Do I understand the business, and does it fall within the circle of competence? Do I understand the intrinsic value of the business today? Am I convinced about the inherent value? What is the possibility of the value changing in the future? Is the stock largely undervalued, and is the situation likely to continue for years?
If I must invest in this business, will I put a large portion of my wealth into it? What is the extent of a downside? Does the business have a moat, which means its ability to withstand competition and make a substantial profit? Is the company management honest and able? Asking the above questions will help investors get clarity on investment judgement. These fundamental questions establish the foundation of value investing, which Pabrai proposes.
It means picking up less risky stocks, but, on the upside, it also has a wide possibility of profit. Pabrai emphasised that investors of value investment must focus on the following parameters. Buying an existing business with an established track record rather than picking risky startups. Pabrai follows his guru Warren Buffet, who also, as an investor, never invested in startups. Buy simple businesses in industries that change very slowly. Aggressive investors often avoid these stocks, but value investors pick up these shares to create value in the long run Buying stocks from distressed businesses in distressed industries where the margin of safety results in attractive value opportunities Invest in businesses with durable competitive advantages or profitable moat.
He emphasises being patient to let the market work. When he identifies such stocks, he stacks the odds of success by creating a wide margin of safety and then bet big. Pabrai has written several books on value investing.
You can gain great insight into the motivation for high-level management decisions based on their compensation. We want to find managers with a long-term view, and if they have a long-term compensation package, their focus will have a long-term perspective. Ideally, we would love to find a CEO with a small salary and significant stock ownership compensation.
These managers tend to have a long-term view, which we want. Watch out for managers with stock options or companies with huge CEO payouts. They will have a short-term outlook and look out for themselves, not the company or the shareholders, because the incentives will encourage boosting earnings instead of building a great company.
Look for insider buying or selling If a senior manager buys or sells company stock, that can tell you much about what is happening with the company. In that case, the buying might indicate they think the company offers a good opportunity or there is a catalyst for its value to increase.
Insider buying or selling can tell you much about what the people closest to the company think about it and its prospects. Try not to jump to conclusions because one manager selling his shares might not mean much, but if the whole management team is selling or buying, that is far more indicative of something much better or worse. Does management have a plan, and do they communicate that plan?
Reading through the annual reports and discussions from the k can help you determine if management has a plan to grow the business and how well they execute their projects. Follow-through is essential to determine the integrity of management and to see if they are the right team to lead the company. Earnings drive Wall Street, and it is the main focus of analysts. They tend to fixate on earnings, and the company may feel the need to hit those earnings projections, to the detriment of the company.
And if that CEO or CFO has stock options tied up in earnings performance and the price of the stock increasing, that leads to more focus on earnings. What management does with the cash that they create can go a long way towards more value for the shareholders. Increasing or paying a dividend, reinvesting in the business, or buying back shares are a few possible decisions.
Finding a great CEO to operate the business will typically not allocate capital well because the two functions are very different. The best capital allocators are typically not day-to-day operators but remain removed from those operations. Warren Buffett would fit into this mold, as he is removed from daily operations. Does management think independently and remain un-swayed by what others in the industry are doing? One of the toughest challenges a CEO faces is to see its competitors having great success and all the earnings they are creating and not copying those methods.
Sometimes companies may create earnings that are not sustainable. Shareholders will often push to maximize short-term earnings, but the best managers will have a long-term view and focus on building for success over the long-term, which might not show results for a year before exploding.
Another way to tell if a manager thinks independently is if they compare themselves to a benchmark instead of competitors. Does the business grow organically? Or through mergers and acquisitions? We can answer this question by viewing the cash flow statement found in the K.
We can classify a business by several growth styles depending on the acquisition percentage. On one end would be those businesses that grow organically. On the other end would be serial acquirers. And others would fall in the middle. The serial acquirers risk paying too much for those businesses and adding more debt to the balance sheet.
Plus, they spend less money on acquisitions and take on less debt. What are the future growth prospects of the business? We can assess future growth by reading through the management discussion and analysis of the K. Management will discuss its plans for the future and how they intend to go about executing that plan. Is management focused on growing quickly or at a steady pace? Growing companies are exciting, but if they are outpacing their business, this could lead to failure down the road.
Focus on whether the company has a disciplined or undisciplined growth strategy. A high growth rate does not guarantee profitability. I am looking at you, Tesla. If the company is growing disciplined, it can control the growth and create more value for the shareholders. Financial Pillar This section will focus on the financial health of the business and will spend some time reading through the financials of the K and Q. The first part is to go through the financial statements.
Go through the financials line by line Income statement — line by line Balance sheet — line by line Cash flow statement — line by line Read through at least two annual reports to compare numbers using an excel spreadsheet or your favorite financial website for comparisons.
Look for trends, either on the upswing or downturn. Make a competitor comparison of the numbers to give you an idea of the strength of the business. What are the business operating metrics that we need to focus on? Every industry has metrics that are more useful for that particular business; for example, price to book is excellent for financials such as banks. The best way to identify whether the company has improving or deteriorating fundamentals for the business is by using metrics.
Operating metrics can help us determine the true health of a business. To identify the metrics that would be best: Find the best industry metrics Research the source of the metrics, i. Identify key risks the business faces We can identify key risks in the K under the risk sections and the management discussion section. Risks are associated with the business and others related to the stock price.
Please focus on the risks associated with the company, as they are more critical. There is a lot of boilerplate language in these sections, and it is essential to read through them and you will learn what to ignore and what to focus on. Assess the strength or weakness of the balance sheet A strong or weak balance sheet can mean the difference between surviving an economic downturn, like the Coronavirus pandemic, or struggling and declaring bankruptcy.
A healthy balance sheet allows a company to take advantage of any opportunity regardless of economic conditions. Our primary goal is to determine if the cash flow is sufficient to meet its debt obligations and if there is a margin of safety to cover those debt payments in the case of cash flows declining.
What is the return on invested capital for the business? Return on invested capital on a business is the profit created by the company relative to the money reinvested in the company. It tells us how well a company is using its assets. The more profit a company can make from its assets compared to the capital required, the better the business. Each industry will have different levels of ROIC, some much higher than others. For example, the tech industry will be much higher than banks because there is less capital expended to create profits.
A couple of rules regarding ROIC: We consider anything below 5 a low-quality business We view any ratio above 10 as a high-quality business Of the ratios we calculate, ROIC remains one of the more important ones to determine because the profit a company can make from its assets and the reinvestments it makes in the business are crucial for the long-term profitability of the company.
Buffett never explicitly says he calculates the ratio; however, he repeatedly talks about finding a business with a high return on capital as one of the most critical requirements. If you are unfamiliar with this ratio, please check this out to learn more. Does the business generate earnings from steady income or one-off transactions? Evaluating companies generating earnings from a steady flow of business is easier to value than companies hitting home runs every once in a while.
Think of companies like Amazon with Amazon Prime, whose steady income makes them easier to value because of the greater predictability of those earnings. Also, there is less pressure and reliance on always having to create new products. Companies like Apple that update their iPhones every few years create consistent earnings with the one product which generates most of their income.
You can learn more about this aspect of the business in the management discussion section in the K. Is the Return on Equity Attractive? Again, measuring the return on the equity the company creates is essential, another Buffett favorite. You can learn more about this here. Is the company conservatively financed?
Using our debt ratios from the balance sheet analysis, we can determine how much debt the company carries. The balance sheet analysis can also show how the company is functioning regarding creating value for the shareholders. If the company uses debt to fund dividend payments or share buybacks, that is a red flag because eventually, the tide will wash out to sea, and they will be there with their pants down.
You can also determine from the notes section of the K what kind of debt they are carrying and when it matures, which can tell us how much the debt might impact our cash flow in the future and the ability to reinvest in the business.
Does the company have a track record of growing earnings above the market average? We are looking for companies who will grow their earnings over a long period. There will be starts and stops, but generally, you want to see long-term growth.
Any company growing revenue should expand its earnings in tandem if they keep the costs under control. Naturally, some costs will rise with an increase in business, but eventually, earnings must outpace the costs. Another trick we can use — observe how they weather the storm.
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