Wednesday, 2 December 2015

Investment philosophy: Don't predict earnings, find companies with predictable earnings

Investment philosophy

The price of stocks are a sum of three parts

1) Quality of the company
2) Future earnings of the company
3) Value of the stock

1) Quality of the company

- Quality of the company consists of 2 components
- The current industry the stock is in
- The historical/current financial health of the company

The current industry the stock is in involves checklists such as
- Stability of the industry
- Monopolistic/Oligopolistic nature of the company
- Company's branding

The historical/current financial health of the company
- Earnings track record (net margins, volatility in earnings, historical growth etc)
- Debt (interest coverage, D/E etc)
- Productivity (ROE, ROA)
- Cash flow (FCF, growth of OCF, expenditure on capex)

Summary: The quality of the company is used as a screen to find out which companies to look at. As a retail investor/long term holder we do not try to predict the future earnings. Thus investing in companies that have great positioning in the market + financial health gives us confidence that the company can deliver on its predicted earnings

2) Future earnings of the company

This literally decides the value of the stock, however its where people have the biggest folly. Sticking to Warren Buffet's principle, we do not try to predict the future, especially for companies that are in cyclical industries or have lumpy earnings.

Thus we rely heavily on the quality of the company, the rationale being: If a company (think JNJ) has a dominant position in the market, good financial health, and has been growing at a rate of 5% a year, there's a high chance its going to grow at 5% a year in the future

3) Value

The problem about identifying good companies with steady growth is 1) There isn't too many of them 2) They are usually properly valued. Even though they would tend to grow in the future (Stock gets cheaper as earnings increase), we would like to purchase a 'wonderful company at a fair price'.

This involves not comparing it with its peers (which are not accurate, probably not in the same position as the firm) but against history, where by logic, if the firm grows constantly, its P/E should be fairly constant. The P/E, forward P/E bands of these stocks rarely fluctuate.

Thus, our job is easy
1) Find stocks that fit our criteria
2) Use consensus estimates/ check its not too far off from historical growth
3) Buy it when its cheap.

You would realize my method is the same as bonds. Or 'equity bonds' as warren buffet likes to call it. As bonds have a universal method of valuation, my job is to find companies that act like bonds and buy it on the cheap.

Selling criteria

Generally, selling criteria is harder than buying. Here's an example, when you see a stock like comfortdelgro trade at lets say 12x (way below its historical average), because of a crisis or whatever, you buy the stock. But when to sell it, 14x, 18x, 22x? That's a harder one to answer

2 criteria
1) When stocks go above a certain value
2) When the fundamentals of the company change

1) When stocks go above a certain value
This is an easy one, usually the stocks i look at usually revert to the mean, when a stock goes 20%+ its historical p/e level its usually time to sell. Give or take. Here's an easy way to think of it:

- stock's earnings is expected to growth 5% yearly
- stock is trading 20% above average p/e
- assume stock will revert back to average

This means that the earnings has to grow 5% for 4 years for the stock to do.... nothing.

2) When the fundamentals of the company change

This is infinitely harder to do, but totally crucial. You would realize the quality of the company is the main/sole reason I like the stock (future earnings + value just tell us when to buy the stock).

Once the quality of the company or the industry changes, you should get out of the stock. This is fairly hard to do, quarterly earnings fluctuate, perceived threats may occur, but identifying a structural shift and a potential de-rating is what thats important.

Warren buffet follows this extremely strictly, he did not sell coke, amex, p&g (aka his untouchables) even though they have constantly exceeded point 1. But he dumps stocks without mercy once he sees 2). Tesco & Walmart got dumped the second he realized there's a structural shift to online retailing.
He dumped airlines the second he realized that discounters are destroying the entire model.

There is no fixed method of doing this, but if your company has constantly missed earnings (2 Quarters is a good gauge) on losing market share, change in regulation, mgmt. doing stupid things, then its time to worry.

Summary: Don't anyhow.

Its the same thing as sticking to your circle of competence. I don't know how to predict earnings, so instead of doing so, I find companies that have predictable earnings and a good track record. I don't try to make 20-30% returns, or pick 'multibaggers', I instead try not to lose money and sleep easy at night.

TLDR version: (step 2 is actually the hardest)
1) Pick good quality companies with predictable earnings
2) wait for the price to fall
3) Buy it when its cheap.