Investment Policy
Version 1.1Value Investor Principles
Investor Attitude
The best quality a value investor can have is discipline. This methodology requires
diligent research, great patience, and the ability to act on sound judgment. Value
investing isn’t nuclear physics; Most of the concepts are easy to understand. Since
the majority of your time will be spent studying companies, it will help to have a
natural curiosity about businesses and how they work.
A value investor sees himself as a business owner as opposed to simply owning
tradable stock certificates. If we consider ourselves businessmen, then our primary
focus should be on the business, and not the market where shares are traded. This
mindset has everything to do with the way we research, analyze, and buy a
business.
What do we mean by ―investor‖?
―An investment operation is one which, upon thorough analysis, promises safety of
principal and a satisfactory return.‖
-Benjamin Graham
Let’s examine each aspect of Graham’s definition more closely.
(1) Thorough analysis: Suggests that our goal is to make informed decisions. This
can only result from sound research and analysis. We never speculate.
(2) Safety of principal: Don’t lose money. Graham is more eloquent, but this is
essentially what he means. We regard this as the most important value
investment principle.
(3) Satisfactory return: Our goal is to seek exceptional returns. As a rule of thumb,
a ―satisfactory‖ return is one that exceeds the yield of Government Bonds and
outgrows inflation over the long-term.
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Safety of principal is the central concept of value investing. Many chase the ―hot‖
stocks of the day, paying a premium for companies they expect to grow forever.
When these hot stocks cool down, guess who’s left holding the bag? It can take
years for prices to recover, and more often than not, they don’t. This is called
permanent capital loss.
There will be ―doom and gloom‖ periods in the economy when every business will
suffer. Political crisis, war, and depression will cause Mr. Market to panic. Stock
prices will fall to levels not seen in years. While most investors flee the market with
great speed, the Value Investor remains calm and begins to look for the best
businesses at the lowest prices. Industrialized nations almost always recover from
these dark periods. Strong, well-run businesses live to tell the tale while weaker,
debt-laden enterprises rust at the bottom of the sea.
As a general rule, the market is overly pessimistic about bad news, and far too
optimistic about good news. This pessimism is usually the cause for severe price
decline in a stock. Even the absence of good news can lead to disinterest in a
business. The Value Investor needs to understand this dynamic but he is not
swayed to one way or the other by the markets. He looks at the facts and forms
conclusions based on sound analysis. If he concludes that the business is in good
shape he will view the price decline as a buying opportunity. If price decline
reflects deterioration in the business he will avoid it altogether, choosing instead to
focus on more attractive investments. The Value Investment creed requires
discipline and logical behavior at all times.
Again, we reflect on the teachings of Graham: ―Investment requires and
presupposes a margin of safety to protect against adverse developments‖ (Graham
12). Implicit in the name ―Value Investor‖ is one who desires quality at a
reasonable price. Buying high-quality companies when they sell at discounted
prices will meet Graham’s safety requirement. Holding these businesses for a long
period will provide a ―satisfactory return‖ in the form of dividend-payments and
capital gain.
Tools Needed
The investor will need the following resources to conduct investment operations:
- Brokerage account
- Research and analysis tools
- Capital
You can open a brokerage account with relative ease. Most of the research and
analysis tools you need can be found on the internet. Morningstar, Yahoo Finance,
and MSN Money are some of my favorites primarily because they provide stock
screeners, company news, and ample financial data. A company’s website is a
great place to start learning about its business. Most company websites include a
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special section for investors. This section may contain everything from educational
videos to annual reports.
Analysis will require thorough study of the company financial statements. It is not
necessary to have an MBA, but you will need to understand business finance. You
can learn as you go by keeping several good finance books in your library. The goal
is to determine the financial strength of the business and to answer important
questions about management performance.
We consider capital to be the most important resource. We buy businesses. When
we’re not buying businesses, we may be buying bonds or foreign currency. In
essence, every investment operation requires a purchase. Gathering capital is
demanding and will call for a special approach to your financial life.
Fiscal Excellence
Your success as an investor will depend on (1) your ability to make sound
investment decisions, and (2) the capital invested. All things equal, the investor
who commits the most capital to his operations will end up with the greatest
terminal value.
Choose a lifestyle that will free up as much capital as possible for investment
operations. The following principles promote fiscal discipline and sound accounting
policy. They are based on personal experience, the practices of Benjamin Graham,
and the tao of Warren Buffett;
1. Always be focused, calm, and patient
2. Meet all financial obligations and be conservative when spending
3. Avoid unnecessary fees
4. Eliminate debt
5. Plan your financial future
6. Seek sound and attractive investments
7. Become a capital resource
8. Be charitable
9. Honor all trusts and contracts
10. Learn, share, and apply knowledge
11. Correct problems and move forward
Commitment to each of these principles will put you on the right path. Be
resourceful and find the best ways to manage your money. A dollar not spent is
another dollar you can invest. Be ambitious with your goals and put your best plan
into practice. Give yourself time to make progress and focus on the future.
Value Investment Framework
1. The Business
Simple and Easy to Understand
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―The first rule of intelligent action by the enterprising investor must be that he will
never embark upon a security operation which he does not fully comprehend and
which he cannot justify by reference to the results of his own study and experience.‖
(Dodd, Graham 52)
Only buy businesses that are simple and easy to understand.
Every investor has a circle of competence. You will find companies that are easy to
understand and others that are difficult to comprehend. Stay away from the
business you don’t understand. It is imperative that you (1) understand how the
business makes money, (2) know the company’s position with respect to peer
businesses, and (3) understand the impact of outside developments on the
business. The investor that accomplishes all three is well qualified for the
investment operation. Investors not meeting this requirement lack the focus, the
knowledge, or experience needed for successful analysis.
Research and analysis is most successful when the investor completely
understands the business. If you invest in a company you do not understand, there
is little chance that you can interpret developments or make wise decisions with
respect to the business (Hagstrom 63).
Diligent research coupled with a strong desire to learn will expand one’s circle of
competence.
Key Points:
- Stay within your circle of competence
- Successful analysis requires complete comprehension of the business
Consistent Operating History
The ideal business would show consistency in financial performance and in the day-
to-day operations of the business. A company that displays consistent results, year
after year, is likely to continue on that path. This exceptional track-record usually
indicates a high quality business—one that can withstand adversity and capable of
strong performance in years to come.
A key point of analysis is past performance during a tough time in the industry.
Compare the business to competitors during that period. For example, Tsakos
Energy Navigation (TNP) was one of three shipping companies that remained
profitable in 2002, the toughest year for tankers in the last decade. Their focus on
long-term charters and fleet diversity ensured consistent cash flow despite a volatile
tanker market. Consequently, TNP emerged from rough seas in 2002 well ahead of
the competition.
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Remember, the goal is to own a company you can keep for a long time. You should
expect the business to outperform competitors in each phase of the business cycle.
If you leave for ten years and come back, the business should be worth considerably
more.
Key Points:
- Strong, consistent performance is a mark of quality
- Look at performance in every phase of the business cycle
Favorable Long -Term Prospects
―I look at long-term competitive advantage. And [whether] that’s something that’s
enduring.‖
-Warren Buffet in Berkshire’s 1995 annual meeting
The economic world contains two major business groups: franchises and
commodity businesses. The former carries a clear advantage over the latter, which
make up the bulk of the economy. A franchise is defined as a company whose
product or service (1) is needed or desired, (2) has no close substitute, and (3) is not
regulated (Hagstrom 71). Individually and combined, these create a competitive
advantage that rewards investors. Franchises are characterized by strong profit
margins which lead to high returns on invested capital. On the other hand,
commodity companies have weak pricing flexibility making them ideal for profit
trouble and low returns. Commodity companies may show strength during a tight
supply period, but these cycles are difficult to predict (Hagstrom 71).
A select few commodity companies become known for product quality, excellent
service, and innovation. When this happens they take on franchise-like qualities
and can charge more for products and services. Customer loyalty is strong, helping
to shore up profits during a downturn in the business cycle. For example, think of all
the search engines on the internet. There are dozens, perhaps hundreds, but
Google is the clear winner. This translates into greater advertisement revenue and
profits.
Answer these fundamental questions about the enterprise: Is the company a
franchise? Is the business known for industry excellence? If so, how committed are
they to maintaining that position?
Think of long-term competitive advantage as durability. Investment deals with the
future and depends on future developments for vindication. A Value Investor wants
a portfolio of companies that can survive the doom and gloom periods, providing
high returns for years to come. We must concentrate on weighing past record and
performance when assigning value to a business, and regard the future more as a
hazard to guard against than a source of profit through prophecy. (Graham 12).
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―The definition of a great company is one that will be great for 25 to 30 years.‖
-Berkshire Hathaway annual meeting, 1996
Key Points:
- Look for franchised businesses
- Focus on brand names that distinguish themselves through product quality,
service excellence and innovation
- Look for long-term competitive advantages in the business
- When assigning value, past performance is more important than potential
performance
2. Management
―Good managements produce a good average market price, and bad
managements produce bad market prices.‖
-Benjamin Graham
Behaves Like Ownership
We expect managers to act and think like owners of the business. Managers who
behave like owners stay focused on the company’s primary objective: increasing
shareholder value. They are inclined to make rational decisions that further that
goal (Hagstrom 82).
CEO avarice is commonplace in many large corporations. Executive compensation,
stock options, and accounting trickery are just several ways a dishonest
management team can damage shareholders. In some instances, entire executive
teams used company money for elaborate parties and personal extravaganza. This
excess has awakened the Securities Exchange Commission, resulting in a sleuth of
investigations and several high-profile indictments. We are in a period of reform but
corporate governance should remain a concern for investors.
Shareholders provide the capital that gives life to a company: Managers are
indebted to the owners and are expected to increase shareholder value. The best
managers see the bigger picture. They work to enrich the lives of the workforce,
forge key strategic partnerships, and build strong customer relationships. A fit
company is usually very profitable and can benefit shareholders in a sustained and
ethical way.
Key Points:
- Management should always act to increase shareholder value
- Executive compensation should be reasonable
- Look at the core values of the business
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Candid with Shareholders
Generally Accepted Accounting Principles (GAAP) refers to a set of widely accepted
accounting standards used to standardize financial accounting of public companies.
It is important to know that GAAP is only a set of standards and there is plenty of
room for accountants to distort figures. Financial accounting standards only require
disclosure of business information classified by industry segment (Hagstrom 94).
Some managers exploit this minimum requirement, leaving owners in the dark
about vital developments. A financially literate investor should be able to answer
these three key questions;
- How much is the business is worth?
- Can the company meet future obligations?
- How is cash allocated?
A good Annual Report will meet GAAP obligations and go much further. It should
provide earnings data for each business division, a breakdown of the business
operations, plus any information deemed valuable to owners. The annual report
should present a clear picture of the company’s financial performance whether
good or bad. Too many managers report with excessive optimism instead of honest
explanation (Hagstrom 95). The best managers are those with the courage to
discuss failure openly. Every company makes mistakes but managers tend to only
focus on successes. Berkshire Hathaway’s annual reports serve as a model for
investors. Warren Buffett and Charlie Munger discuss business problems and
management error openly.
Key Points:
- Management should report bad news with honest explanation
- Quarterly and Annual Reports should meet GAAP obligations and go much
further.
Properly Allocates Cash
The most important management act is allocation of the company’s capital.
Management behavior in this regard ultimately determines shareholder value. The
management team decides how to spend the company’s earnings. They can
reinvest earnings in the business, or return the money to shareholders. This
decision is an exercise in rationality.
A company that generates cash in excess of its needs has three options: (1) reinvest
the cash in the business, (2) it can buy growth, or (3) it can return the money to
shareholders. It is at this crossroad where we must keenly focus on management.
If extra cash, reinvested in the business, can produce a high return on equity, then
that is the logical choice. If they can not increase return on equity (ROE) through
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cash reinvested, then the capital should be returned to shareholders in the form of
dividends or a share buyback programs. Share buyback programs are the most
favorable course of action because they create the most shareholder value. We will
further examine share buyback programs in the Catalyst section of the policy.
A company that has poor economic returns and continues to reinvest cash is
wasting a valuable resource. This will degrade shareholder value over the long term
or it will lead to the second option: buying growth, which can cause greater harm to
shareholders. Management fails to increase ROE from reinvested cash so it decides
to acquire a company. These acquisitions usually come at great expense to the
purchaser. Management is now faced with the task of integrating the new company
into the business and can lose focus on the core business.
Key Points
- Cash allocation is the most important management act
- When cash reinvestment does not yield a higher ROE, the only logical course
of action is to return cash to shareholders
- Share buyback programs offer the greatest reward to shareholders
- Beware of acquisitions to fuel growth
Resists the Institutional Imperative
What is the ―institutional imperative‖?
―The tendency of corporate management to imitate the behavior of other managers,
no matter how silly or irrational that behavior may be.‖ (Hagstrom p.97)
Buffett considers this unseen force to be the main cause for irrational behavior. He
believes that the institutional imperative is responsible for the following conditions;
―(1) The organization resists any change in its current direction; (2) just as work
expands to fill available time, corporate projects or acquisitions will materialize to
soak up available funds; (3) any business craving of the leader, however foolish, will
quickly be supported by detailed rate-of-return and strategic studies prepared by his
troops; and (4) the behavior of peer companies,…will be mindlessly imitated.―
(Hagstrom p.97)
Think of it this way. Company A is in the same industry as B, C, and D. Company C
acquires company D. Company A decides to acquire company B because it feels
this is necessary to compete with company C. Company C struggles to integrate the
new business and never has another profitable year. Company B suffers the same
fate.
A good manager makes decisions based on business expertise—not the behavior of
outside management. He must always know the condition of the business, the
nature of company operations, or be willing to seek the direction of those who do.
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Managers of this grade have no problem resisting the institutional imperative. They
are more likely to confront problems and are capable of making fundamental
changes if necessary. It may be necessary to accept a short term loss in order to
realize prosperity in the long-term.
What causes the institutional imperative? It is always more difficult to confront
problems head on. Most managers lack the courage or innovation to do so and are
tempted into buying a new company instead of facing the facts.
Key Points;
- Good managers make business decisions based on their intellectual and
financial ability, not the behavior of a peer group.
- Look for managers with the courage and creativity to confront problems
head on.
- Beware of management teams consumed with hyperactivity. This is a sign
that the institutional imperative has entered the decision making process.
Management Strategy
A good manager can start with a vision and build a strategy for success. In a
perfect world, the corporate mission is handed down to each team and becomes
manifest in the actions of every worker. As a potential shareholder, learn as much
as you can about management’s strategy. Compare their strategy to other
companies in the industry. Is the business plan designed for long-term success? -or
designed to temporarily inflate the stock price? Pay close attention to how they
deal with rising operating costs, such as increased labor or fuel rates.
Strategy is meaningless if the business doesn’t execute. Study the annual reports
of a business for a five year period. Compare earlier strategies with the current
business strategy. If the company is on track, the corporate mission will be
consistent and the business will have achieved several major milestones. If neither
case is evident then one should be concerned at the apparent lack of focus and
poor performance.
Key Points;
- Get to know the business strategy
- Company activity should reflect the corporate mission
Look for managers that focus and execute.3. Financial
Balance Sheet Analysis
The Balance Sheet is a snapshot of a company’s financial condition at a given point
in time. It shows how solvent a business is and what shape –good or bad –it is in.
The balance sheet tells you how much the company is worth, how much it owes,
and the resources it has to survive (Browne p.88).
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The most important aspect of the balance sheet is liquidity, or the amount of cash
available in the short term. According to Christopher Browne (Tweedy, Browne
Company), ―liquidity provides the flexibility to withstand down cycles in the
economy, pay dividends to shareholders, buy back stock, and take advantage of
future opportunities.‖
Another factor to consider is debt, the short and long-term liabilities. Make sure the
business is not overburdened with debt and that there is enough capital to stay in
business during tough times (Browne p.88).
Current Assets: cash and assets that can be quickly converted to cash in a short
period, such as a year or less.
Current Liabilities: debt that falls due within a year or less.
Current Ratio = Current Assets/Current Liabilities
Current Ratio: Companies ability to pay its short-term obligations. Rule of thumb is
a ratio of 2:1. A declining current ratio year over year may indicate that a serious
liquidity problem is developing. Compare with competitors.
Quick Ratio = Current Assets (no inventory)/Current Liabilities
Quick Ratio: Also known as acid test ratio. Company may not receive full value for
inventory in a quick liquidation period, so it is more revealing to see the current ratio
without inventory. The quick ratio gives a clear view of a company’s cash position
versus its bills.
Working Capital = Current Assets – Current Liabilities
Working Capital: The more the better. See if this number is rising or falling.
Long-term assets: This includes real estate, ships, factories, equipment, and
investments in subsidiaries or stocks that the company does not intend to sell.
Long-term liabilities: Debt that is due longer than one year from now, such as bank
loans, public and private bond issue, and long-term leases for property and
equipment. Look at trends over the past few years.
Debt-to-equity ratio = total debt / shareholder equity
Debt-to-equity ratio: If the number is higher than one, we know that the company is
funded primarily by debt rather than equity investment. Compare with other
industries. In general, a high debt-to-equity ratio means that a company has been
financing its growth by borrowing. The less debt on the balance sheet, the greater
the margin of safety.
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Debt-to-assets ratio = total debt / total assets
Debt-to-assets ratio: A company should not owe more than half what it is worth.
Careful analysis of the balance sheet is the first step of financial analysis. You are
looking for red flags that may signal some problems with the business. Always look
at the trends over past five years and compare your findings with the competition.
Debt, assets, and leverage ratios give you valuable information about the
company’s health and future prospects.
Income Statement Analysis
The income statement is a record of cash flowing into a business and how much
was paid out in a period of time. As with the balance sheet, most companies report
this quarterly and annually.
Sales/Revenues: The first line on the balance sheet is revenue. Look at the past
five year revenue trend. Growing revenue is good –indicates that the company is
making progress. If revenue is declining it is important to understand why before
passing judgment on the security. Revenue loss could be temporary, resulting in
lower stock prices, or a good buying opportunity.
Examine the revenue sources. What divisions provide the most revenue? Are these
core businesses? Look at the trends. Again, growing revenue in a division reflects
strength while declining revenue in a division requires further analysis.
Cost of goods sold: Direct cost of producing whatever product or service the
company sells.
Gross Profit Margin = gross margin / revenue
Gross Profit Margin: The steadier the gross profit margin, the better the business.
Operating Expenses: Also called selling, general, and administrative expenses in the
income statement. These are fixed costs not directly involved in producing
whatever the company sells. If operating expenses are high or rising, management
is not effectively controlling costs.
Operating Profit/Operation Income: Operating profit, or earnings before interest and
taxes, is used by Browne to value a company. Browne states, ―…as it is the figure
most likely to be used by anyone interested in acquiring the entire company.‖
Extraordinary Items: These are items that do not occur with any predictability.
Net Income:
Net Profit Margin = net income / revenue
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Net Profit Margin:
ROC (Return on Capital) = net income / (beg. Capital + stock holders equity + debt)
ROC: This measures how much cash a company can generate with the capital it
uses. ―A company with a high return on capital has a much greater chance of
financing growth with self-generated cash than one with a low return.‖
(Browne p.99) Be mindful of trends and look for stability. This also indicates that
management is effectively investing and managing reinvested profits each year.
Book Value
Book value = Total Assets – Total Liabilities
The book value of a
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