Dr Ajibola Awolowo
A popular quote by William Edward Deming says, “If you can’t describe what you are doing as a process, you don’t know what you are doing”. This has been the drive behind this set of articles which we conclude today. I have tried to make my stock picking process as plain and as easily understandable as possible. This is not because my process is the best. Rather, it is because it has worked for me and it might serve you equally well.
In the preceding two articles, we went through the first 10 hurdles which help filter the thousands of companies in the investing universe to just a handful of wonderful companies. Only companies that are astounding and have many factors working in their favour make it this far.
Just to recap what the initial 10 hurdles are:
- The company must come into my consciousness.
- The company must consistently be making profit or there must be a cogent and temporary reason why they have failed to do this.
- The company must have a high gross margin.
- The company must also have a high net margin.
- High cumulative annual growth rate in revenues, gross/ net profits, assets and equity.
- High Return on assets and return on equity in the latest year.
- Rising or stable ROE and ROA over the last 5 years.
- A reasonable debt profile.
- I must be capable of understanding the business.
- The company must have skilled and honest management.
This brings us to the final and the most important hurdle. This last hurdle can make or break your investing practice. It is what makes a difference between making a profit or registering a huge loss.
In truth, if you have done all the hard work well, you should not just like the companies that have made it this far, you should have fallen in love with them already. This is where we are most vulnerable. We become prone to acting out of our emotions without thinking. At this point, we just want to log into our brokerage account and click on the “BUY” button. We have invested so much time and resources into the research that we feel justified to just go out and buy them.
I recognise there are various schools of thought when it comes to what price to pay to own a business. Some believe that no price is too high as long as the company keeps growing the size of its pie while another believes the exact opposite. Personally, I belong in the second camp and I will try to tell you why.
In the 1960s and 1970s, there were a group of companies on the New York Stock Exchange called the Nifty fifty. They were wonderful companies with high earnings growth. They were even called one-decision companies because the only decision you had to make was to buy them. They did so well that everyone wanted to own them. Examples included Coca-cola, Kodak, General Electric, Halliburton, IBM, Walmart etc.
With this sort of demand came rising prices of the companies. Since the companies were growing their earnings, investors believed no price was too high to pay for them and their Price/ Earnings ratio went as high as 50 which was above the market average of about 20 back then.
Over the next decade however, their growth stalled and prices came crashing down. Investors eventually realised that some prices are indeed too high to pay for growth. I believe many investors today need, and will get, a repeat tutorial on this lesson soon.
To be fair, research by Professor Jeremy Seigel showed that if you had bought the Nifty Fifty at their peak and held them for over 25 years, you still would have made a decent profit. In reality, how many people can watch the value of their investment plummet by over 80% within a few years and still hold them for over 20 years beyond the decline?
This is why I believe the price one pays, even for the most wonderful of all wonderful companies, matter a lot. Even great companies can be a bad investment just as a bad company can be a wonderful investment, occasionally. What makes the difference? The price you pay for it versus the value you get from owning them. I hope this proves my point that valuation matters, possibly the most, in investing.
The 11th and final hurdle companies face before earning a buy rating into my portfolio is that the company must be selling at a price below its intrinsic value. As Charlie Munger said, “No matter how wonderful it (a company) is, it is not worth an infinite price”. I want to only buy this wonderful company when it is selling at a bargain as this is the only way to protect myself from the future which is inherently unpredictable with any sort of certainty.
This brings us to the elephant in the room. How do I determine a good price to pay for a wonderful company?
There are multiple ways to do this but I will limit this article just to two of them. The first is by using the price to earnings ratio while the second is by doing a discounted cashflow or dividend discount model valuation. Don’t worry, I will not bore you with all the details.
From the 5 year financial chart I had earlier constructed, I already know what the earnings of the company was for each year. I then check what price the company sold for on the last day of each of the 5 years. This is just arbitrary as the company may have sold for a higher or lower price in the year. Using this price per share or market capitalization of the company, I can calculate the price to earnings ratio of the company for each of the five years by dividing it by the earnings per share or the profit after tax respectively.
Now that I know the P/E ratios of the company over the last 5 years, I calculate the average P/E ratio and buy the company only if it is presently trading at or below the average of its 5 year P/E ratio. This method is simple and ensures that I am not overpaying for the company when compared with what it has traded for in the last 5 years.
It is important to note, however, that this method is flawed and prone to errors. The earnings or price in one of the previous 5 years may have been abnormally high or low which can skew you average P/E ratio and influence the price you are willing to pay for the company today. It is generally an easy way to gauge how much you should pay but one must be conscious of the pitfalls of this method.
This brings us to the second and more reliable way to determine value – Discounted Cash Flow/ Dividend Discount Models. This method operates on the principle of the time value of money. Money in your hands today is worth more than money promised to you in future. In investing, the future promised income are the future free cash flows the business will generate and the dividends it will pay out to you in future.
To value a business, you need to determine the value of all the future free cash flows/ dividends and discount them (using an appropriate discount rate as determined by you) to arrive at what that future income is worth today. Once I have arrived at this value, I aim to buy the company at a discount to this value which protects me from the unknown.
In following all the rules highlighted, I find a handful of wonderful companies but cannot buy them as they mostly trade at lofty prices. The key is patience! I wait for opportunities that come only occasionally such as the COVID induced decline in prices or bad news about a company or sector which causes prices to decline markedly. I admit that this discipline means I miss out on some juicy opportunities based on valuation but it protects me from a nifty fifty type of drawdown. My focus is not just on the upside but protecting my downside as well.
To end this article, I would like to iterate that, I don’t think it matters much what process you follow in stock picking. As long as you follow a proven process which minimizes the influence of your emotions in your stock picking, you should do just fine. Personally though, the process explained in this trilogy of articles works just fine for me and I am in no rush to change my winning formula.
Dr Ajibola Awolowo can be reached via valuenigeriawithajibola@yahoo.com