrinsic value. In fact it is time to buy– Buy when market is falling

• Ways to mitigate risk– Diversify– Long term investment

Dwell over this…Dwell over this…

• There is a lot of money hidden here because, there are many fools and limited smart guys.

• Every one thinks he is in the minority category above

• There could be few billionaires but also remember that most end up loosing money. Try for a decent 15-20% per year, returns and not 150-200%. It is possible with much lesser risk.

• Read further

So…Do thisSo…Do this

• There is no short cut

• Study financial statements – Profit and loss statements– Balance sheets– Last 5 to 10 years history

• Future market prospects for the products / service of the company

• Management strengths and weaknesses

• Mutual funds are safer to start with but this also required knowledge

• NSE top 50 are better companies to begin

• Think of long term investment (more than 5 or 10 years)

Do thisDo this

• Most important, think in “%” gain / loss not in absolute Rupee amount. It should beat 8%(bank interest in India)

• Invest small amount in 10 selected companies

• Start keeping your own records of…– P&L / BS information as per learning from this presentation– PE multiple– Use stock monitor software provided on ICICI direct, Rediff or similar

sites, it will tell you worth of your portfolio on any day. Note and see what is happening to your portfolio. Analyze and learn.

– Accountants are experts at analysing the financial statements and therefore could have been the richest but they are not

– Learned people also get fooled. Winston Churchill and Charlie Chaplin were almost bankrupt during market fall in 1939

3 types of high performing companies3 types of high performing companies

• Innovative product – ( Pepsi, Gillet, Wrigley, Hershey, Budwiser, Coors, Kraft, The Washington post, P&G, Phillip Moris, Sony)

• Innovative service - (Moody’s Corp., H%R Block inc., American Express, The service master company, Wells Fargo & Co. )

• Low cost buyer and seller- High volume low margin game (Wal Mart, Costco, Nebrasca Furniture Mart, Borsheim’s Jewlers, Berlington Northern Railway)

Company profit and lossCompany profit and loss statement looks like this statement looks like this

• Sales revenue 100• COGS 30• _____________________________________• Gross Profit 70• _____________________________________• Operating Expenses

– Admin + Sales exp. 21– Research Exp 10– Depreciation 7___________________________________________

• Operating income 32

Gross profitGross profit

• Higher GP companies have durable competitive advantage eg.– Coca Cola: 60%, Moody’s 73%. Burlington railways:

61%, Wrigley: 51%

• Low GP ( indicates fiercely competitive business) companies can be in trouble eg.– United Airlines: 14%, GM: 21%, US steel: 17%, Good

year tyre: 20%

• Microsoft is at 79% but Apple is at 33% Rule - General rule: 40% GP is good

Sales and general administrationSales and general administration(SGA) expanse(SGA) expanse

• Coca Cola S&D exp is consistently high at 59% of GP

• Consistently Moodys: 25%, P&G: 61%

• GM, ford fluctuation is due to sales revenue fluctuation– GM fluctuates: from 28% to 83%– Ford motors : From 89% to 780%

• Intel has low SGA exp. But high R&D spend, else they will be out of business

• Good year has high interest exp due to high capital investment requiring debt

Rule - SGA exp under 30% is fantastic

Research and developmentResearch and development(R&D) expenses(R&D) expenses

• Here the company has competitive advantage created by a patent

• It will last only till patent expires

• Or newer technology replaces it eg.– Audio discs, Cassettes, CD, DVD– Filament lamps, CFL, LED

• Merck spends 78% of GP on SGA, 29% of which is on R&D

• Intel spends 30% on R&D

• Coca cola has no R&D costs

Rule - Risky for long term investment

DepreciationDepreciation

• EBITDA: Trick found out to get more debt by adding back depreciation as cash flow can support more debt

• Depreciation examples– Coco cola: 6%– Wrigley’s: 7%– P&G: 8%– GM 22 to 57% - high

Rule - Lesser the better

InterestInterest• Interest paid on debt – financial cost• Examples ( % of operating income)

– P&G 8%– Wrigley’s 7%– Good year 49%– South west airlines 9%– United airlines (in out of bankruptcy) 61%– American airlines (troubled) 92%

• Exceptions– Wells and Fargo bank 30%– It is high but lowest in banking

• Bear sterns – Was paying 70% in 2006– 230% in quarter ended 2007– Was forced to merge at 10$/share when it was at 170$/share earlier

Rule - Durable companies have interest payout less than 15% of operating income

P&L statementP&L statement• Sales revenue 100• COGS 30_____________________________________• Gross Profit 70_____________________________________• Operating Expenses

– Admin + S&D exp. 21– R&D Exp 10– Depreciation 7 ___________________________________

• Operating income (PBIT) 32___________________________________• Interest expense 2• Gain (loss) sale of assets 12.75• Other 2.25___________________________________• PBT 15• PAT 5.25

Gain (Loss) sale of assets and Gain (Loss) sale of assets and otherother

• It covers income due to sale of fixed assets like property, plant and equipment

• Other includes sale of patents and leasing agreements

Rule: As these are non recurring, these should be removed for looking at company’s net earnings.

Net earnings - PATNet earnings - PAT

• Company should show historical upward trend, single year is not sufficient

• Examples of Net earning to revenue ratio– Coca cola: 21%– Moody’s 31%– South West airlines 7% ( competition)– GM: 3% ( super competitive auti business)

Rule: More than 20% is good, less than 10% is bad. There can be exceptions

• Banks and financial institutions: Abnormally high ratio means acceptance of higher risk for easier money and a long term disaster.

EPS – Earning per ShareEPS – Earning per Share

• Ratio of PAT to number of shares

• Market price of company is a multiple of this ratio and therefore very important

• Look for consistency over long period (company does not require much process change) and upward trend (strong economics)

Rule -– Good company: 1.42, 1.3, 1.48, 1.60, 1.65, 1.95. 2.06, 2.17, 2.37, 2.68,

2.95– Stay away from this company: 5.24, 8.53, 6.68, 1.77, 3.35, 5.03, 6.39,

(6.05), 3.89. (0.45), 2.50 – Shows fiercely competitive industry with boom and slack years

Bombay stock exchangeBombay stock exchangePE ratio historyPE ratio history

• PE ratio = Share price / Earning per share

• Generally PE of 16 is OK

• Too high ( >30 ) means market is over heated and will fall some time

• Too less means market is under valued due to sentiments but will revive some day

• PE varies industry wise– IT companies have higher(25 PE)– Compare with peer companies

Balance SheetBalance Sheet

• It gives snap shot about company on any given day

• It is never for a period : 1 year, quarterly etc.

• It has:– Assets - what company owns – Liability - what company owes to others__________________________________________

• Asset less Liability = Net worth of the company

Balance SheetBalance Sheet

Assets–Cash ( fix deposits etc.)–Receivables–Plant and machinery–Working capital ( Inventory, WIP, FG )–Intangible assets

Liabilities–Payables ( Loan, payroll, tax, supplier payment etc.)–Long term loan

Shares holders equity–Retained earning / loss

Cash Cash

• There are 3 ways of creating cash for the business1. Sale of new bonds or equity2. Sale of assets3. Created by on going business

• Good company has lot of cash and low debt

• 3rd option company has advantage that it will sail

• through troubled time. 1 and 2 are for that year only and not ongoing cash creation

• Check for last 5-7 years BS to see if it consistently is cash rich

InventoryInventory

• It represents raw material, semi finished and finished parts in ware house of a company

• Large inventory is not good. It means large money blocked which results in loss of business opportunity and interest

• It also means high cost of obsolescence in case product changes

• Its OK if inventory is rising corresponding to earning (constant inventory to sale ratio)

Net receivablesNet receivables

• Payment due after few days after sale of product or a service

• Receivables – Bad debts = net receivables

• Competitive company will show lower receivable to sale ratio as that of a competitor

Other current assetsOther current assets

• Advance payments like– Insurance premium– Electricity bills– Income tax recovery

Current ratioCurrent ratio

• Ratio of Current assets to current liabilities

• > 1 is good ( It shows ease with which cash can be generated for meeting creditors obligations at a short notice)

• Exceptions( Their earning power is quite high to cover liabilities if required)– Moody’s: 0.64– Coca cola: 0.95– P&G: 0.82

Property / plant & equipmentProperty / plant & equipment

• Durable companies do not require to upgrade plant & equipment continuously

Billion USD Equipment Debt Earning

Wrigley 1.4 1 0.5

GM 56 40 -ve

– Making chewing gum is more profitable than competitive car industry as same equipment is ok

GoodwillGoodwill

• Exxon buys an oil company A and pays more than A’s book value then this excess is recorded in Exxon’s assets as goodwill

• When we see increase in goodwill over the years that means company is making acquisitions

• This can be good if they are durable companies

Intangible assetsIntangible assets

• Cant be physically touched

• Like: Patents, TMs, Copy rights, franchises, brand names and software

• Coke’s brand name is worth more than 100 Bn $, however does not appear on BS as it is internally developed. Look for such companies

• Similar examples are Wrigley, Wal Mart, Mc Donalds

• Thus such durable companies remained hidden from the investors

Other long term assetsOther long term assets

• Investment > 1 year– Other company stocks– Real estate– Own subsidiaries

• It is carried in books at cost. This means, actual value today can be much higher

• Warren Buffet – Bought controlling stake in Berkshire Hathway – Stopped paying dividend and generated cash– Went on 40 year shopping spree looking for durable companies– Today he is worth 50 Billion US$ give or take

Return on capital employed Return on capital employed (ROCE)(ROCE)

• Ratio of earning to assets

• Higher the better

Assets

Billion $

ROCE

Coca cola 43 12 %

P&G 143 7%

Moody’s 1.7 43 %

Long term debtLong term debt

• Durable companies do not have long term debt

• Too much debt coming due in current year can create cash flow problems and bankruptcy

Debt equity ratioDebt equity ratio

• For durable companies the ratio is < 0.8

• But banks are exception. Up to 7 is good and shows conservative lending practices

– Moody’s 0.63– Coca cola 0.51– P&G 0.71– Good year 4.35 (?)– Ford 38.0 ( not good)

Book valueBook value

• Total assets – Total liabilities = Book value • Also called as Shareholder’s equity

• Common shares: Holders are owners, can elect board of directors and CEO. Receive dividends as per recommendation of the board.

• Preferential shares: Don’t have right to vote but have right to receive fixed dividend. It is similar to debt but is not deductible for calculating tax. Therefore it is expensive money. Avoid company with such shares.

• Paid up capital: If 100 Rs. Share is sold to public for say 120 Rs. Then Rs. 100 will be shown as shareholder’s equity and Rs. 20 will be shown as paid up capital.

Retained earnings Retained earnings

• Profit can be paid out as dividends to share holders or held back as retained earnings

• Retained earnings can be reinvested for further faster and profitable growth

• Durable companies have high rate of growth of retained earnings

• For the past 5 years average rate of yearly earning of some companies is: Coca cola – 8%, Wrigley – 11%, FeWells Fargo – 14%, railway – 16%, Berkshire Hathway – 23%, GM is –ve

EPS and PE ratio (Important)EPS and PE ratio (Important)

• Earning per share = Profit after tax / number of shares– Your investment growth is directly proportional to increase in EPS

• PE ratio = Market price / EPS– PE has no financial significance. It represents market sentiment.

Example: Political stability, monsoons, good or bad news about company’s future business plans etc. Your investment growth is also directly proportional to increase in PE

• Historically PE of16 is healthy

• >30 means heated market• At about 40 you can sell and wait for 6 months ( keep money in

bank etc. and wait for market to collapse back to say 20 and then buy

Sub prime crisisSub prime crisis

• Example: Investment banks borrow money at 6% and offer money for home loans at 8%. They earn 2%

• Thus on 100 Billion $ they will earn 2 Billion $ / year… every year

• But if home buyers cannot pay back 8% interest ( which actually happened when economy started to slip) then banks went into trouble.

Cash flow Cash flow

• From Operating activities– Cash flow = Net income + depreciation + depreciation– Depreciation and Amortisation are added back as

they don’t eat up any cash

• From investing operations ( Always –ve)– Capital investments (expenditure) made during that

period

• From financial operations– Payment of dividends– Buying / selling of stock

Capital expenditureCapital expenditure

• Durable companies spend < 50% of net earnings on capital expenditure

• Over 10 years period, durable companies spent much less % of net earning on capital expenditure– Coca cola 19%– Moody’s 5%– Wrigley 49%– Altria 20%– P&G 28%– Pepsico 38%– American Express 23%– GM 444% Bad– Good year 950 Bad

When to buy / sellWhen to buy / sell

• Buy at low price. It will give you long term advantage.– Stay away in bull market– Buy in bear market

• Sell when– Company is going to loose its advantage

• Higher technology replaces lower

• When you see a better company for investment

• Bull market when P/E ratio is > 40

• Take a break. 6 months or a year (banks). Then invest when there is bear market

All the Best……Happy investing