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Home > Investor's Education > Investing 101

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9 STEPS TO VALUE INVESTING TUTORIAL
 

Our Objective:

To achieve a target annual return of 15%- 25% on our investments

The key to building a successful portfolio is to:

1. Identify very good businesses

2. Buy them at a good price (huge discount)

3. Wait for the market to realize its true value or over-value it

What is a VERY GOOD business? It is one that:

1. Has exceptionally good long-term economics

 

2. Has a durable competitive advantage (economic moat) that protects it from any competition.

3. We can predict with strong confidence that over the long term, earnings, shareholder value & prices will grow.

4. Can recover and prosper in the event of any major recession or bad news.

Buffett’s Investment Philosophy: Investing from a Business Perspective

When you buy the stock of a company, you are buying to become a part-owner of the company.

If the company earns $3 per share in 2004 (EPS) and you own 500 shares => You have earned $3 x 500 = $15,000

 

The Price You Pay Determines Your Initial Rate of Return

You buy OSIM stock at  $0.89

Earnings per share is  $0.071

Earnings per share growth rate  31.14%

Your initial rate of return is $0.071 / $0.89 = 8%

Would you rather… put your money in FD at 2% per year

OR invest in OSIM that returns 8% per year, with a growth rate of 31%?

9 STEPS TO VALUE INVESTING


The first 7 criteria are used to determine if the stock you are investing in is a GREAT BUSINESS that will grow in value over time.

The 8th and 9th criteria are used to determine if the price is right and if it is the BEST TIME to buy the stock.

IS IT A VERY GOOD BUSINESS?

Criteria #1:

History of Consistently Increasing Sales, Earnings and Cash Flow

* Note that earnings, net income and profits are used interchangeably, while Sales & Revenue are used interchangeably

The first indication of a good business is one that has at least a 5-10 year history of CONSISTENTLY INCREASING SALES, EARNINGS, & CASH FLOW, especially during tough times.

If a company’s past earnings show consistency, then future earnings will be more predictable to forecast with confidence.

For example, look at General Motors Corp and Johnson & Johnson’s Earnings (in green) and price chart (in black). General Motor’s past earnings are too erratic to predict with certainty. However, JNJ’s earnings can be forecasted with a lot more confidence.

Chart 2: Stock Price & Earnings Chart

Screen Capture From www.corporateinformation.com


While earnings can be creatively manipulated by accountants, cash flow & sales cannot be manipulated.

SALES REVENUE & CASH FLOW FROM OPERATIONS should also increase at same rate as EARNINGS.

Where To Find This Information?

Go to Morningstar.com => Enter Quote => Financial Statements

To look at the company’s ‘Sales Revenue’ and ‘Net Income’, look under ’10-yr Income’.

Table 3: Income Statement from Morningstar.com

Screen Capture From www.morningstar.com


 

To look at the company’s ‘Cash flow from operations’, look under ’10-Yr Cash Flow’.

Table 4: Statement of Cash Flows From Morningstar.com

Screen Capture From www.morningstar.com


Since ‘Sales Revenue’, ‘Net Income’ and ‘Cash Flow from Operations’ have been increasing consistently over 10-years, Criteria 1 PASS.

Criteria #2:

Sustainable Competitive Advantage

For the company to continue to increase earnings growth, it must possess a sustainable competitive advantage (wide economic moat) that protects it from any potential competition.


 What Creates a Sustainable Competitive Advantage?

1. A Strong Brand E.g. Coke, Nike, Hersheys, Budweiser…

2. Huge Market Share. E.g Wal-Mart, GE, VISA, ExxonMobil

3. High Customer Switching Costs. E.g. Adobe, Stryker.

4. Patents, Copyrights, Government Approvals or Licenses   E.g. Pharmaceutical companies, SPH

5. The Network Effect. E.g. EBay, Google

Note: A competitive advantage created by a HOT new technology isn’t sustainable because it is only a matter of time when the technology is made obsolete by a better one.


 

Examples of Companies with Sustainable Competitive Advantage (Wide Economic Moats)

Examples of Companies with Narrow Economic Moats

Where Do I Find This Information?

Read and thoroughly understand the company’s business model by entering the ticker symbol (e.g. JNJ) into:

1) finance.google.com (Go to ‘Summary’),

2) Morningstar.com ( Go to ‘Company Profile’ and ‘Analyst Research’)

3) Moneycentral.com (Guided Research -> Stock Research Wizard).


From understanding the business model, you can distinguish if the company has a Competitive Advantage’ or is ‘Price Competitive’.

Morningstar.com’s ‘Analyst Research’ (Premium Paid Service) does the classification for you.


JNJ’s huge market share, strong consumer brands (e.g. Tylenol, Johnson’s Baby Shampoo, Neutrogena etc…) and pharmaceutical patents give it a sustainable competitive advantage (wide economic moat) Criteria 2 PASS.

Criteria #3:

Future Growth Drivers

Although the company has a strong track record of consistent revenue and earnings growth, are there any strong goals and strategies that management has announced that will continue to drive growth into the future? Are there any new market opportunities that will allow the company to keep selling more products and services?

• Development of new product lines

• Upcoming product innovations

• New application of patents

• Expansion in capacity

• Opening new markets

• Building more outlets

• Huge untapped market potential

Where Do I Find This Information?

To read about the company’s future growth plans, you can go to:

a. Company’s website and go to ‘Investor Relations’ (Find the Link from Finance.Google.com)

b. Company’s Annual Report under ‘CEO’ Message’ or ‘Future Growth Plans’ (Google Search)

c. Morningstar.com => Analyst Research => See ‘Growth’ and ‘Bulls Say’ (Premium membership)


Criteria #4:

Conservative Debt

The next criterion is that the company should have a conservative debt policy. The rule of thumb is that long-term debt should be less than 3 X Current Net Earnings (After Tax)

Long Term Debt  < 3X Current Net Earnings (After Tax)

Note: While having conservative debt is useful for generating growth while keeping ROE high, too much debt can lead to bankruptcy during a prolonged recession or calamity.

Where Do I Find This Information?

Go to Morningstar.com

-> Enter ‘Ticker Symbol’ -> Financial Statements

-> 10-Yr Income (to check Net Income)

-> 10-Yr Balance Sheet (to check Long-Term Debt)


Since JNJ’s long-term debt ($2.014 billion) is much lower than its Net Income ($11.053 billion) in 2006, CRITERIA 4 PASS

Criteria #5:

Return of Equity (ROE) & Return on Assets (ROA) Must be Consistent & High. ROE > 12-15% & ROA > 7%

A company that shows a high & consistent ROE indicates that:

a. The company has a sustainable competitive advantage.

b. Your investment in the form of shareholder’s equity will grow at a high annual rate of compounding that will lead to a high share price in the future.

Generally, a company that has ROE of 5-10 years:

ROE > 15% => Great Investment

ROE > 12%  => Good investment

ROE = 12% => Fair investment (most global business average this)

ROE < 12%  => Unattractive investment

Danger: Some price competitive companies show high ROE as they purposely shrink their equity base through large dividend payouts or share repurchasing. To solve this problem, Return on Assets (ROA) should be consistent and > 6-7% as well.

How To Find This Information

Go to Morningstar.com

-> Enter ‘Ticker Symbol’

-> Go to ‘Key Ratios’


Since JNJ’s ROE is > 12% and ROA > 7%, Criteria 5 PASS

Criteria #6:

Low Capital Expenditure (CAPEX) Required to Maintain Current Operations

There is no use in a company generating high earnings if a substantial amount goes to replacing plant & equipment in order to maintain current operations and competitive advantage. This is normally so for PRICE COMPETITIVE businesses and businesses involved in MANUFACTURING.

Why? Because the earnings cannot be paid out as dividends, be retained to be re-invested in growth projects or to re-purchase shares.


How To Find This Information

Read and thoroughly understand the company’s business model by going to finance.google.com, morningstar.com (analyst research) and moneycentral.com (stock research wizard) and the company’s website.

From understanding the business model, you should only invest in companies that:

a. Does not require high capital expenditure to maintain efficiency or replace plant and machinery

b. Does not require extensive research to maintain competitive advantage

c. Produces a product that hardly goes obsolete

To find Free Cash Flow/ Sales Revenue,

Go to Morningstar.com => Financial Statement => 10-Yr Income and => 10-Yr Cash Flow.


Criteria #7:

Management is Holding/Buying the Stock

The next factor to look at is whether the company’s own directors are holding, buying or selling their own shares.

If you find that KEY APPOINTMENT HOLDERS like the CEO, CFO or chairman are selling a LARGE proportion of their own stock, then it may not be as good an investment as it seems.

Where Do I Find This Information?

Go to Moneycentral.com

-> Investing

-> Enter ‘Ticker Symbol’ -> Fundamentals -> Insider Trading

-> This will show you if key appointment holders are net buyers/sellers


-> Also, click on ‘Research’ -> ‘Stock Rating’

-> Go to ‘Ownership details’

-> Anything below a ‘C’ grade fails the criteria


Criteria #8:

The Company is Undervalued: Stock Price Is Below Intrinsic Value

 

You should only buy a stock if its CURRENT SHARE PRICE is SIGNIFICANTLY BELOW its INTRINSIC VALUE.

When you buy a stock that is UNDERVALUED, it gives you a high margin of safety.

For example, if a company’s stock is worth $50 (i.e. Intrinsic Value) and it is selling for $25 (i.e. Current Share Price), it will definitely be a great buy.

Why is a Great Business Undervalued?

Great Businesses become undervalued from time to time because the market is irrationally driven by fear and greed in the short-term.

Stock markets tend to over-react to bad news in the short-term, sending the stock’s price way below its true value.

A value investor who knows the true value of the stock will take advantage of this and buy while the company is on ‘sale’ and sell when the investor optimism returns.

The Bad News Must Be Temporary

Always check that the bad news that causes the stock price to decline is a temporary reason and DOES NOT affect the company’s long term growth prospects.

Common reasons for short-term undervaluation are:

a. The stock’s sector (e.g. Heath Care) goes out of rotation

b. The overall stock market is declining due to recessionary fears

c. The company misses its quarterly earnings estimates

d. Product or patent failure

e. Accounting or management scandal

Find Out the Reasons For The Stock Price Decline

Go to finance.google.com

-> Check the news for reasons of price decline


How to Calculate a Company’s Intrinsic Value

The Value of a Stock is Equal to the Present Value of All Its Future Cash Flows

To be even more conservative, I calculate the Intrinsic Value of a stock to be the sum of all its future cash flow for the next 10 years only!

In certain cases (especially Singapore stocks), where it is more tedious to calculate and project CASH FLOW, I use EARNINGS PER SHARE as a proxy instead.

Using the Intrinsic Value Calculator (Cash Flow)

Key in the Following Values:

-> Name of Stock

-> Stock Symbol

-> Operating Cash Flow (Current)

 : Go to Morningstar.com-> Financials -> 10-Yr Cash Flow

-> Cash Flow Growth Rate

 : Use EPS Growth Rate as a Proxy

: Moneycentral.com -> Research ->   Earnings Estimates -> Earnings Growth Rates

-> No. Of Shares Outstanding

 : Go to Morningstar.com-> Financials -> 10-Yr Income

-> Current Year Discount Rate

The ‘Intrinsic Value Per Share’ is automatically calculated.


Criteria #9:

Stock Breaks Out of Consolidation Or On An Uptrend and must be above the 20 or 50-Day moving Average

This final criterion will help you time your investment just before the stock makes its upward move.

You would want to know if the stock price is on a DOWNTREND, on an UPTREND or in a CONSOLIDATION pattern (moving sideways).

Always go with the current and avoid going against the current of investor psychology as much as possible. Once a trend is established—whether it's moving up or down—a stock is more likely to stay in that trend than to reverse.

Stock Price On An Uptrend


The Best Time to Buy Would be When The Stock Price Dips On An Uptrend

Stock Price In A Consolidation Pattern

 

The Best Time To Buy Is When The Stock Breaks Out Of the Consolidation Pattern on High Volume

Stock Price on a Downtrend


Avoid Buying Stocks When It Is Still On A Downtrend! Keep It On Your Watch-list Until It Bottoms Out.

Also, ensure that the stock price is ABOVE THE 20-DAY AND/OR 50-DAY MOVING AVERAGE. When the stock price cuts ABOVE the 20-day and/or 50-day moving average, it signals that the stock will rise even higher.

The 20-Day Moving Average cutting ABOVE the 50-Day MA is also a signal to buy.


Where Do I Find This Information?

Go to Optionsxpress.com

-> Look at the 6-month, 1-year, 2-year and 10-year price chart

-> Tools -> Apply Studies -> 20-Day and 50-day MA


From observing JNJ’s stock price over different periods, you can see that the stock price has consistently is on a long-term uptrend (from 5-year chart).

Currently, the 6-Month chart shows that JNJ is still on a shorter-term down-trend as is BELOW the 20 and 50-day Moving Averages.

It is NOT the right time to buy. Put JNJ on your watch-list and get ready to buy only when JNJ reverses into an UPTREND and cuts above the moving averages.

What Do You Do Once You Buy?

Regularly monitor the progress of your stock portfolio by checking:

1) Daily

o US Companies

o www.moneycentral.com => Portfolio/watchlist

o Watchlist of your US online broker

o SG Companies

o www.sgx.com => Live prices

o Watchlist of your local broker

If price drops significantly, check news and announcements

• US: Check finance.google.com

• SG: Check www.sgx.com => general announcements

2) Quarterly Review

US Companies

o Morningstar.com => Financial Statements & analyst research

o Finance.Google.com => Financial Statements

SG Companies

o SGX.com => company’s all-in-one info => general announcements and financials

3) Real Time

• Activate a Google alert for US and SG stocks

• Activate a Listedcompany.com alert for SG stocks

Seven Reasons To Sell A Value Stock

You Should Sell A Value Stock For Profit Only When…

1. The stock price drops 20% below your purchase price. A 20% drop is very unlikely if you buy a very good company that is undervalued.

2. You found you made a mistake when evaluating the company, as it does not meet one of the 9 investment criteria.

3. During your regular evaluation, you notice a negative change in one of the 9 investing criteria, and it does not seem temporary (e.g. fall in profit margin, earnings per share, ROE etc…)

4. Management takes action that is not in shareholder’s best interests or dilutes their stakes significantly.

5. You identify a much better investment (higher growth prospects, better price) that will give you a much higher annual rate of return.

6. When the economy is approaching a bubble and the stock’s price is way overvalued.

o Inflation is very high => FED begins to raise interest rates

o S&P 500 PE ratio is above 30.

7. The Stock price reverses into a downtrend

Other than these seven reasons, allow the value of your stock to compound over the medium to long term.

About The Author

Adam Khoo is an entrepreneur, best-selling author and a self-made millionaire by the age of 26. Over the last 15 years, he has trained over 245,000 professionals, executives and business owners to tap their personal power, achieve breakthrough results and excellence in their various fields of endeavor.

Discover his million dollar secrets and download your FREE "Get Out Of The Rat Race!" report at Secrets Of Self-Made Millionaires now...
 
 
 
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